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The Pros and Cons of Hedge Fund Investing

Hedge funds get a lot of hoopla. They're sexy. They're elite. Christian Bale stars in Hollywood movies about them. But just because they're glorified doesn't mean they're worth the hype. What's all the fuss all about?

Unlike mutual funds, the average American can't invest in hedge funds. There are extremely high investment minimums, often in excess of $1 million. Some of the less exclusive funds may require a down payment of "only" $100,000 or so, but that can actually be a warning sign.

At the same time, the concept of the hedge fund is a beautiful thing: In up or down markets, they're supposed to make money. That's why hedge fund managers make the big bucks.

[See: 13 Money Hacks to Turbocharge Your Investments.]

As with anything, hedge funds have their pros and cons. Let's take a look at some of the bigger ones, starting with the pros:

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Pro: Hedge funds are flexible. The access to obscure financial instruments is probably the biggest advantage hedge funds have over traditional mutual funds.

"There are lots of strategies, merger arbitrage, for example, that offer modest returns at very low risk," says Richard Spurgin, associate professor of finance at Clark's University Graduate School of Management. "Hedge funds can use leverage in order to gear up the strategy so that the returns are more attractive and the risk is still at an acceptable level. Mutual funds can't do this because the law limits their use of leverage."

You didn't see many mutual funds making big bucks betting against subprime mortgages during the 2008-2009 financial crisis, but the hedge fund industry was able to use esoteric financial instruments (and leverage) to their advantage.

Pro: Hedge funds offer diversification. The major clients that frequent hedge funds don't want their portfolios to go up and down with the net worth of the average investor. These major clients often include pensions, endowments and other high net worth investors with more money than you can imagine.

"The typical annual payout for a pension plan is 4.5 percent," says Kumar Venkataraman, at the Cox School of Business at Southern Methodist University in Dallas. That means pension plan retirees or university endowments are due $45 million every year in a $1 billion fund.

"Add annual inflation of 2 percent and an objective to grow the assets by 2 percent. Thus, the target return is 8.5 percent." That is a tough rate of return to achieve in a typical portfolio of 60 percent stocks and 40 percent bonds, particularly in today's low interest rate environment.

"That is what hedge funds promise -- a significantly higher return than bonds, but also a low correlation with stocks. Thus one can view the growth in hedge funds as an unintended consequence of the low interest rate policy of central banks," Venkataraman says.

Con: Hedge funds have high fees. The flexibility and ability to diversify one's overall portfolio comes with a high cost. In fact, hedge fund fees are unlike those seen anywhere else in the world of investments.

Bill Robertson, a portfolio manager on Covestor, a Boston-based online investing company and CEO of Big River Capital Management, says that hedge fund fees doubled when massive institutional demand flooded the industry.

"Fees doubled from the traditional 1 percent management fee with a 20 percent performance fee (known as 1/20) to 2 percent management fees with 20 to 50 percent performance fees," he says.

[Read: 9 Steps to Take Before Retirement.]

That's an astronomical cost. Rain or shine, bull or bear market, every year your fund manager gets 2 percent of your assets. With index funds like Vanguard demanding just 0.2 percent annually, you better be confident the pros of hedge funds are worth 10 times index funds -- and a 20 percent (to 50 percent) cut of your upside.

Con: Hedge funds tie up your money. "Investments in hedge funds often have lock-up periods that don't allow investors to withdraw their funds. And withdrawals can only be made at certain intervals such as quarterly or biannually," says Robert R. Johnson, president and CEO of The American College of Financial Services in Bryn Mawr, Pennsylvania.

While it's true that your traditional hedge fund investor shouldn't find themselves in a big money crunch, things happen. You can buy or sell into a mutual fund or low-cost exchange-traded fund any day of the week. Waiting six months to get your dough back is a major downside you don't see in many asset classes.

Con: Hedge funds have high tax burdens. No one likes paying taxes, and when you're shelling out 2 percent and 20 percent fees already, ponying up to Uncle Sam can be painful -- especially when much of hedge fund returns can be taxed at ordinary rates up to 43 percent. That's a major cost, considering long-term capital gains tax amounts to just 15 to 20 percent.

[See: 8 Easy Ways to Make Money.]

With taxes amounting to yet another fee, the cons are certainly serious enough to make an investor question whether the pros make hedge funds a worthwhile investment at all. If you're mulling moving some money over to the hedge fund world, do yourself a favor and talk to a qualified financial advisor before making any moves.



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