Hedge funds.Billionaire investor Warren Buffett thinks they're a fad, while fellow billionaire George Soros used them to strike it rich. Hedge funds are controversial, complex and often shrouded in mystery. And while they've long been a secret haven for the ultra-wealthy, mainstream investors are starting to take notice.

Hedge funds are unregulated private investment vehicles that share some common traits. They're typically organized as limited partnerships or limited liability companies, charge performance-based fees, and restrict participation to a defined number of institutions and wealthy individuals.

But here the similarities end.

Because they're unregulated, hedge funds can invest in anything they want. Domestic stocks, global bonds, derivatives, currencies, sub-prime auto loans - you name it and there's probably a hedge fund somewhere investing in it. There's even a hedge fund starting soon that will gamble investors' capital by making Vegas-style casino bets. In fact, there are now over 7,000 hedge funds with about $870 billion in assets - up 260 percent in the last five years, and over 30 percent this year alone.It's easy to see why investors like hedge funds. They can invest in areas where few mutual funds dare tread - like arbitrage, distressed securities, and currencies. They can boost returns with leverage, hedge positions using sophisticated risk-management strategies, and rotate among investments at will. Plus, there's always been a certain prestige in using exclusive investment funds run by legendary financiers like Soros, Julian Robertson and Paul Tudor Jones.

The returns aren't bad either. For example, since 1988, the Van U.S. Hedge Fund Index has produced compound annual returns of 16.7 percent, versus 12.3 percent for the S&P 500. And according to data published by Big Four firm Ernst & Young, the top decile of hedge funds registered compound annual returns of over 30 percent from 1998 to 2003, dwarfing returns for the top mutual funds and major stock indices.

Also, because hedge funds often focus on risk management and non-correlated investments, they avoided much of the recent bear market's carnage. For instance, the CSFB/ Tremont Hedge Fund Index registered single-digit gains each year from 2000 to 2002, while the S&P 500 dropped an average of 10 percent per year. "One major advantage of hedge funds is their ability to help reduce risk during market downturns," said John Bagley, a CPA with Strategic Wealth Advisors in Scottsdale, Ariz.

But hedge funds aren't for everyone. In fact, they're only legally allowed to accept "accredited investors" - those with a net worth over $1 million or whose net income exceeds $200,000, or $300,000 for couples. Most funds also require minimum initial investments of at least $250,000. Investors who don't meet these criteria can still access hedge funds using "hedge funds of funds" - investment pools that spread capital among several different hedge funds that often have lower investment thresholds.

Hedge funds are also expensive. They generally charge up to 2 percent of managed assets, plus 20 percent of fund profits as an incentive fee. Well-known funds with strong track records often charge much more. If you want to invest in multiple hedge funds using a fund of funds, expect to pay an additional 1 percent to 2 percent of assets, and another 5 to 10 percent in incentive fees to the fund of fund's manager. And these fees only work one way - if the fund makes money you pay the incentive fee, but if it loses money, it doesn't owe you a dime.

Liquidity is also a problem. Unlike mutual funds, there's no public market for hedge fund units, nor can they be easily redeemed. Instead, each fund creates its own redemption rules, often requiring investors to lock up their initial investment for a year, and thereafter only allowing quarterly redemptions. This creates problems for investors who need ready access to their capital or want out of an under-performing fund.

"Hedge funds aren't very tax efficient," said Mark Patterson, a CPA and tax expert with Stockman Kast Ryan + Co., in Colorado Springs, Colo. "They frequently have high turnover, which generates lots of short-term capital gains. This frequent trading can also impact whether dividends qualify for preferential tax treatment. And like mutual funds, investors have very little control over when gains and losses are recognized."

"There's also a danger a hedge fund will simply close its doors after several quarters of poor performance," he said.

In fact, a recent study by Burton Malkiel of Princeton University and Atanu Saha of Analysis Group found that of the 604 funds reporting data in 1996, under 25 percent are still around today. They also estimate that more than 10 percent of funds close each year. While this financial Darwinism helps weed out weak funds, it can cost trapped fund participants most of their invested capital.

Finally, because hedge funds are unregulated, it's hard to get reliable information on them. They aren't required to file periodic performance reports or disclosure statements with the Securities and Exchange Commission. And while several firms like CSFB/Tremont and Van Hedge Fund Advisors compile hedge fund data, funds aren't under any obligation to provide complete or consistent information. Moreover, some of the aggregate data must be taken with a grain of salt, since it often excludes under-performing funds that have closed. The Malkiel study estimated that this "survivorship bias" exaggerates aggregate performance by 3.74 percentage points.

This regulatory void has also contributed to a growing incidence of misconduct. During the past five years, the SEC has brought over 50 cases against hedge fund advisors for allegedly defrauding investors of $1.1 billion. And while the SEC recently imposed stricter regulations starting in 2006, it's unclear how much this will help.

One thing is clear - hedge funds are here to stay and will continue to generate interest among investors. "Increased regulation, heightened media scrutiny, and market forces will all help make hedge funds more transparent and accessible to individual investors," says Bagley. "Ten years from now, the hedge fund industry will look far different than it does today."

David A. Twibell, J.D., is the president of Flagship Capital Management (www.flagship-capital.com), a portfolio management and wealth advisory firm in Colorado Springs, Colo., that specializes in risk-controlled investment strategies. Reach him at (719) 785-4832.

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