Phoebe Venable: Taking the mystery out of hedge funds

Twenty years ago, hardly anyone talked about investing in hedge funds. In fact, very few investors had even heard of them. Today, approximately 10,000 hedge funds make up a $2 trillion industry and the number of billionaire hedge fund managers grows every year (there are now 46, says Forbes).

Yet when we read or hear about hedge funds, most of us really have no idea what they are. We know they’re about big money and that we’re intrigued by the wealth-invoking name.

So let’s dispel the mystery. Here’s what a hedge fund is.

A hedge fund is a pooled investment vehicle. Almost all investors are familiar with the idea of pooling assets for investment purposes because this is the basic concept behind mutual funds, in which many of us have IRAs, 401(k) plans and other retirement accounts invested. As of year-end 2012, the U.S. mutual fund industry had $13 trillion in assets under management in 7,596 mutual funds, according to the Investment Company Institute. But being pooled investment vehicles is pretty much where the similarities end.

Since the introduction of hedge funds, regulators have restricted investing in them to “qualified investors,” namely wealthy individuals and institutional investors such as pension funds, endowments and foundations. Despite all the mainstream discussion of hedge funds, only a limited portion of the population can actually invest in them — which explains why you may have known very little about them.

Unlike highly regulated mutual funds, hedge funds allow you to invest in any opportunity in any market. A hedge fund can buy and sell securities, sell short, trade options and derivatives, borrow money to enhance returns and more. Hedge funds often use complex investment techniques and trading structures that simply aren’t allowed in the world of mutual funds.

What’s in a name

The word “hedge” means to limit or qualify something with conditions or exceptions. Strangely enough, most hedge funds don’t actually hedge — though in the past they did and the name stuck. They can lose money like virtually every other investment. The primary aim of most, but not all, hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns.

Unlike a mutual fund that is priced every day in the public markets and by law must provide investors daily liquidity (i.e., you can sell at the market price daily), a hedge fund is not publicly traded and is not liquid. The typical hedge fund offers investors the opportunity to sell or add to their investment at the end of each calendar quarter. But some hedge funds only allow investors to enter or exit their funds once a year. This lack of liquidity is the most important factor to consider before investing in a hedge fund.

A general rule of thumb is that if you don’t understand it, don’t invest in it. So if you don’t own a hedge fund and were feeling left out, don’t worry. There are plenty of other investment options that are easy to access, easy to sell and easy to understand. Talk to your financial adviser about what is right for you and your family.

Phoebe Venable, chartered financial analyst, is president and COO of CapWealth Advisors LLC. Her column on women, families and building wealth appears each Saturday in The Tennessean.