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Hedge Funds and Mutual Funds: Some Further Thoughts

Why should investors be interested in what hedge funds are doing given that the average investor cannot invest in one? Brian McQuade of Hedge Fund Center provides some thoughts.

1. Hedge funds vs. mutual funds - structure: The primary difference is the legal and regulatory structure that a hedge fund operates under. A hedge fund is largely unregulated, whereas a mutual fund is very highly regulated. Given that, hedge funds are allowed to engage in activities that mutual funds can not, which would lead some to believe that hedge funds are more risky.

2. Hedge funds vs. mutual funds - marketing: Hedge funds marketed in the U.S. can only be sold to "accredited investors" as per the SEC. To be "accredited" an investor must have a net worth (assets - liabilities) in excess of $1,000,000 or have an income of at least $200,000 ($300,000 if married). Why is this? The SEC, as a securities regulator, is out there primarily to protect "the little guy." So, an investor that has a lot of money to invest, according to the SEC, should be expected to make more informed decisions and take on higher levels of risk.

3. Hedge funds vs. mutual funds - transparency: An investor can visit hundreds of web sites to get stock quotes and ratings on funds from Lipper and Morningstar. No such independent rating organization exists for hedge funds. Also the SEC restricts the online viewing of performance data to accredited investors.

4. What is leverage and the risks of leverage? Leverage involves borrowing money that you don't have and investing the borrowed funds. Examples include people who use margin accounts and mortgages. Numerical example: If you have a dollar and you borrow another dollar you have $2 to invest. If you invest and it pays off, your $2 may turn into $4. You can pay your $1 loan back and keep $3. You have just made 200% on your money, versus only 100% if you did not borrow (or leverage) with that dollar. The risk is that the markets turn against you and your $2 investment is worth, say, 50 cents. You then can cash out at 50 cents, but you still have to pay back your $1 loan.

5. Implications of leverage in hedge funds vs. mutual funds: Mutual funds are limited in the amount of leverage they can take on by the SEC. For the moment, hedge funds are not, but that is being looked at by the Fed and Congress. Long Term Capital Management is a victim of leverage that did not pay off.

6. What should the average investor take away from the recent happenings to Soros, Robertson, etc.? The average investor should realize that the strategies employed by these managers haven't worked in the recent past. As an example, many pundits are saying that "value is dead." That's not necessarily true. Value is "out of favor" and it is hard to predict when it may come back in style. Lessons for investors: stay diversified, stay educated and don't try to time the market based on what professional investors are doing. By the time information about what these professional investors are up to is reported, its safe to assume they are working on a different strategy.

7. Effects on market because of hedge fund activities? Although leverage, short-selling and other speculative activities are employed by hedge funds, the average investor should not worry about the stability of financial markets because of a few bad apples that have made the headlines.

8. Information for investors that are allowed to invest in hedge funds: Given the information gap between mutual funds and hedge funds, it is critical to perform due diligence on hedge funds. What we recommend to visitors at Hedge Fund Center is that they review the offering memorandum carefully, check for audited financial results, review the firm's Form ADV (if the manager is a U.S.-based registered investment advisor) and inquire about how bumpy the ride has been (what was your worst month or quarter, e.g.). Just because a hedge fund is allowed to do things that mutual funds cannot, that does not make them riskier - it just depends on the strategy the manager is using.

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