Risks Reach This Growing Arena

Hedge funds, once seen as an exotic investment, have become more of a household name. But that doesn't mean investors should overlook the risks of these funds.

Who could forget Amaranth Advisors?

The six-year-old fund was one of the biggest U.S. hedge funds last year, with investors such as Credit Suisse Group, Goldman Sachs and the Morgan Stanley Institutional Fund of Hedge Funds.

Yet in late September, the Greenwich, Conn., firm closed up shop after losing nearly $6 billion in less than a month.

Its energy bets plunged as natural gas prices did.

Back in 1998, the collapse of Long Term Capital Management stunned Wall Street and shook up the global financial markets.

Yet the number of hedge funds keeps growing. They more than doubled from 6,000 in 1999 to 10,000 last year, estimates Greenwich Alternative Investments.

The beauty of hedge funds is they can go long or short in stocks. The funds are free to invest in other assets such as futures, options and emerging market debt. So they can do well even when the stock market is down or stuck in a rut.

The downside? Despite their booming growth the past decade, hedge funds draw little regulatory oversight. They don't have to register with the Securities and Exchange Commission, like mutual funds do. Hedge funds don't have to report their assets, performance or other data.

Also, because many hedge funds are young, they have no track record for potential investors to consider.

"You have to do your homework when buying into a hedge fund," wrote Ann Logue in "Hedge Funds for Dummies." "You have to ask a lot of tough questions about who the fund manager is, what he plans for the fund's strategy, and who will be verifying the performance numbers."

Many folks are protected -- in that not anyone can buy into a hedge fund. As of now, only those with a net worth of at least $1 million or an annual income of $200,000 or more can invest.

Late last year, the Securities and Exchange Commission proposed adding a requirement that you must also have at least $2.5 million in investments, excluding real estate, to qualify as a hedge fund investor. That could help slash the number of qualified households.

On Feb. 23, federal officials gave guidelines that fund investors and institutions should follow, but set no rules. They said hedge funds should be limited only to the wealthy.

"These guidelines should serve as a foundation to enhance vigilance and market discipline further," Treasury Secretary Henry Paulson, who heads the President's Working Group, said in a written statement.

High minimums may limit who can buy into hedge funds. But strong demand has led to hedge funds of funds, which are hedge funds that invest in other hedge funds. These tend to have lower minimums of about $25,000 and file reports with the SEC twice a year.

Fees can add up. On top of a management fee, investors often must pay underlying fees for each of the hedge funds.

Also, because hedge funds tend to borrow large amounts of money to invest, they can boost their gains or incur hefty losses.

So you could make -- or lose -- a lot of cash.

If you meet the minimum financial requirements and are still intrigued by hedge funds, what steps can you take before making the jump?

To start, Logue recommends asking hedge fund managers detailed questions about investment strategy, performance, risk management, fund operations and compliance. Also, don't forget to closely study any literature you receive.

"Beware the hedge fund that gives investors no information or that refuses to agree to an annual audit -- that's a blueprint for fraud," Logue said.

She suggests calling a fund's former employees and current investors, and confirming what's on the fund manager's resume. A Web search may also uncover more info on the fund or the manager.

Sites Logue mentions include:

sec.gov/divisions/enforce.shtml (SEC).

nasdbrokercheck.com (National Association of Securities Dealers).

nfa.futures.org/basicnet (National Futures Association).

Copyright 2007 Investor's Business Daily, Inc.