They generate a lot of headlines but not great returns. Here’s how to get the best of what they offer and pay a lot less. By Bob Frick, Senior Editor September 1, 2011 What exactly are hedge funds? They’re private investment funds for the rich. A broader, if somewhat cynical definition comes from hedge-fund manager Cliff Asness, of AQR Capital: “Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has been making money.”SEE ALSO: Our Special Report on High-Net-Worth Investors Then why the hedge-fund mystique? It mainly comes from some big-name managers, who win and lose billions on gutsy bets and wield immense financial power. For example, hedge-fund rock star George Soros bets on how currencies will rise or fall, and he is so influential that his opinions can affect a currency’s value. John Paulson made billions by betting against mortgages. The dark side of this mystique is hedge funds gone haywire. In the late 1990s, Long-Term Capital Management goofed in its bets on European, Japanese and U.S. bonds, and it had to be bailed out under the direction of the Federal Reserve Bank of New York. Advertisement What does hedge fund mean? The first was started by Alfred Winslow Jones in 1949, and it truly was about hedging—protecting against losses. Jones figured that by buying stocks he thought would do well in the long term and then selling short stocks he predicted wouldn’t do well (a strategy to profit when prices drop), he would limit or eliminate losses. However, over the years hedge fund became an umbrella label encompassing all the strategies these funds use. Today, less than 30% of hedge funds follow Jones’s long-short strategy. We should also note that long-short funds didn’t cover themselves in glory during the meltdown of 2008. Morningstar reports that the average fund lost 18.6% in 2008, about half the loss of Standard & Poor’s 500-stock index. And their performance since the market bottomed in March 2009 has been less than one-third that of the S&P 500. What are the funds’ other strategies? Data firm Hedge Fund Research lists four major categories with 27 subcategories (and ten sub-subcategories). But hedge funds mostly do a few basic things in addition to the long-short strategy. They use futures to bet on the direction of currencies or commodities. They profit from differences in prices between two or more markets—buying cheaply in one market and selling at a higher price in another. Merger arbitrage seeks to profit from the likelihood that an announced merger will actually go through. Advertisement Because many of these strategies are risky, about one in four funds are combinations of funds, which can decrease volatility. How big is the hedge-fund market? Big. The 9,400 or so hedge funds hold just over $2 trillion in assets. By comparison, 7,600 mutual funds -- including ETFs, closed-end funds and unit investment trusts -- have about $12 trillion in assets. But hedge funds use leverage -- meaning borrowed money -- far more than mutual funds, so their impact on markets is disproportionately larger. A relatively small number of funds dominate the hedge-fund industry, with 63% of hedge-fund assets managed by less than 10% of the funds. The market crash in 2008 has stunted the growth of hedge funds. That year, assets actually fled the industry -- a first. (Investors withdrew about $154 billion in 2008 and another $131 billion in 2009.) Since then, the flow of assets into hedge funds has resumed, but it has slowed since the funds’ heyday in the 2002–07 bull market. The number of new funds is also down. Advertisement How have hedge funds performed? They’ve been mediocre, overall. A recent paper in the Journal of Financial Economics says that from 1980 through 2008, the average hedge fund returned an annualized 6.1% after fees, compared with 10.8% for the S&P 500. One of the authors of that paper, Ilia Dichev, of Emory University, says that performance is worse than it appears because hedge-fund investors tend to chase returns more than most investors. Chasing returns is a bad strategy because you tend to buy high and sell low. In the case of hedge-fund investors, it has had the effect of cutting that 6.1% return in half, says Dichev. Another concern for investors is that many funds disappear—either because of illegal activities or because they make big bets on bad strategies, lose most of their value and liquidate, often paying investors pennies on the dollar. In 2005, when investors were sending hedge funds billions in new assets, 10% of them liquidated. And then there are the fees. The standard rate is “2 and 20,” which means a fund charges an investor 2% of assets annually, plus 20% of any gains. That puts a damper on investors’ returns really quickly. Advertisement In any given year, however, some funds hit high-double-digit returns and sometimes even low triple digits. And some have built impressive long-term records. For example, multibillionaire John Paulson, of Paulson & Co., runs several successful hedge funds that routinely land on Barron’s list of top funds. For instance, his Paulson Credit Opportunities, which has cleaned up by betting against mortgage-backed securities, has a three-year annualized return of 24% through last year. Who invests in hedge funds? About half of hedge-fund assets come from individuals, who are required to be well off. The rest comes from institutions and family foundations. So, should I invest in a hedge fund? First, you have to qualify. Second, are you serious? After all you’ve just learned about the risk, returns and sky-high fees? Nevertheless, some financial advisers suggest that if you have a portfolio of at least several million dollars, you should put 10% to 15% in hedge funds, diversifying among several or buying a fund of funds to minimize the risk. The sensible reason isn’t because you want a shot at multiplying your millions, but because hedge funds represent assets that are different from standard stocks and bonds. Adding different types of assets to a portfolio reduces its volatility. How do I invest in a hedge fund? By law, hedge funds can’t advertise, so you have to seek them out. Your broker or financial adviser can put you in touch with a hedge fund, or with firms that vet funds and match them to clients. What if I want the benefits of hedge funds but don’t have the money or don’t want to take the risk? You’re in luck. Many investment companies have started so-called alternative mutual funds that follow hedge-fund strategies. At last count, Morningstar reports 247 alternative mutual funds. In fact, as the hedge-fund business continues to lick its wounds after the 2008–09 drubbing, many hedge-fund managers are looking to start mutual funds, often partnering with existing mutual fund companies, to get new sources of assets. Mallory Horejs, an alternative-investments analyst at Morningstar, says that “investors are psychologically driven right now for downside protection,” which makes them ripe for what hedge-fund strategies offer. Horejs also says that assets that don’t follow the up-and-down moves of the traditional stock and bond markets are “definitely compelling” to investors hungry for less volatility. However, she notes, most of the alternative funds swarming the mutual fund space aren’t worthy of your consideration. “There’s a lot of bad product out there,” she says. You’d do well to wait a few years, when many more funds will have longer track records. In the meantime, consider these 5 Hedge-Fund Lookalikes. We’d recommend placing just 5% to 10% of your assets in a couple of them. Once you get used to their unique rhythms, you could expand your holdings as the selection of good alternative funds increases and your confidence in them grows.