BusinessReport.com

Hedge funds are like race cars. Regular people don’t get to play with them, and they take high-octane fuel to run.

Or, in the case of hedge funds, high-octane markets.

Though the performance of hedge funds—especially the bigger ones—has dropped a few RPM the past couple of years, they’re still making a lot of money for a lot of people. From the manager’s perspective, hedge funds are a gold mine partly because of the high fees they charge—as much as a quarter of an investor’s profit.

“They’re making money in ways mutual fund managers drool over,” LSU finance professor Don Chance says.

From the investor’s standpoint, hedge funds give access to unconventional markets at a time stock-and-bond markets are largely saturated and less likely to produce big windfalls compared to years past.

“There’s a massive amount of money out there looking at the stock-and-bond market and just kind of yawning,” Chance says.

Hedge funds are essentially private investment portfolios that have few if any limits on what they can invest in. Investors often aren’t told where their money is being invested and might even be restricted from pulling their money out.

Fortune magazine writer Alfred Winslow Jones invented the “hedged fund” in 1949. Hedge funds, as they’re known today, have been around for decades, though they have really caught fire only in the past 10 years or so, Chance says.

An example of the reach hedge funds give investors is commodities. On their own, an investor is going to have a tough time trading in the commodity futures market. But hedge funds can do anything they want, swooping down on all types of markets all over the world and getting out just as fast.

Unrestricted, hedge funds scour the globe for market opportunities that will yield a few nickels here, a few nickels there. They’re a lot like private equity funds, Chance says.

Hedge funds, even big ones, can be shoestring operations with just a few people. For anyone with the right contacts and salesmanship skills, a billion dollars isn’t so hard to come up with, Chance says. Of course, a billion dollars ain’t what it used to be.

Not just anybody can play. Some hedge funds won’t look at you twice unless you can come up with, say, $50,000. The minimum buy-in varies according to the individual fund, though there’s a good reason they’re mainly the preserve of the affluent. When a hedge fund implodes—as Connecticut-based Amaranth Advisors did so spectacularly in the fall—the people getting hurt can generally afford it.

“If what I give you is all I can lose, I don’t see what’s wrong with that,” Chance says. “This is not people investing their retirement savings.”

Walter Morales, president of Commonwealth Advisors, says it’s wise to check out a hedge fund thoroughly before jumping into it. On the plus side, hedge funds can generate enormous profits since they’re not bound by the same rules that restrict and essentially penalize other types of investors.

On the down side, hedge fund managers frequently are not registered with the Securities and Exchange Commission, which means no oversight and no transparency. Hedge funds that blow up tend to have the same things in common: self-administered, highly leveraged, unregistered and unaudited.

“You have to be a pretty sharp investor to be able to feel comfortable that you are not going to get ripped off in a hedge fund,” Morales says.

He recommends criminal background checks on managers. And just because a manager gets the investing side doesn’t mean he gets the day-to-day operations side. Plenty of hedge funds have launched and stalled because the people running them lack the basics of maintaining a business—meeting payroll and the like.

Also, beware of hedge funds that have gotten too large, Morales says. Once they grow to $1 billion, returns start falling.

“One of the real ironies is that some of the highest returns come from newer and smaller managers,” Morales says. “But they’re also the riskiest to give money to.”

Rest assured more hedge funds will hit the wall in due course. That’s because they’re leveraged to the teeth. Even worse than hedge funds when it comes to leveraging are something called collateral loan obligations, Morales says. All this leveraging could be bad news for the economy down the road, he adds, calling the incidence of leveraging today “dangerous.”

Chance says hedge funds are like an opiate to the managers—often young—who put them together. The smart thing to do would be make a billion dollars then get out.

But they don’t. They can’t.

Chance predicts a great shakeout sometime in the future, perhaps similar to the $1 trillion collapse of Long-Term Capital Management in 1998. LTCM, a massive hedge fund run by Nobel Prize-winning economists and renowned Wall Street traders, nearly collapsed the global financial system.

He’s not so sure the economy is in jeopardy, but can imagine a scenario in which the markets receive a good rattling.

“There was a major shake-out when Long-Term Capital Management went under,” Chance says. “Amaranth went out last year, but there hasn’t been one that rippled through the market fund after fund. I wouldn’t be surprised if something like that happened at some point.”