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investment companies and hedging risks According to the Encarta Dictionary, to hedge means "to take measures to offset any possible loss on a financial transaction, especially by investing in counterbalancing securities as a guard against price fluctuations."

And that's just what a hedge fund is designed to do — to minimize exposure to market risk and thereby boost investment returns.  To do that, hedge fund managers employ a number of counterbalancing techniques, including combining long and short equity positions, investing in distressed or bankrupt companies, investing in derivatives (including options and futures contracts), and investing in privately issued securities.

But hedge funds have long been labeled as being highly risky investments — precisely because of the investment techniques their managers employ.  Proponents counter that hedge funds — which typically seek positive returns irrespective of the overall market trend — are a good way to beat the market when compared to mutual funds, whose performance mirrors the overall market's performance.

Certainly, mutual funds are more popular than hedge funds, with more than $8 trillion in assets in the USA, compared to $1 trillion held in hedge funds.  That could also be due to the fact that hedge funds are typically limited to very wealthy investors, with investable assets of more than $1 million.

The U.S. Securities and Exchange Commission recommends asking six questions when considering a hedge fund investment:

  1. Read the fund's prospectus and related materials.  Make sure you understand the hedge fund manager's strategies — know where your money will be going.
  2. Understand how the fund's assets are valued.  Valuation of hedge fund assets is not always straightforward; understand before you invest.
  3. Know what you'll be paying in fees.  Hedge fund managers may take 20% of the fund's profits as their performance fee plus 1-2% of invested assets.
  4. Understand any limitations on your right to redeem shares.
  5. Research the background of the hedge fund manager.  Prior to 2004, hedge fund managers were not required to register with the SEC.  Since February 2006, though, all hedge fund managers should be registered.
  6. Ask questions.  If you're investing in a hedge fund, you're likely investing a lot of money; you have a right to know where your money is going and who will be managing it.
For more information on hedge funds, check out the Managed Funds Association website.
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