A Hedge fund typically uses leverage, such as options, where a relatively small amount of money can control a lot more of a security. A person who can predict the future correctly can make a lot of money. Unfortunately, I do not know of anyone who can predict the future with 100% accuracy.
What this means is that when things are going up they go up faster than the rest of the market. Conversely, when things are going down they go down faster than the rest of the market. This is illustrated by the Boyer Allen Pacific fund that is down 28% for the year while it was up 52% during 2007.
At first glance it appears that this fund is up 24%, 52% - 28%. However, this is not true and can be illustrated by starting with $1.00. If it goes up 52% then the value is $1.52. When $1.52 goes down 28% the end value is $1.52 times 0.72 = $1.08. This fund is up 8%. Everyone is happy with a 52% return. Few people are happy with a 28% drop. At a 34% drop this fund will be even.
This year some hedge funds have reportedly gone bankrupt and some hedge fund managers have been arrested. Since nobody knows the future investing in hedge funds more closely resembles a form of gambling rather than a form of investing.
The lessons learned from this article are:
- Understand what you are investing in.
- Do not chase phenomenal returns made by a fund in one year because it may very well be followed by a phenomenal correction after you purchase it. Remember the story of the tortoise and the hare.
- Buying of a hedge fund is to be avoided by the average investor who can not afford to take this much risk
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