Beware of Hedge Fund Investing
Have you ever heard the saying, "If it's too good to be true, it probably is"? This is also representative of hedge funds.
A hedge fund is usually a private investment set up as a management portfolio. A group of investors puts money into the hedge fund, which is controlled by a hedge fund manager. The manager or other managers of the fund use aggressive financial strategies to increase their investments to millions, many times billions, of dollars. These aggressive strategies have a high amount of risk, but are supposed to be extremely profitable if managed correctly.
To enter or invest in a hedge fund, often times the investor must have at least a million dollars to put into the fund. That is why hedge funds are mostly for the very rich.
However, some hedge funds are poorly managed. Many funds start to invest heavily in leverage, or the amount of debt. This strategy can prove quite profitable if managed correctly, yet even the world's most renowned financial experts cannot control leverage when it spins out of control. For example, in the collapse of the 2004 Bailey Coates Cromwell Fund, bad stock choices prevailed. As a result, "...poor decision making involving leveraged trades chopped 20% off of a $1.3-billion portfolio in a matter of months. Investors bolted for the doors and on June 20, 2005, the fund dissolved..." (Investopedia).
Another significant hedge fund mistake is putting all your eggs in one basket. In other words, the risk is not spread out and the investment portfolio is not diversified. As any reputable financial adviser will tell the average Joe, he or she must have multiple investments. However, many hedge fund managers and investors decide to move all of the fund's money into one single investment. This is never a good strategy and often fails in the end.
Many of the largest hedge funds have collapsed due to arbitrage. Arbitrage is when an asset is both sold and purchased at the same time. Investors try to exploit the price difference between the sale and the purchase. This strategy is what brought on the most famous hedge fund collapse in history (to date). Long-Term Capital Management collapsed due to millions of dollars of investments in Russian markets. When Russia defaulted on its debt in 1998, Long-Term lost $4 billion -- all due to the arbitrage strategy. The most stunning part of this collapse was the managers behind the fund were Nobel Prize-winning economists and world renown financial experts.