Hedge funds are like promising new drugs. They tend to be expensive and you don't know quite what they're going to do. While hedge funds can...

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Hedge funds are like promising new drugs. They tend to be expensive and you don’t know quite what they’re going to do.

While hedge funds can freely experiment with trading strategies, for most individual investors, predictable returns and lower risk and expenses are more worthy goals.

Tom Muldowney, managing director of Savant Capital Management in Rockford, Ill., says you can avoid the high costs of hedge-fund investing and lower your portfolio risk by holding no-frills index funds.

“You have to be able to lose it all in a hedge fund,” Muldowney says. “For most people, this is unacceptable. If you want to truly lower risk, you can use index (mutual or exchange traded) funds that employ much lower than average risk with modest expenses.”

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To understand why hedge funds — largely unregulated investment pools for investors with more than $1 million in net worth — are desirable for enhancing returns and lowering risk, you have to understand how hedge funds operate. The funds are allowed to make any number of bets on the market using borrowed money and derivatives, contracts whose value is tied to the value of another asset or an index.

Because hedge-fund managers aren’t locked into a fixed investment objective, they can trade in the opposite direction of the market. While this can lower market risk, it often raises the probability that managers will make bad guesses.

Costs of funds

While such freedom in managing money has its advantages, it also comes with a price. Hedge funds typically charge 1 percent to 2 percent in annual management fees and 20 percent of profits, versus an average 1.5 percent fee for conventional stock mutual funds.

A fund of funds, which owns several hedge funds, is among the costliest vehicles to own. In addition to the underlying fund expenses, these funds add another layer of charges.

You start out in a hole when investing in a hedge fund since managers charge their fees even if they fail to beat market benchmarks or lose money.

“If it (the manager’s strategy) works, he gets a compensation windfall,” Muldowney says. “If it fails, only the investor loses. This compensation model creates an incentive for the hedge-fund manager to take additional risks.”

Fund opacity

Regulation of hedge funds pales in comparison to that of mutual funds and banks.

Hedge funds with more than $25 million in assets and more than 15 clients must register as investment advisers with the U.S. Securities and Exchange Commission by February. Hedge funds in the $1 trillion industry now don’t have to report much information to investors.

“Even a moderately sophisticated investor wouldn’t have the tools to evaluate most hedge funds,” says Marshall Blume, a professor of finance at the Wharton School at the University of Pennsylvania in Philadelphia.

Blume said he is troubled by the dearth of information provided on how funds price their assets, disclose risks, and use derivatives and leverage.

“Many hedge funds play with complex, custom-designed derivatives, which are not traded often and not listed on the exchanges,” he said. “Not only are outsiders in the dark about these matters, but even the hedge funds may be unsure what these instruments are worth.”

Alternatives

Want less volatility than a hedge fund? Muldowney says you can achieve a return of about 7.8 percent — after expenses — by holding a low-cost mix of index funds. Here’s what he suggests:

• 50 percent in bonds, inflation-protected securities and international bonds.

• 21 percent in U.S. large-company growth and value stocks.

• 12 percent in U.S. small-company value stocks.

• 11 percent in international large- and small-company stocks.

• 3 percent in emerging-market stocks.

• 3 percent in real-estate-investment trusts (commercial property).

Muldowney, who has an eye on predictable returns, says “since you control the allocation, you control the target rate of return.”

Eye on risk

One of the prime selling points of hedge funds is that they may reduce market risk because managers can easily move in and out of the stock market or bet against it. That is, they can be long, short or neutral on market direction.

Yet because of poor disclosure, the risks are largely unknown.

In contrast, Muldowney’s allocation allows you to monitor and control risk and target returns. The portfolio above, for example, has a standard deviation (a common risk measure) of 9 percent. That compares with a 20 percent standard deviation for large-company stocks (from 1926 to 2004) and 33 percent for small-company issues, according to Ibbotson Associates, a Chicago-based research firm.

It’s only natural for investors to want to exploit every opportunity, especially when it involves a real or imagined market-beating strategy.

Yet more money chasing fewer investment opportunities tends to damp returns across the board. Managers also regress to the mean — in other words, one-time stars eventually become average or below-average performers, particularly after their heavy expense load is deducted.

One final bit of wisdom on hedge funds: “Some (perhaps many) hedge-fund managers are likely to prove incapable of delivering the returns that investors apparently expect.”

This observation is not from a financial planner, academic or investor advocate. You can thank Federal Reserve Chairman Alan Greenspan for this pearl.