How do the rich get richer? They hedge their investment bets using hedge funds!

You don't hear too much about hedge funds if you're not an "accredited" investor or "qualified purchaser" with millions in investment assets. But there certainly are a lot of investors who fall into that category and are willing to pay significant fees to get into a hedge fund.

The term "hedge fund" is used to define an investment vehicle that is exempt from registration under the Securities Act of 1933 and the Investment Company Act of 1940 — and all the protective regulations of those laws. Thus, these "alternative" investments can be offered only to a small number (fewer than 100) sophisticated investors.

According to industry source Barclay Group, hedge fund assets have grown from $323 billion in 2000 to more than $1.8 trillion last year. And the number of funds has grown during the last seven years, from around 550 to well over 13,000.

Hedge funds use varying strategies in their efforts to outperform market benchmarks, such as the S&P 500 stock index. Some take "short" positions to offset their ownership of stocks. Others use futures and options to hedge their outright stock purchases. Most don't explain exactly how they intend to "beat" the market — and they aren't required to divulge their strategies.

Hedge funds typically charge performance fees of 20 percent of the profits, plus an annual management expense of about 1.5 percent. And, unlike traditional mutual funds, hedge funds are not required to report their results publicly. Many funds that lose money quietly go out of business. And hedge funds are not liquid; many allow withdrawals only monthly or quarterly.

Choosing a Hedge Fund

Morningstar, the Chicago-based company that rates traditional mutual funds, has just launched proprietary hedge fund performance ratings for thousands of hedge funds and 17 hedge fund indexes it created. The categories are based not only on the funds' self-descriptions, says John Reckenthaler of Morningstar, but also on historical performance correlations.

Because hedge funds are reluctant to reveal their positions, if not their strategies, this is admittedly a difficult task. Reckenthaler suggests these Morningstar Hedge Fund ratings are a "starting screen" and not the only way to judge hedge funds.

Chicago money manager Kay Torshen, president of Torshen Capital Management LLC, specializes in choosing hedge funds for her clients, who range from wealthy individuals to endowments and pension funds.

Even John Templeton, of international investing fame, asked Torshen to select some of his hedge fund investments.

Torshen brings a lifetime of trading experience to this task, having started trading on the floor of the Chicago Board Options Exchange in the late 1970s and then building a specialist firm on the Midwest (Chicago) Stock Exchange that handled millions of dollars worth of transactions a day.

When she sold her company in 1993, Torshen turned her trading experience to evaluating the complicated strategies proposed by hedge fund managers. She's known for her ability to ask penetrating questions and probe any weakness in their hedging plans.

Torshen warns: "Hedge fund managers are unusually sophisticated and intelligent and can tell an attractive story. It's very important to evaluate the risk objectively and not get carried away by the glamour."

Hedge Fund Warnings

She notes that the current volatile markets make investing in a hedge fund even more complicated. Some hedge funds may lose their investment talent because they need to recoup current losses before paying bonuses to managers out of profits. And valuation of investments inside the hedge fund may be difficult, requiring managers to make estimates.

But Torshen also says tough times, like current market conditions, provide great opportunities for hedge fund managers and investors. Well-performing funds that have been closed to new investors are seeking additional capital to take advantage of distressed situations.

So how do you pick a hedge fund? Having penetrated the inner working of hedge funds, Torshen's advice is valuable. "Don't assume that the fund's strategy works, that it works in all market conditions, or that they will have the discipline to execute it in all market conditions," she says. She suggests investors diversify — spreading their capital among well-chosen hedge funds with different market strategies — or a fund-of-funds.

Of course, stellar past returns are not guaranteed to be repeated in the future. And don't forget stories of hedge funds that collapse completely, losing almost all of their assets — such as Long Term Capital Management or Amaranth.

There's a reason hedge funds are limited to sophisticated investors: They can afford to lose! And that's The Savage Truth.

Terry Savage is a registered investment adviser and is on the board of the Chicago Mercantile Exchange. She appears weekly on WMAQ-Channel 5's 4:30 p.m. newscast, and can be reached at www.terrysavage.com. Her new book, "The Savage Number: How Much Money Do You Make?" has just been published. To find out more about Terry Savage and read her past columns, visit the Creators Syndicate Web page at www.creators.com.

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