By YOUNG MONEY Staff
28 June 2011

The financial market has developed into a relatively complex interweaving of assets and financial tools designed around them. The broad variety of derivatives is designed to allow investors to hedge against potential losses, keeping the market running even through unexpected shocks. Hedge funds are meant to be a means of tapping into these powerful tools to actively manage money to find the best returns. Forbes' Rick Suarez suggests that most hedge funds rarely live up to this promise and as a group they rarely merit serious investment.

Any kind of investment raises the question of risks versus rewards. For hedge funds, however, this calculation becomes difficult - if not impossible. Most such funds disclose very little of their investment strategy, out of concern that other firms could adopt parts of it. For investors, though, this means that expected returns can only be taken on faith and previous performance, which is hard to necessarily pin to the company's strategy. Looking at the industry more generally, the tendency for companies to report profits only at the best of times and failure to include shuttered funds both skew perceptions of overall success.

Suarez cites lack of liquidity, or the ability to transfer assets from one class to another, as a concern for both hedge funds and their investors. As funds seek the absolute maximum return on all the assets in the fund, many turn toward financial instruments with high returns and limited ability to withdraw money. In particular he notes the use of auction rate securities, which include high fees and limited opportunities for many withdrawals, though many funds failed to realize this.

Ultimately Suarez notes that the cost of these funds rarely matches the returns they see, often charging 2 percent of all assets and 20 percent of all profits. Funds that hold portions of other funds can prove even more expensive. In this case, hedge funds must perform substantially better than the market, simply to meet the same returns and in a down economy they can ultimately cost more than a mutual fund that has performed just as poorly.

Nonetheless, hedge funds have been increasing in popularity. The Financial Times reports that a Citigroup survey found hedge funds as a whole added $85 billion in assets last year, with mid-size funds growing by 37 percent. The New York times reports that the market stands to shift substantially as a growing number of funds fall under Securities and Exchange Commission regulation. New rules would force any funds with more than $150 million in assets to register with the regulator.