Insider Jeff Fleming

Evaluating Your Options

In fast moving markets, you'll hear a lot about hedge funds. This week, Jeff explains how hedge funds operate. Plus, how to handle retirement investments in a volatile international market.

Dear Jeff:
The term "hedge" has been used for several decades to refer to a house increasing in value along with inflation and protecting its owner.

What is a hedge fund? Does it protect one from inflation? Is it a type of growth fund? Thanks for your comments,

Roger

Jeff Says:
The word "hedge" might be used in reference to a house only if you are talking about its bushes. Hedge in the investment context, however, means to minimize the effects of a possible loss by investing in something that should act in an opposite manner.

For instance, stock investments serve as a hedge against inflation due to their historically higher returns. A little more complicated hedge would be to buy a stock that you think will increase in price and simultaneously buy a put option. The put option allows you to sell a security at the exercise price stated in the option if the actual price of the security falls. If the price of your stock goes up, you sell it for a profit minus the price of the option. If it goes down, you exercise your option. At a minimum, the option substantially reduces the loss. In other words, it was the hedge against a downward trend in the price of the stock.

If that is not aggressive enough for you, consider using borrowed money for both sides of the transaction. This allows you to leverage your returns to incredible levels, both up and down. Whew! Is that intimidating or what? I was nervous just writing it.

Hedge funds buy stocks and options using these techniques and others, including selling short other stocks of the same industry in which it holds stock. The intended result is to earn positive returns regardless of stock market fluctuations or changes in interest rates.

Keep in mind, however, that hedge funds are not mutual funds. They are private limited partnerships run by the general partners. For their efforts in handling the trading activity and day-to-day administration, the general partners are compensated primarily from a percentage of the profits. This is certainly a good incentive for them to make the fund profitable.

Investors are called limited partners and must be sophisticated accredited investors, due to the inherent risks associated with short selling and options. This limits the amount of publicity hedge funds receive, but the primary reason for the limited information is that hedge funds are prohibited from advertising. Instead, they raise money through the use of consultants who have qualified purchaser clients for which hedge funds may be suitable. So, unless you fit into the accredited investor category, hedge funds will not be an investment option for you.

Investing for Retirement