Affordable Hedge Funds

By Daniel Kadlec

One of the best ways to make money and reduce risk in today's choppy market is through a classic hedge fund: one that bets on some stocks to go up and others to go down. Since January 2000, when the Dow peaked, hedge funds have risen 13% on average, while the typical stock has fallen 20%, reports Hennessee Group, a hedge-fund tracker. Over the past three years, assets in the 6,000 U.S. hedge funds have more than doubled, to $563 billion.

Most of that money has flowed in from the very wealthy, who can pony up the $1 million minimum investment required by the typical hedge fund. But Wall Street is making hedge funds and similar investments more accessible to the merely well-off. That's a welcome development, but it's one that requires some caution about fees, returns and types of funds. Hedge funds come in many varieties and are by no means a sure thing--especially those that use a lot of leverage and make big bets. Recall the disastrous collapse of freewheeling Long-Term Capital Management a few years ago. Even George Soros has had trouble from time to time. Focus on ones that seek to hedge against market risk. They usually trounce the market when times get tough. Here's how to play:

HEDGE FUNDS. These investment vehicles are lightly regulated but can accept only 99 "accredited" investors who have at least $1 million in net worth, excluding home equity. A typical hedge fund charges an annual fee of 1% of assets invested, plus 20% of profits. More hedge funds are opening to those with "just" $100,000 to $250,000 to invest, but these are mainly new funds or those with lackluster performance. One strong exception is JLH Capital Investment, a "market-neutral" fund that requires a minimum stake of $250,000. A similar fund is Gryphon Partners, with a $200,000 minimum.

FUNDS OF HEDGE FUNDS. These vehicles reduce risk by owning slices of many kinds of hedge funds, from those focused on classic long-short strategies to ones that specialize in arbitrage, pairs trading or specific market sectors. Funds of funds not registered with the Securities and Exchange Commission (sec) are run much like straight hedge funds. Many have dropped their minimums to $250,000 or less. In this class, Aurora, P&A Diversified and Stellar Partners have each risen more than 50% over the past three years. One advantage with funds of funds is that they have access to the best managers, who charge high minimums. The big drawback is that you pay two layers of fees: one to the fund-of-funds manager, who in turn gets charged by each fund in the portfolio.

The latest wrinkle is funds of funds that are registered with the SEC. These are subject to stricter reporting and disclosure requirements and must have a board that looks out for shareholder interests. Investors must still meet the net-worth test, but the number of investors is unlimited. Minimums run as low as $25,000. The biggest player is UBS PaineWebber, which manages $3 billion like this. Similar funds are sold at banks and other firms. In addition to management and profit fees, they may carry sales charges up to 5%.

LONG-SHORT MUTUAL FUNDS. A handful of ordinary mutual funds also employ long-short strategies. Funds like Merger Fund and Calamos Market Neutral have trounced the market for three years. These kinds of funds may carry hefty sales charges. But they do not have onerous incentive fees, and minimums are as low as $2,000. These mutual funds face modest restrictions on their use of leverage. But that makes them less risky--a major attraction in any kind of long-short fund.