Hedge funds for Average Joes? Yes, They Do Exist

July 12, 2009— -- Irish-American author J.P. Donleavy, in his wonderful book The Unexpurgated Code, details the difficulties of social climbing in England if you are not to the manor born. People who try to invest in hedge funds will find themselves having conversations similar to those in the book:

You:Hey, what a great hedge fund! Can I invest?

Hedge fund:No.

You:Gee, what a bunch of snobs. I've got money, and that's good enough for me.

Hedge fund:Yes, but it's not good enough for us.

Some mutual funds use similar investment strategies as hedge funds, the freewheeling, lightly regulated investment pools for the ultra-rich. Should you invest in hedge-like mutual funds? Possibly. But remember that many hedge-fund strategies depend on brilliant hedge-fund managers — many of whom are already running hedge funds.

The basic idea of a hedge fund is reasonably simple, however. A hedge is a kind of insurance bet, one that pays off if your other strategies go wrong. A hedge fund might take 80% of its portfolio and bet that certain stocks will rise, called "going long." It might take 20% of the portfolio and bet that certain stocks will fall, called "going short." In theory, if the stock market goes sour, your short positions will offset some of the losses in your long positions.

In recent years, however, the term "hedge fund" has come to mean any aggressive investment pool aimed at wealthy, sophisticated investors. Some hedge funds can invest in pretty much anything they like: currencies, futures, bonds, stocks, yaks. Others specialize in specific strategies, such as merger arbitrage, which involves simultaneously going long and short on the stocks of companies involved in an acquisition.

The fund industry has rolled out two categories of funds that borrow from the hedge-fund book:

•Market-neutral funds. These funds roughly match their long and short positions, so that their return depends on stock selection, rather than the market's broad movements. These funds have gained 0.5% this year, vs. -1.2% for the Standard & Poor's 500-stock index.