Financial Literacy - Retirement income planning
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Hedge funds for the average investor

Aside from the standard meat-and-potatoes equity and fixed-income investments that should make up the portfolios of most people, several alternative asset classes are available to individual investors.

Alternative assets are a good diversification tool because they're generally not correlated to the stock market. This means when the market goes down, alternative assets may go up or stay the same and vice versa.

Large investors such as pension and endowment funds have been attracted to hedge funds because of their reputation for producing high returns. But it's difficult to tell how successful hedge funds are because the historical data leaves much to be desired.

"They are self-reported. Indexes of hedge fund performance are biased by the fact that those that do poorly go out of business and those that do well stay in business," says Walt Woerheide, Ph.D., CFP, vice president of academic affairs and professor of investments at The American College in Bryn Mawr, Penn. "And so when you look at the index over time, it's really an index of those that have done well."

Though people refer to hedge funds as a single category of investment, they actually follow different strategies that try to beat the market.

"One may engage in bankruptcy situations. Another may be involved in merger and acquisition opportunities. The variety of strategies that hedge funds follow is all over the place. It's not a homogenous type of investment," says Woerheide.

'Alternative' investments
  1. Long-short funds.
  2. Commodities.
  3. Multistrategy funds.

Like actual hedge funds, hedge-like mutual funds also follow various strategies, but they are much more transparent and less controversial than their brethren. In general, they're more expensive than other stock funds, charging 2.04 percent a year on average, versus 1.47 percent for actively managed stock funds and 0.78 percent for equity index funds, according to Morningstar. Some hedge-like mutual funds cost as much as 3.89 percent, and a couple cost more than 5 percent annually.

That's cheap compared to real hedge funds, though.

"They get something like a 2 percent fee and then 25 percent of the profits if they make money. And then nothing happens if they lose money," says Woerheide.

Albert Chu, chief investment officer for Wealthstone in Columbus, Ohio, believes that getting exposure to the asset class is worth the fees in some cases.

"We index our large-cap managers since they tend not to outperform and with those savings we're going to allocate some fee dollars to some of our alternative strategies," he says.

Should you choose to dabble in these alternative investments, be sure to investigate them thoroughly or get some good advice from a trusted adviser.

Long-short funds

According to investment research company Morningstar, about 75 mutual funds employ hedging strategies.

"The easiest example of an alternative strategy is going to be a long-short fund or opportunistic equity," says Chu, a chartered financial analyst and chartered alternative investment analyst.

A long-short strategy involves investing in stocks with positive prospects (making long bets) as well as stocks that are expected to decline in value.

"If a portfolio manager has a group of stocks, they're going to go out there and buy their best ideas and hope they rise in value. And that is a long (bet)," Chu says.

Then if they find some challenged companies, the fund managers will short those companies and put together a long-short portfolio.

Here's how short-selling works: The investor can use leverage, by borrowing money on margin from his broker, to borrow the stock at a certain price and sell it to someone else. When the stock price drops, the investor buys the stock at market price, gives it back to the broker and pockets the profit.

Short-selling is a highly risky strategy, because if a stock goes up instead of down as expected, the investor's potential for loss is unlimited.

Long-short funds are the most widely available hedge strategies in mutual funds, and most don't require big minimum investments.

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"You're going to have a different return pattern than the overall stock market," says Chu.

Recent history bears this out. Long-short funds outperformed the S&P 500 during the 17-month bear market that ended March 9, 2009. The hedge-like mutual funds lost 15 percent on average while the broad market plummeted 43 percent.

Long-short funds also haven't rebounded as much either. Since March 10, the S&P gained 50 percent through mid-August, while long-short funds advanced 16 percent.

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