Hedge Funds have been a hot investment lately. Once reserved for the very wealthy, hedge funds now have minimum investments as small as $10,000. Should you jump onboard the hedge fund bandwagon, or let this latest investment craze pass you by?

Hedge funds are pools of private money that use specialized investment strategies in an attempt to earn greater returns for their investors. They can invest in just about anything in an attempt to make money. Usually, hedge fund strategies include the ability to short the market so they can profit by correctly timing market declines.

Hedge funds have become popular because, historically, some have returned over 20% per year. As a result, the number of hedge funds has grown dramatically the last few years. Many successful mutual fund managers have left fund companies and started their own hedge funds. Since hedge fund managers often receive as much as 20% of the gains, the managers can make a lot more money.

Hedge funds are normally structured as a partnership or a limited liability company. As such, only ‘accredited’ investors can participate. An accredited investor is someone with over $1,000,000 in investable assets or an annual income over $200,000 per year.

Not a lot of people fall into this category. And Wall Street knew those high returns would be an easy sell to other investors. So they created a fund of hedge funds. Think of it as a mutual fund that invests in hedge funds. Voila, small investors now have access.

Don’t let the attraction of high returns tempt you into investing in a hedge fund or a fund of hedge funds. I believe they are unsuitable for almost every investor. Here’s why.

First, those sky-high returns were achieved when there were a small number of hedge funds pursuing each strategy. Now there are so many hedge funds pursuing similar strategies, the returns aren’t there. Worse, it’s forcing managers to pursue even riskier strategies.

It’s like being at an auction. If you are the only one bidding you’ll probably get a great deal. If you are one of a hundred different bidders there’s not much chance of getting a bargain. In fact, if you don’t watch out you might even pay more than the item is worth. That’s what has happened in the hedge fund world.

Very few hedge funds have current returns anywhere near those stellar returns of the past. In fact, it’s been reported that the majority of hedge funds have actually performed worse than the market indexes for much of this year. Some have even closed down and returned the money to their investors because they couldn’t meet their objective.

Hedge funds have very high costs. Whereas an expensive mutual fund might charge a 1.5% management fee per year, the typical hedge fund charges 2%. Plus, the hedge fund manager will typically take 20% of any gains. It’s even worse with a fund of hedge funds because there is an additional layer of fees. You take the risk, they take the reward.

Hedge funds and funds of hedge funds have little regulation and even less disclosure. The potential for fraud is high and transparency is low. Investors are trusting someone they don’t know to handle their money and will have little idea what they are doing with it. Big money investors get info the small investor can’t.

Most hedge funds require that you remain invested for a set period of time—say 1 year. If investors start withdrawing their money, it may force the manager to sell investments at a loss, harming the investors that remain.

Since hedge funds with long histories of stellar returns are closed to new investors, you’ll have to take a chance on managers with little or no experience in the Wild West world of hedge fund investing.

Lastly, for those who must have alternative strategies, there are many options to short the market or to get double the market return through mutual funds offered by Rydex and Profunds. These mutual funds are transparent, regulated and much, much less expensive. Even so, they still aren’t for the faint of heart!

So I recommend investors let the hedge fund bandwagon pass them by.

Have a financial question? Send me an email and I’ll personally respond, free of charge. Go to www.guardingyourwealth.com and click on ‘Ask Jeff’.

In addition to being a nationally syndicated columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide.