Retirement Planning - H is for Hedge Funds in Disguise

If you have a pension, you are probably invested in some way in hedge funds. They have been described as the gated community of investing in part because they require large amounts of available capital - and I mean millions of dollars worth. Because pension plans need diversity and risk, they often benefit from some of this sort of 'outside of the mutual fund regulatory world' type of investment approaches. Twenty-five percent of them do. The individual investor often consider the "average investor"has barely any exposure. Mutual funds would like to tap that marketplace and in all likelihood, your 401(k) will be seen as prime hunting grounds for these newer funds.

Among these investment techniques is the ability to short a stock, use various types of arbitrage and options trading while others simply act as a fund of funds or a mimic fund to a larger successful brethren. Many of these techniques have netted investors huge sums of money in return for this risk. As the market fell 39% in 2008, hedge funds experienced losses of a far less (20%).

So if one of these funds turns up in your 401(k) list of available investments, should you buy it? Yes and no.

If you do not know what shorting a stock is, then probably no. Shorting a stock is a trader technique of borrowing shares of a stock in the belief that the stock will go down in price. When it does, the fund (manager) buys the borrowed shares at the new lower price.

If you are unsure how arbitrage works, then this might be a reason to stay away as well. Arbitrage attempts to capitalize on price disparities. The could come from underpriced mergers that are about to happen or from the difference between a convertible bond and the option to buy the stock. Yes, its complicated and risky.

If you have no clue what it means to neutralize the market, then avoid the pitch that these are essentially conservative funds. They are conservative - by comparison to other hedge fund activity - but they are by no means without risk. In fact, recent numbers show that these types of funds - that use a method of protecting the fund's holdings, usually stocks that are chosen to outperform, by using short positioning in broader indexes or options to keep the gain within a certain range. The returns on these funds can run from a negative 22% to a positive 13% over the last twelve months.

Should you look at these funds as part of your portfolio? Probably not... unless you have managed to embrace your inner risky person. If that is the case, then owning a ten percent stake in a fund that works like a hedge fund might work. They cost less than a hedge fund but I would be willing to wager, more than twice what you are paying for an average, run-of-the-mill actively managed fund.

Chance are, if you do have access will come to you as 130/30 fund. Although 100% of the money in the fund is invested, an additional 30% is borrowed as a short sale. This gives the illusion of being invested 130%. (Visit here for a discussion on the various types of risk and here to learn more about 130/30 funds.)

Once again, it pays to keep in mind what kind of investor you are, how much risk you can tolerate and when it is you plan on using that retirement investment as income. Keep in mind that these types of funds have only the smallest of track records.