If you're a small investor, hedge funds have one large drawback: You need at least $1 million to become a partner in one. If you've got the money, one advantage is the range of choices hedge funds give you. They range from international giants to tiny specialty firms, each offering its own strategy for hedging against risk and maximizing returns.
One "pro" for investing in hedge funds is the fund manager has strong incentives to make you money. Pay is performance based, so the more money she makes for you and your partners, the more money she earns. The manager invests her own money in the fund. If her investment picks cost you money, she loses out too. Managers often specialize in particular fields -- biotech, for instance -- or strategies. As a partner, you make money from their expertise.
Now the bad news: Pay for performance doesn't guarantee the fund will make you any richer. Some managers gamble on risky investments in hopes of earning a huge return and performance fee, and the risks don't always pay off. In some hedge funds, manager performance fees are as high as 40 percent, which takes a bite out of your profits. In a worst-case scenario, you could wind up investing in a hedge fund run by the next Bernie Madoff. Starting in the 1980s, Madoff defrauded investors of $60 billion before the scam collapsed in 2008.
Hedge funds have an advantage over mutual funds because they aren't as tightly regulated. That leaves you free to employ a wider range of strategies to manage investments and hedge against loss. The hedge fund philosophy on making money is another plus. Many investment strategies focus on doing better than the market, but hedge funds seek an absolute rate of return. The goal is to make you and your partners a profit, not just to outperform a benchmark such as the S&P index.
Despite the stunning performance of some superstar funds, critics say most aren't all that successful. In his 2012 book, "The Hedge Fund Mirage," former fund manager Simon Lack claimed all the money invested in hedge funds would have been twice as profitable if investors had put it in Treasury bills. Because hedge funds don't have to file financial reports with the Securities and Exchange Commission, it may be hard for you to get a realistic picture of the fund's performance.