By Scott Paul Frush, CFA, CFP,President, Frush Financial Group,
Author of *Understanding Hedge Funds, and Optimal Investing

For investors looking to gain an investing edge, hedge funds may be the smart solution. There are no guarantees with investing and there are no shortcuts. The same is true with hedge fund investing. Historically, hedge funds have not only generated attractive positive returns in good markets and bad markets, but also have helped to reduce total portfolio volatility risk. This means solid returns with controlled risk.

These are some of the benefits of hedge funds. One of the primary drawbacks with investing in hedge funds is selecting the right one and making it work for you. The following are seven sensible - and simple - strategies for helping to promote successful hedge fund investing.

Strategy 1: Do Your Preliminary Background Research Thoroughly.

Managing your money always begins with you. Selecting a hedge fund based on a recommendation from a friend or advisor is not good enough. Investors need to take a more proactive role in screening and evaluating hedge funds thoroughly. Since the investments are unregulated by the SEC and government authorities, you are on your own. Background investigations should be done, as well as asking many questions to identify proper fit. Reading and reflecting on the required disclosure documents is highly encouraged. Checking with people who have invested with them is also a good idea. (Please consider posting a question on our WME discussion group)

Strategy 2: Seek Out Hedge Fund Managers with Demonstrated Success

It is most important to invest with managers that have demonstrated success on a consistent basis. Of course, past performance is not a guarantee of future performance, but consistent attractive performance over many years speaks volumes. Always ask to see a performance composite and inquire about years with poor returns.

Strategy 3: Pursue Hedge Funds with Investor-Friendly Provisions

Although the performance track record is very important, investor-friendly provisions is a close second. Such considerations include high-water mark provisions, return hurdle provisions, reasonable fee structures, and fair redemption provisions. All else being equal, hedge funds with return hurdles and high-water mark provisions are ideal. At the same time, hedge funds with flexible, instead of stringent, redemption provisions offer investors more opportunities to withdrawal their investment with minimal challenges. Lastly, investigate incentivized fee arrangements and ensure they are fair and appropriate.

Strategy 4: Evaluate Hedge Funds Within the Context of Your Overall Portfolio

Don't view hedge funds as stand alone investments. Rather, they should be considered within the context of your overall portfolio. This means you understand the impact to your overall portfolio when you invest in hedge funds. At the same time, managing the remaining allocations of your portfolio, such as equities, fixed-income, and money market instruments, should be accomplished with your hedge fund investments in mind. For example, if you build a portfolio heavily emphasizing equity investments and believe your exposure to equities is excessive, then a long equity hedge fund may not be the most appropriate investment. A short equity hedge fund may be more suitable.

Strategy 5: Diversify Your Hedge Fund Portfolio

Funds of hedge funds provide many benefits that other hedge funds do not offer. First, funds of hedge funds provide immediate and enhanced diversification - the result of investing in multiple hedge funds. Secondly, funds of hedge funds provide a means for the investment masses to invest in hedge funds. Most funds of hedge funds have low initial minimums, which is in contrast to stand-alone hedge funds. Other benefits include risk management and professional oversight. Regardless of whether or not you select a funds of hedge funds or stand-alone hedge funds, diversifying your portfolio among multiple managers and even among multiple strategies is a wise move that will enhance your total portfolio.

Strategy 6: Walk Away When Appropriate

Regardless of the investigation, research, and screening you may do, some hedge fund investments simply do not work out as anticipated. Perhaps the issue is performance related, perhaps the key manager retired, or perhaps the relationship between you and the manager took a nosedive. Regardless of the reason, investors at some point will find it necessary to walk away and switch to another manager. When such situations arise, make sure you understand what is expected of you prior to making the change. Some hedge funds have flexible provisions for withdrawing investments while others have cumbersome provisions. The most important lesson here is to make the switch when the time arises. Waste little time if things are not working out.

Strategy 7: Be a Rational and Informed Hedge Fund Investor

The number one golden rule of investing is to manage your portfolio as a rational and informed investor. This is smart advice for both hedge fund investing and general investing. If you are able to accomplish this goal then most everything else will fall into place.

To become a rational and informed hedge fund investor, you will need to be proactive in learning what rational and informed investors do and do not do. There are many pitfalls along the way. In addition, you will want to learn the key lessons of hedge funds and investing basics. What are rational investors? Rational investors do not fall victim to the most common behavioral blunders investors often make. These behavioral blunders include such things as illusion of control, blinders, overconfidence, denial, and herd instinct. By mere definition, rational investors become informed investors over time. Being informed means you know and fully understand key lessons of investing, such as no investment is guaranteed and not to invest in anything you cannot afford to lose. Strive to manage your portfolio as a rational and informed hedge fund investor.

* (This article is adapted from Understanding Hedge Funds, by Scott Frush, © Copyright 2006, McGraw-Hill Inc.)