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Unfortunately, determining which fund to go with for a retail investor is difficult, as there are many unscrupulous fund managers who might seek to take advantage of the fact that they are playing with other people's money and making (at least) the management fee. This can lead even scrupulous hedge fund managers to take unnecessary risks.
The danger of hedge funds being mismanaged truly cannot be overstated. For example, Bernie Madoff ran a large exclusive fund and while it was a Ponzi scheme, which while illegal and with "fantasy returns," that sophisticated investors most certainly should have realized were not realistic, Madoff continued to be able to bring in investors. However, Madoff's investors were all relatively financially sophisticated people with huge assets. While his scheme caused them financial damage, the damage was manageable and it was confined to a group of people with assets that greatly outstripped those of the average American. In other words, none of Madoff's investors went hungry as a result of his scheme. However, it is not difficult to imagine what might happen if there was a hedge fund which purports similar returns to a larger retail investor audience which sought to make its money not in a small number of individual clients with large investments, but with huge number of small investors from the general public. If any one of these went under, it could literally threaten the retirement and assets of middle-income individuals. If that occurred, then the government would be under pressure to do something to ameliorate the problem, and any investment that seems to invite the idea of a government bailout makes people nervous. Since this type of behavior has happened before (Internet bubble, housing bubble, etc.) it is likely that in this day and age of high technology another industry will come along in similar fashion. This seems likely given the fad and glamour the media is focusing on the hedge fund industry. While there is legitimacy to the use of hedge funds in an investor's portfolio, the potential abuse of hedge funds for retail investors seems more dramatic given the fact with leverage and short-selling as part of the design one could lose more than the initial investment. This specific aspect may be particularly troubling for retail investors to handle as it is not a simple concept and requires a detailed knowledge of money and mathematics.
Typically the laws around the world prevent hedge fund type investments from reaching retail investors for the reasons previously described. However, fund managers are become cleverer and have devised ways to circumvent existing legislation. "Many are keen to diversify their investor bases -- and in some cases, to avoid strict new regulations from the EU that may limit their ability to sell their traditional offshore funds open only to institutions and wealthy individuals" (Jones 2010).
Regulation of the industry began in earnest in 2008 because of the financial crisis where investors were outraged that they lost money with fund managers over-leveraged and without enough liquidity to allow them to pull their money out. However, there is still concern "whether greater liquidity and transparency actually lead to better risk-adjusted returns" (Harris 2010) it seems that when the government goes to protect the public from themselves as well as the fund managers, the very thing that each investor is shooting for (above average returns), may be compromised. The regulations are imposed on everyone to prevent the small minority from abusing the system. This has a parallel in the United States Transportation Safety Administration (TSA) with many rules on security in the airport and on airplanes that actual deter from a happy flight experience at the expense of zero tolerance for harm to anyone. When government regulations do not keep up with the pace of innovation on the part of fund managers, they may have "allowed entry by the back door for strategies where the risks are hard for investors to assess" (Skypala 2010).
All told, it is apparent that for an average retail investor, hedge funds offer a greater risk than other forms of investment, and this risk makes them a poor investment choice. This can stem from a lack of understanding about the fund, a shortcoming on the fund manager to provide enough information to the public to make an informed decision (based only on what regulation suggests to provide), and the desire of the fund managers to keep their dealing secret to avoid copycatting and degradation of returns because too much information is known about what they might plan to do. As a result, one must conclude that hedge funds are not suitable for retail investors.
Agarwal, V 2009. "Hedge funds for retail investors? An examination of mutual funds," Journal
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Jones, S 2010. Winton opens new fund to retail investors. Available from:
Lott, T 2011. Greenlight capital: Retail investors can buy a top hedge fund for close to book value. Available from: < http://seekingalpha.com/article/288270-greenlight-capital-retail-investors-can-buy-a-top-hedge-fund-for-close-to-book-value>. [27 February 2012].
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