What’s a hedge fund and how could it damage your portfolio? For starters, it can involve speculative strategies like short-selling, derivatives and margin trading.

What’s a hedge fund? It’s an investment product that carries a lot of risk? The marketing of investment products is a highly developed and well-financed art. It tends to focus on an idealized description of the investment-product manager’s goals, rather than on how the manager will pursue them. It may gloss over the risks and instead aim to give you a warm, fuzzy feeling about what’s happening with your money.

This feeling may spur you to put your money in unsuccessful investment products that fall short of your expectations, sometimes by a wide margin.

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What’s a hedge fund investing strategy really doing?

Hedge fund investing mostly aims to buy good stocks and sell bad stocks “short” (that means borrowing bad stocks, selling them, and only buying them back to repay the loan after prices have dropped). The hope is that will generate money regardless of the market’s direction.

Here’s the typical strategy of hedge fund investing: If the market goes up, the good stocks should rise more than the weak ones, so the gains on the good stocks should exceed losses on the short sales. If the market falls, the bad stocks should fall more than the good, so gains on the short sales should exceed losses. But profitable short selling requires superhuman timing, and the inevitable mistakes can be incredibly expensive.

In essence, hedge-fund managers are generally supposed to buy stocks they like, while simultaneously selling short in stocks they feel are unattractive.

This aims to put their fund in a “market-neutral” position. By buying good stocks and shorting bad ones, you have hedged your stock market exposure. Theoretically, this means you make money regardless of which way the market moves.

If the market goes up, all or most of the stocks you own or have shorted are likely to gain as well. However, if you have chosen your buys and short sales wisely, and diversified, the stocks you own are likely to gain more value in total than the stocks you’ve sold short.

You are unlikely to make as much profit in a rising market as a so-called “long-only” investor (one who only bought stocks but didn’t do any shorting). But you are still likely to make money.

If the market goes down, all or most of the stocks you own are likely to go down. But the stocks you’ve sold short are likely to fall more than your buys. That’s because bad stocks—those with high risk and/or little investment appeal—are particularly vulnerable to big declines when the market as a whole is falling.

That’s the basic concept of hedge fund investing, but it’s hard to apply consistently. This is mainly due to the difficulty of making money as a short seller. Timing—getting in and out at the right moment—is vastly more important for a short seller than a stock buyer. But bad stocks tend to be more volatile and unpredictable than good stocks.

What’s a hedge fund manager’s role?

Hedge-fund managers aim to use these manoeuvres to offset the risks of investing in stocks or other volatile investments. This combination can work well for years, but, in fact, the risk is merely hidden. At unpredictable moments, this risk flares up and the strategy backfires. Rather than offset the risk, the hedging tactic may amplify it. This can turn a seeming investment haven into a financial nightmare.

In general, hedge funds are hugely profitable for the sponsors—the fund and the brokerages that sell these investments. Due to incentive fees, investors pay extra if the fund performs well. Brokers are also happy to sell the funds and earn commissions.

In addition, hedge funds trade heavily, and they usually trade through brokerage firms that sell their funds to investors. It’s a common investment situation. The fund makes money; the broker makes money; sometimes even the client makes money. Of course, some investors lose heavily, due to the fees and risks. But, as they say in the investment business, “two out of three ain’t bad.”

What’s a hedge fund look like as an investment? Here’s what to look for.

To succeed as an investor, you need to disregard the marketing message. Instead, focus on where your money is going. This determines how much risk you take on, and how likely you are to lose or make money.

Above all, when considering any investment or investment product, it pays to do three things:

• Maintain a healthy sense of skepticism. A logical, believable prediction or forecast can and often will fail.
• Avoid investments that expose you to conflicts of interest.
• Keep in mind that virtually all investment products are made up of three key elements—fixed returns (bonds), equity or business ownership (stocks), and bets on the timing and/or outcome of future events (insurance, derivatives, options, futures etc.) Combining any two or three of these elements will raise the cost, and will often cut the long-term return as well.

That’s why you’re better off in general to stay away from investment products. Instead, invest your money in high-quality stocks, and fixed-return investments—if you want to own them—such as GICs and short-term government bonds. This is more trouble than buying ready-made investment products, but it can cut your risk and provide higher long-term profits.

How do you think more regulations for hedge funds would impact the market?

Lucky investors could make a lot of money with hedge funds, but most investors end up losing. Do you think a hedge fund investment is worth the risk?