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Hedge Funds? What For?

Despite their trailing the broad market lately, hedge funds continue to attract money. Why? Part of it may be snob appeal - they are reserved for upper-income folks. Yet they also are a good way to diversify your portfolio. And some actually do spectacularly well.

Hedge funds certainly are not for the average investor, but if you are one of the more sophisticated, and you're willing to take on greater risk for returns, these vehicles may be the place to invest some of your money.

Hedge funds are the mystery players in the investment universe. You can think of them as something like mutual funds for the very wealthy. In fact, many hedge fund investors are institutional ones, like college endowment funds. The reason is that hedge funds invest very aggressively, suitable only for those who have the financial wherewithal to afford the risks.

Although hedge funds largely lagged the market in recent years - up only 4.5% in 2014, as measured by the Eurekahedge index , compared with a more than 13% rise in the Standard & Poor's 500 Index - many still find them attractive , as they can deliver stellar returns. India-focused funds, for example, gained 39% last year. The best performing one was Passage to India Opportunity Fund, which was up 225%.

For the sophisticated investors, hedge funds offer diversification. They typically invest in derivative investments , such as options. And because of the lack of heavy regulation, hedge fund managers can invest in mainstream investments, such as stocks and bonds, in alternative ways that mutual funds mangers or individuals can't.

The $6.1 billion Pershing Square Capital, for instance, uses an activist strategy, where the fund participates in the management of companies in which it owns a stake. It returned 32.8% last year.

Hedge funds also work to create risk adjusted returns. They may produce more consistent results than the underlying market. It is even possible for hedge funds to be profitable when the markets are in retreat.

To invest in a hedge fund, you must be an accredited investor . This refers to people who have either $1 million in assets or make $200,000 in income (or $300,000 together with a spouse). Hedge funds generally have fairly high initial investment requirements, typically $50,000 or higher. They also require that your investment remains with the fund for at least one year before you can cash out.

If you qualify, investing in hedge funds can be a good way to diversify your portfolio. That isn't to say you should put all your money in hedge funds. Diversification is important with investments of all stripes. You may want to have the bulk of your money invested in mutual funds or exchange-traded funds, stocks, bonds and real estate, but have a portion in hedge funds. For example, you may consider allocating 10% to 20% of your portfolio to hedge funds, split between two or three funds. This is similar to what you do with any other asset allocation.

There are many different hedge funds available. They're not as standardized as mutual funds or exchange-traded funds. Each may specialize in a certain aspect of investing and has its own specific policies and benefits. Make sure you thoroughly investigate the hedge funds that you plan to invest in, as they are not like other kinds of investments that you are familiar with.

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Jeff Rose, CFP, is the founder ofAlliance Wealth Managementin Carbondale, Ill., and also is the founder of the website Good Financial Cents and Life Insurance by Jeff .

AdviceIQ delivers quality personal finance articles by both financial advisors and AdviceIQ editors. It ranks advisors in your area by specialty, including small businesses, doctors and clients of modest means, for example. Those with the biggest number of clients in a given specialty rank the highest. AdviceIQ also vets ranked advisors so only those with pristine regulatory histories can participate. AdviceIQ was launched Jan. 9, 2012, by veteran Wall Street executives, editors and technologists. Right now, investors may see many advisor rankings, although in some areas only a few are ranked. Check back often as thousands of advisors are undergoing AdviceIQ screening. New advisors appear in rankings daily.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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