Various Hedge Fund Managers are being exposed as scam artists. Hedge fund investors all over the globe are wondering if their hedge fund is legitimate and if their money actually still exists. Bernie Madoff has shown us how greedy people can steal a person’s life savings easier than stealing candy from a baby.

Not to mention, Hedge funds get commissions of up to 20% of your gains and their products are barely regulated, they’re not registered with the U.S. Securities and Exchange Commission (SEC) and are not obligated to report publicly where your money is invested or how it’s doing.

Overall hedge fund performance has been disappointing over the past five years. This calls into question the industry’s value as a practical investment vehicle.

Of course, not all Hedge funds are Ponzi schemes or are in jeopardy of going bankrupt. Many investors have made hefty returns over the years investing with top managers.

This article will explain the current state and future prospects of the hedge fund industry.

What is a Hedge Fund Exactly?

A hedge fund is simply a private investment fund open to a limited range of investors.

Each fund can choose a broad range of investments and has its own strategy. The manager determines the type of investments and the methods of investing the hedge fund will undertake. A hedge fund will normally announce a specific investment strategy and investment type.

Not all hedge funds actually “hedge”, by seeking to offset potential losses by hedging their investments using different methods like shorting stocks.

Hedge funds are normally open only to a limited group of wealthy investors. This provides them with an exemption in many jurisdictions and frees them from too many regulations.

Many hedge funds are located offshore including the Cayman Islands, Ireland, Luxembourg, British Virgin Islands and Bermuda. The Cayman Islands have been estimated to host to about 75% of the world’s hedge funds, with nearly half the industry’s estimated $1.225 trillion.

What do Hedge Funds Charge?

Hedge funds are not a unique asset class or investment strategy, but a unique fee structure.

A hedge fund manager will usually collect both a management fee and a performance fee. Typically a manager will charge fees of “2 and 20″, which refers to a management fee of 2% of the fund’s NAV per year and a performance fee of 20% of the fund’s profit. That’s why you hear about managers making billions of dollars per year.

Some managers even charge investors a withdrawal fee or redemption fee if they withdraw money from the fund before a certain period of time. This is to dissuade investors from withdrawing funds after periods of poor performance.

Hedge fund returns are reduced significantly by the high fees that are charged.

Hedge Fund Regulation

Who regulates hedge funds? Well they are barely regulated and that is the problem.

Any Joe Shmoe can open up a hedge fund with a few thousand dollars. They can set up shop and start soliciting investors for capital in just days. It’s a bit scary when you think about it.

Hedge funds are defined as an investment company, but operate under exemptions from the registration requirements. The two major exemptions are granted in Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940.

As private, lightly regulated partnerships, hedge funds are not obliged to disclose their activities to third parties. This is in contrast to a regulated stock or mutual fund that usually has to meet stringent regulatory requirements for disclosure. A number of hedge funds offer very limited transparency, even to investors.

Some U.S. based hedge funds don’t even use independent third parties as an administrator or a custodian of their assets. This has lead to conflicts of interest and in some cases even assisted fraudulent activity.

Why are Investors Losing Trust in the Hedge Fund Business?

Since late 2006, over 100 funds have imploded, mainly due to investors pulling out funds due to poor performance.

Some hedge fund managers are turning out to be crooks. For example: Bernie Madoff ran that huge Ponzi scheme and another guy, Kirk Wright of International Management Associates, supposedly defrauded his clients out of $180 million.

And don’t forget Long-Term Capital Management, the hedge fund that collapsed in 1998 during the Asian Financial Crisis.

The Future of Hedge Funds

The hedge-fund shakeout over the coming months could be brutal as we could see the collapse of many hedge funds. Hundreds could go under by the end of March. The result of hundreds of hedge funds all trying to unwind their positions at the same time could be very troubling for the stock market.

Quantitative hedge funds, or quants, were pulverized by the credit freeze and market turmoil last summer and are still struggling. Quants use sophisticated computer programs that make big trading bets. The Quant model is a flawed investment strategy that breaks down when the markets act erratically.

Also, the increase in trading volume may be reducing the market anomalies that are a source of some hedge funds’ performance.

Not to mention that the government is pushing for more regulation and changing of the tax laws affecting the industry. This has many managers shaking in their boots.

Overall, it looks pretty grim for the hedge fund industry going forward.

Before you Invest in a Hedge Fund

It looks like a big shake up is on the horizon for the hedge fund industry, but the top performing hedge funds will survive well into the future. If you do decide to invest in a hedge fund, please do your homework and make sure your fund is reputable and is managed effectively.

Really the only one you can trust with your money is yourself. Research is the key to good decisions.

When picking a hedge fund look at the fund’s financial history. See if the fund has consistently made money over the years and at what rate. Compare it to the Goldman Sachs and Merrill Lynch hedge fund indices to get an idea of how it’s doing.

Now don’t be swayed by promises of extraordinary returns. There is always a catch, and often risks are not totally explained. It is hard to estimate the likely returns or risks of a hedge fund.

Many studies have shown that past performance is not indicative of future returns. So don’t rely on performance entirely when choosing a fund.

And most importantly: Make sure the hedge fund has a large, well known and reputable accounting firm auditing their books before investing with the fund. Remember Bernie Madoff had just one guy in a small office auditing his books and look what happened!