z75 >> ok this is going to be a majorly long answer, but i shall attempt to do it anyway just for the interest of everyone and to right misconceptions..
hedge fund by itself is a very loosely coined term. it generally means most collective investment that is outside the mutual fund world, and is investing in publicly listed assets. there is a loosely defined set of investment guideline, but since investors are officially investing into an investment company as a partner, the SFC kind of guidelines do not apply and fund managers can have the flexibility to do alot more things.
mutual fund on the other hand is governed by a very strict set of rules. funds usually have a predefined scope of product it can invest in (e.g. bonds, asian equity, european equity...). It must have at least maybe 80% or 90% of the value of the fund invested in the said portfolio (i.e. if today 1mio USD is invested into a 10mio mutual fund, the money has to be used to increase the portfolio in the same proportion by 10%).
so when the market turns downwards, mutual fund bare direct hits because it holds in its portfolio 80~90% of straight investment into the assets (i.e. stocks).
as mentioned, HFs are loosely grouped. there are thousands of funds all doing different things. some HFs are very similar to equity mutual funds, just that they have the allowance of buying maybe bonds or borrowing money to increase their leverage. some HFs deal largely with forex, or commodities (the blown up amaranth, motherrock, etc.).
alot of hedge fund uses equity one way or another. but instead of only direct investment in equity, they might be doing convertible arbitrage, equity long short or merger arbitrage.
equity long short is easiest to explain,
--> if you think that over long term citibank will perform better than JP Morgan, you buy 1million of citigroup and you short sell 1million of JPM, and bet on the relative performance of the two shares. even if the whole finance market is to crash, as long as JPM shares falls more than citigroup, your portfolio would still make money.
or merger arbitrage:-->
assuming company A offers to buy company B at $1 per share or $1.50 worth of company A shares. As company B shares would hover around the 1.10 or 1.20 mark, you can buy company B shares and short sell company A shares, once the merger is approved, you accept company A shares as exchange and use the shares to return the short sold position you had.
trading strategy that uses both long/short side of the market and derivatives are what traders in bank had been doing all decades, and they are generally lower risk, allowed for each trade to be leveraged by borrowed money. traders that did well in the banks believe they can replicate what they have done and set up their own hedge funds.
so why the blown up...
some hedge funds take extremely huge bet relative to their value of investor asset. those are the funds that made 25~50% annually for the last 1~3 years. an investor has to know he/she is taking extremely huge risk.
similarly, LTCM (another famous blown up story of nobel price winners) did such a high leverage on some bond portfolio that when russian government defaulted on their payment of government bonds, their portfolio were killed.
a typical hedge fund gains maybe 8~12% a year, and can do it on a consistent basis.
hope that gives a better picture of why I say hedge fund is less risky compared to mutual funds.
you have bad eggs once in a while but overall the flexibility given to the manager can help your money grow in a more controlled pace.