The answer to this fundamental question is crucial because it lays the foundation for designing a sound portfolio of hedge funds. Unfortunately, many hedge fund professionals and investors believe that a hedge fund is any collective investment vehicle that charges enormous fees, is unregulated and can use shorting strategies. Most people suffer in hedge fund investing because many of these so-called hedge funds do not capture the features hedge fund investors seek. To avoid this problem, investors must have a working definition of the term "hedge fund" in order to be certain they are actually buying hedge funds instead of something that just looks like a hedge fund.

PARADIGM's Definition

According to PARADIGM, a hedge fund is an information age company that generates skill-based profits through its ability to monitor and process constantly changing information using financial instruments without any reliance on market direction. Under this definition, a hedge fund is not a diversified portfolio of assets that seeks to outperform a relevant benchmark. A hedge fund is more appropriately classified as a company trying to maximize profits.

So let's look at each aspect of this definition a bit more closely:

INFORMATION PROCESSING:

Because of advances in computer and communications technology, we are now bombarded with constantly changing information in a way that was almost unimaginable a few decades ago. We all have a sense that we could profit from the barrage of information that hits us every day if we had the time and skill to analyze the information appropriately. Hedge fund managers serve a useful purpose in performing this function for us. Hedge fund managers are highly skilled entrepreneurs who, through an unusual combination of training, education and expertise in a particular area, have better access to and ability to process information than the rest of us. So according to our definition, hedge fund managers are information processors who, through their skill, create value. Our portfolios of hedge funds provide an INFORMATION PROCESSING PREMIUM™ (similar to a risk or liquidity premium) that did not exist before the information age.

NO RELIANCE ON MARKET DIRECTION.

PARADIGM's definition was developed within the framework of modern portfolio theory, which recognizes that markets are efficient. According to the efficient market hypothesis, managers who derive returns by timing a market or attempting superior stock selection generally will not outperform the broad market. As a result, the equilibrium price for traditional money managers is about 1% per year. Study after study confirms that net of this modest fee, traditional money managers do not persistently out-perform the bond or stock indexes. Investors who obtain their exposure to traditional equity markets through hedge funds, which typically charge 20% performance fee in addition to a management fee of 1-2%, are paying too much. Hedge funds that derive returns from riding a market or picking stocks will hand their investors only 80% of market gains but 100% of market losses. These funds succeed only in transferring investors' wealth to the hedge fund manager. In the long run, investors who invest in hedge funds that are basically stock picking or market timing cannot and will not come out ahead after paying a 20% performance fee. PARADIGM estimates that 80% of the 4000 so-called hedge funds available today are precisely these overpriced stock pickers and market timers.

PARADIGM searches for hedge fund managers that are information processors. These managers understand that no one knows whether the stock, bond or any market will go up or down tomorrow, next week or next month. They do not ever rely on the market. They rely only on their expertise of gathering and processing information relevant to their area of specialty and exploiting what they can predict (relationships between securities and other financial instruments) while diligently avoiding or controlling their exposure to what they cannot predict - market direction.

SKILL-BASED ABSOLUTE RETURNS

PARADIGM's emphasis on manager skill rather than market conditions recognizes that hedge funds should perform regardless of market circumstances. As a result, the performance of PARADIGM's hedge funds should persist over time. In light of recent market conditions, hedge funds should be viewed as a potentially attractive alternative to traditional equity investments.

HEDGE FUNDS ARE NOT DIVERSIFIED PORTFOLIOS OF ASSETS-THEY ARE INDIVIDUALLY MANAGED COMPANIES

Many people view a hedge fund as the diversification equivalent of a mutual fund. This is a mistake because a single hedge fund is not a diversified investment. A mutual fund is diversified because its performance depends, to a great extent, on the independent performance of the numerous management teams running the companies it owns. Hedge fund performance, on the other hand, depends almost exclusively on the decisions of one person-the hedge fund manager-regardless of how many positions the hedge fund holds.

This difference between hedge funds and mutual funds is due to the fact that mutual funds are portfolios of assets and hedge funds are not. In addition to owning stocks, hedge funds short stocks (a strategy designed to profit from declining prices), trade in and out of stocks and use other instruments such as futures, options or other derivatives that do not represent ownership of an asset like stocks do.

We recognize that hedge funds are companies that produce returns by providing a service (information processing) rather than broad market exposure to various assets. This concept is very important in hedge fund investing because, like any business or stock, hedge funds are extremely risky. The only way investors can mitigate their exposure to these risks is through a diversified portfolio of many hedge funds.

Past performance is not necessarily indicative of future results.