This statement can also tip off the investor if the company is having trouble paying its bills or provide a clue as to how much cash it might have on hand to repurchase shares, pay down debts or conduct another potentially value-enhancing transaction. (To learn more, read The Essentials Of Cash Flow.)

Using Leverage and Derivatives
Hedge funds typically use leverage to magnify their returns. They may purchase securities on margin, or obtain loans/credit lines to fund even more purchases. The idea is to seize on and/or take advantage of an opportunity. The short version of the story goes that if the investment can generate a big enough return to cover interest costs and commissions (on borrowed funds), this kind of trading can be a highly effective strategy.

The downside is that when the market moves against the hedge fund and its leveraged positions, the result can be devastating. Under such conditions, the fund has to eat the losses plus the carrying cost of the loan. The well-known collapse of hedge fund Long-Term Capital Management occurred because of just this phenomenon. (To learn more, read Massive Hedge Fund Failures and Hedge Funds' Higher Returns Come At A Price.)

Hedge funds may purchase options, which often trade for only a fraction of the share price. They may also use futures or forward contracts as a means of enhancing returns and/or mitigating risk. This willingness to leverage their positions with derivatives and take risks is what enables them to differentiate themselves from mutual funds and the average retail investor. This increased risk is also why investing in hedge funds is, with a few exceptions, reserved for high-net-worth and accredited investors, who are considered fully aware of (and perhaps more able to absorb) the risks involved.

Unique Knowledge from Good Sources
Many mutual funds tend to rely on information they obtain from brokerage firms and/or their own research sources, and/or relationships they have with top management.

The downside to mutual funds, however, is that a fund may maintain many positions (sometimes in the hundreds), so their intimate knowledge of any one particular company may be somewhat limited.

Hedge funds – particularly those that maintain concentrated portfolios – often have the ability and willingness to get to know a company very well. In addition, they may tap multiple sell-side sources for information and cultivate relationships they've developed with top management, and even in some cases secondary and tertiary personnel, as well as perhaps distributors the company uses, ex-employees, or a variety of other contacts. Because hedge funds usually aren't beholden to the company/investment and because fund managers' personal profits are intimately tied to performance, their investment decisions are typically motivated by one thing – to make money for their investors.

Mutual funds directors often keep an eye on the exit door as well, but a single position may only represent a fraction of a percent of a mutual fund's total holdings, so getting the absolute best execution on the way out may not be as important. So, because they often maintain fewer positions, hedge funds usually need to be on the ball at all times and be ready to book profits.

The Bottom Line
Although often mysterious in nature, hedge funds use or employ some tactics and strategies that are available to everyone. They do, however, often have a distinct advantage when it comes to industry contacts, leveraging investable assets, broker contacts and the ability to access pricing and trade information.