A friend asked me to explain to her what hedge funds are. She is a fairly na?ve investor, as you might suspect from her question. So I thought: why not kill 65,001 birds with one column, since I am sure that some people out there in Bermudaland would also like to know the answer to that question.

This will doubtless open me up to all manner of letters from readers who have a different opinion, or just think I plain don?t know what I?m talking about, but hedge funds are important to Bermuda, and becoming more important, and a good columnist knows no fear. I can?t claim sophisticated knowledge in this arena, which will probably be a relief to everyone.

Mutual funds, as I?m sure you know, are pools of money that enable investors to participate in large transactions with their pooled money. The larger the transaction, the cheaper the fees, so mutual funds can be an efficient way for investors to invest. Plus, as part of a pool, mutual fund investors can own a wider range of shares than they might be able to with just their own small amount of money.

By contrast, hedge funds were, until recently, one way for very rich people to invest. By definition, hedge funds used to be much riskier than mutual funds. Hedge, in this context, is not a green thing at the end of your garden, but a financial term denoting an investment made to head off a possible outcome, as in a ?hedge against inflation?.

The key-defining element of a hedge fund, however, is not who invests in it or what it chooses to invest in, but its ability to sell short. I?ll explain. If you buy some shares, you are what?s called ?long? those shares. If you sell shares you do not own, but hope to buy later, you are said to be ?short? those shares. Why would you sell what you don?t have? You would do so if you believed the price of those shares were going to go down. By selling them now, you receive their value today, and then when their price falls, you buy back the shares at a lower price, and make a profit.

Sounds simple, but short selling, or ?shorting? stocks, is a truly risky business.

Selling short is much more dangerous than buying long. If you buy shares and hold them, the absolutely worst that can happen is that their value drops to zero, and you would lose 100 percent of your investment. If you sell short, you have established upon the sale how much you will receive, regardless of what happens. The price of the shares you have sold could, in theory, rise and keep rising, and you could lose much more than you received. In theory, you could lose an infinite amount. Your risk is, in essence, unlimited. That?s the structural difference between a hedge fund and a mutual fund. Mutual funds don?t sell short, as a general rule. They buy only shares the manager thinks will go up in value, or pay a rewarding dividend, and mutual fund investors cannot lose more than they invested.

That?s structural, but there is a practical difference between mutual funds and hedge funds. Mutual funds (broadly speaking) invest in buying and later selling stocks, relatively simple financial instruments, or even cash. The Butterfield Money Market Fund, for example (in which I have some money), pools the power of pipsqueaks like me (financial pipsqueaks, that is), and buys large certificates of deposit, which tend to pay a better rate of interest than regular deposits. In the 20-plus years that some of my savings have lived in that fund, their value has never gone down. Very little risk, relatively little reward.

Hedge funds often trade in riskier investments such as futures, derivatives, foreign currencies, odd or inaccessible markets, and other sometimes incomprehensible financial instruments. The risk here is far greater, and so therefore is the potential reward. Many hedge funds have very high minimum investments, which discourages the less wealthy from investing in them.

With cash, the investment grows slowly, but without risk. With mutual funds or direct ownership in stocks, you would hope to see prices increase in the majority of your investments over time. Hedge fund managers may lose more bets than they win ? seven out of ten investments failing to produce a profit is not unheard of ? but when an investment succeeds, it pays off well enough to cover the losses on those that did not. That?s the idea, anyway.

So, traditionally, hedge funds have taken relatively wild risks, in the hope of a better return for their well-to-do investors. Rich folk usually have a good chunk of their money invested in safe things, and then put a small amount into riskier ventures to boost their overall return. (The short form of all this is: the rich get richer.) Lately, however, there has been so much private money floating around, in the States and Middle East especially, as a result of the housing bubble, enormous bonuses for financial professionals, the passing of the Baby Boomers? parents and a hundred other things, that hedge funds have been in great demand and have had to look elsewhere for things to invest in. They have moved a little toward less risky investments, in part because their investors are not now all traditionally rich people who understand such things.

One supposedly less risky investment into which they have moved clients? funds of late is reinsurance. More than half of the world?s reinsurance is now sold in Bermuda, which is why insurance journalists have had to learn about hedge funds. I won?t bamboozle you with the technicalities of what these hedge funds are doing, although not all of them are taking wild risks. At least one new hedge fund-owned Bermuda reinsurance company sells itself as likely to produce smaller profits ? and therefore smaller losses in tough years ? than the standard reinsurance companies.

In short, for the average investor, hedge funds are probably off the radar. If you don?t have much, you shouldn?t risk it all, says the voice of prudence. (Cue letters from all manner of folks who will argue that approach is cowardly, or just plain wrong.) The philosophy of getting rich slowly espoused by this column demands that you remain a prudent investor at all times. Save a little, and then save some more. And don?t bet it all on high-risk investments, hunches, or any other far-out techniques. Cowardly, maybe. Richer, definitely.