Have you ever wondered how a hedge fund really works? What after all are they hedging anyway? And how is it that they can mangage to  beat the market so handily?

Well the answer is pretty simple.

They're not hedging anything for the most part.

Instead it's their use of leverage that makes all of those big returns possible. Not to mention those huge fees.

And while that same leverage does work like a charm on the way up, it is another story entirely on the way down--especially if you are on the other end of a margin call.

It may sound complicated, but in reality it is pretty simple. In fact, the graphic above does a nice job explaining it all.

It came courtesy of the Washington Post originally, but I found it myself this morning on HousingPanic.

Click here for a larger version. It's entitled: "How Debt Bites Back"

Hedge funds, by the way, are the only part of the financial system that is operating without a net right now.  That being said, you can expect that many, many, more of them will be going belly up in the future.