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Heads Up for Hedge Funds

By: Investor Solutions

By: Investor Solutions, Inc.

The hedge fund industry has experienced a considerable growth in the last decade with an estimated 300 funds in 1990 to more than 3000 today! Hedge Funds have long been considered a very risky and unpredictable alternative to the common mutual fund investment, and the money flow into these types of funds has increased significantly. Are hedge funds the next best thing to Mom’s apple pie, or are they just an over-inflated tire just waiting for the big blowout?

In the past, hedge funds were only available to the very wealthy, sophisticated investor. Typically a cool $1 million was the minimum investment, and you needed to have a net worth over $1 million or an annual income of at least $200,000 individually (or $300,000 for joint incomes) to even qualify. So, what’s all the hype about hedge funds now? Well, now they’re available to a broader spectrum of investors through funds of hedge funds. The attractiveness of these hedge funds came out of the recent bear market experienced from 2000 to 2002, where many investors decided they needed some type of risk protection to their investment approach.

Like mutual funds, hedge funds pool investor’s money and invest those funds in financial instruments positioned to make a positive return. The underlying concept with the hedge fund is that people give their money to hedge fund managers expecting either a very high return or a “hedge” against prevailing market trends, or both. Unlike mutual funds, hedge funds are not registered with the SEC, meaning that they are subject to very few regulatory controls. In addition, many hedge fund managers are not even required to register with the SEC and therefore have no SEC oversight! Could this be a leading reason why the SEC and NASD have recently filed a number of cases where investors suffered substantial losses due to fraudulent activity at hedge funds? According to the SEC, most of the charged hedge fund companies lied to investors about the experience of their managers and the fund’s track record. Many were the classic “Ponzi scheme,” where the early investors were paid off to make the scheme look legitimate.

There are some hedge funds that are registered with the SEC, however; the underlying investments are still unregistered, private hedge funds. These are called a “fund of hedge funds” which provides the opportunity to invest in a group of private hedge funds through one single fund. This fund of funds allows a greater number of investors to get involved at lower investment minimums. However, the SEC still takes the viewpoint that since these investors have a lot of money then they should exercise the necessary sophistication to research the hedge fund and its managers prior to participating in such vehicles.

To try to achieve a positive investment performance, hedge fund managers are using sophisticated investment strategies and techniques that may include, among other techniques:

Short Selling (selling securities you do not own)

Arbitrage (profiting from price differences in multiple markets)

Investing in Derivatives, such as options and futures

Investments in volatile international markets

Hedging (buying a security to offset potential loss on an investment)

Buying Concentrated Positions in a single market/issuer

Investing in distressed or bankrupt companies

Investing in privately issued securities

Leverage (borrowing money for investment purposes)
The organization and mission of the hedge fund is very different than the traditional mutual fund in that it operates much like a private enterprise and it seeks returns on its capital regardless of how the stock market behaves. Due to the unregistered status of private hedge funds, many of the investor protections that apply to registered investment products (such as mutual funds); do not apply to hedge funds. As you might expect, the potential to add high returns to your portfolio comes with some strings attached:

No Limit to the use of Leverage – If a fund takes in $200 million, the fund manager may go out and borrow $2 billion (10 times what he has in assets)

No Protection against Conflicts of Interest – A fund manager may buy a particular security for the hedge fund and sell the same security in his personal accounts.

Fairness in the Pricing of the Fund Shares – Managers are not required to provide periodic pricing or valuation information to investors.

Disclosure of Fund Information – Private hedge funds are not required to disclose information about a fund’s management, holdings, fees, expenses, and performance.

Complex Tax Structures – Often hedge funds have complex tax structures and delays in distributing important tax information. Also, may require you to obtain an extension to file your income tax return.

Can be Highly Illiquid – Hedge funds typically limit opportunities to redeem, or cash in your shares (e.g. twice a year), and often impose a “lock-up” period of one year or more, during which you cannot cash in your shares.

Risky Investment Strategies – Use of speculative investment and trading strategies that can result in large losses, with the ever-present possibility of losing essentially all assets and even having to fold the fund.

Unregistered Investments – Investments are not subject to the SEC’s registration and disclosure requirements. This makes it difficult to assess the performance of the underlying hedge fund to independently verify its accuracy.

Often Charge High Fees – Hedge funds typically have a much higher fee structure than mutual funds, usually an asset management fee of 1-2% of assets, plus a “performance fee” of 20% of the hedge funds profits. And if you invest in a “fund of hedge funds” you’ll need to tack on another layer of fees charged by the company compiling the group of funds.

Without the disclosures that the securities laws require for most registered investments, it can be quite difficult to verify representations received from a hedge fund. Due to the limited ability of the SEC and other securities regulators to check hedge fund activities, the burden of the risk will rest on your shoulders. And keep in mind the fees in these funds can get a little crazy too. If you have the fortune of a very good year (20% return), fees incurred could easily exceed 6%, netting you well under 14% in return (e.g. 1 % asset mgt fee for the hedge funds, 1% to the fund of fund managers, and 1/5 for a “performance fee” to the hedge fund manager). For sure, someone is getting rich here, and it’s most likely not you. If you decide (despite all the drawbacks) that you absolutely must have a hedge fund, do your research before you invest, ask questions about the fees, understand how to redeem your shares, and research the background of the hedge fund manager. There’s a lot of mine fields out there when investing in hedge funds, make sure you don’t step on one.