Hedge Funds, Part II

By Nancy Zambell, Contributing Editor, Financially Fit

In last week’s issue of Financially Fit, we covered the origin of hedge funds, their goals and the typical methodologies and strategies implemented to achieve them. This week, we’ll wrap up this series by looking at investor qualifications, compensation of managers, the regulatory environment, problems in the industry, and resources for further information.

Not every investor is a hedge fund candidate

For years, hedge funds were available only to the very well-heeled investor, folks with more than a million dollars to invest. Circumstances have changed today, with some smaller fund minimums as low as $100,000 or $250,000, but the average investment minimum for hedge funds is still around $1 million.

Additionally, to invest in hedge funds, investors must be ‘accredited’ or ‘qualified’. Accredited, in terms of individual investors, means an investor whose net worth or joint net worth is more than $1 million or who had more than $200 thousand in income (more than $300,000, if joint) in each of the two most recent years, with reasonable expectation of reaching the same income in the current year.

A qualified investor is defined as an individual or family business with more than $5 million in investments or discretion over $25 million of investments.

Consequently, while hedge funds are now more open to a wider variety of investors, participation in individual funds is still limited to high-net worth individuals or institutional investors including pension funds, charities, universities, endowments and foundations.

But there is one category of hedge fund investing that has made these vehicles more attractive and available to individual investors: Hedge funds of funds.  These investments, many with minimum accounts of $25,000, are funds that invest in hedge funds, rather than in individual securities.

And while investing in a hedge fund of funds can offer extra diversification, there are a couple of twists that investors need to be aware of:

• Additional layer of fees: Hedge fund of funds charge a fee for managing the assets, and perhaps a performance fee, in addition to the fees charged by the underlying individual hedge funds. This added level of fees can substantially reduce investment return if the returns themselves are unimpressive. Of course, if the performance of the fund is outstanding, the fees may be a non-issue.

• Less transparency: Most hedge funds privately-run, and are therefore, not subject to much regulation, so heaping fund upon fund requires much more due diligence on the part of the investor.

Consequently, the role of manager of the fund of funds becomes very critical, and is worth a thorough investigation.

Yes, hedge fund managers generally take home big paychecks

Fees for managing hedge funds are generally not limited. Most managers typically receive a combination of 1-2% of the assets under management as an annual fee, plus a percentage of the profits (usually 20%) they generate from the investments they manage.

According to USA Today, the top 25 hedge fund managers earned an average of $363 million in 2005, up 45% from 2004. Compared to the $10 million a typical CEO of a U.S. Fortune 500 company takes home, that’s a pretty good paycheck!

Of course, the job isn’t very secure. One bad year, and hedge fund investors do not hesitate to take their business elsewhere, often precipitating the demise of the fund. In fact, in just the first six months of 2006, according to Hedge Fund Research of Chicago, some 326 hedge funds went out of business, due primarily to below-par returns.

And while many hedge funds can be very profitable as investment vehicles, as of this writing, the average fund in the HFRX Global Hedge Fund Index is up 4.0% for the year, while the Dow Jones Industrial Average has climbed 10.7% and the S&P 500 has risen 8.5%. Consequently, it behooves an investor to choose his funds very carefully.

Hedge funds are not required to register with the SEC

Hedge funds usually issue securities in private offerings and they are not required to make periodic reports to the Securities and Exchange Commission (SEC). However, their managers do have a fiduciary duty to their clients and they are subject to the same anti-fraud rules as other investment advisers. And if they do register with the SEC, they are required to provide investors with a prospectus and also must file certain quarterly reports with them. 

However, they are not totally unregulated. Several international agencies and U.S. government agencies including the Federal Reserve, SEC, Department of the Treasury, the Commodity Futures Trading Commission, the National Futures Association, the Federal Deposit Insurance Corporation, the Comptroller of the currency, do offer some level of oversight and say-so as to the business affairs of hedge funds.  

Our federal government attempted to bring hedge funds under more severe regulation when it enacted a rule that required hedge funds with more than 14 investors and $25 million in assets to register with the SEC and undergo routine inspections. That requirement went into effect last February, in the face of tremendous opposition from the industry. In June, it was rejected by a U.S. Court of Appeals, and the SEC decided not to appeal that decision. However, the SEC is introducing a new anti-fraud rule and also considering additional minimum asset and income requirements for hedge fund investors.

More oversight may emerge, as a result of the recent loss at Amaranth

Wall Street was sent into a tizzy in 1998 when the bottom fell out for hedge fund Long-Term Capital Management (LTCM). When prices went against them, a weak risk management system and highly leveraged investments led to a $4.6 billion loss overnight. But because the fund had taken on huge positions that were linked to many financial institutions, which could have created tremendous economic repercussions, the Federal Reserve Bank of New York organized a bail out by the banks.

After that fiasco, the clients of hedge funds tightened their counterparty risk management strategies, and leading hedge funds have worked to developed best practice guidelines for the industry.

There are plenty of other examples of problems in the industry. I’ll cite two here which should give you an idea of the importance of proper investigation of management when considering investing in a hedge fund:

• The management of Lipper Convertibles (not related to Lipper Inc., the mutual fund data firm) perpetuated a fraud in the late 90s that wasn’t discovered in 2002. Profits were inflated by 40%, more than $300 million. The fund paid out early investors who are now being sued by a trustee to retrieve more than $100 million from them.

• Failed Connecticut hedge fund Bayou Management LLC did the same thing. Two of the fund’s founders inflated profits and now the trustee is attempting to reclaim more than $100 million – profits + initial investment – from investors.

Then, of course, the latest headline-making incident, as well as the biggest hedge fund loss ever: Amaranth, a Connecticut hedge fund, announced a few weeks ago that it had lost $6 billion, a whopping 55% of its assets, due to bad bets on natural gas prices.

The result of this is election-concerned Congress getting back into the act, now considering legislation for more oversight. We’ll see how that plays out after next month’s elections.

Better safe than sorry

While hedge funds can add significant returns to your portfolio, you can see that they are not without risk, and should only be purchased after a thorough vetting.

Here are questions you may wish to consider as you investigate the investment potential for hedge funds:

Read a fund’s prospectus or offering memorandum, as well as any related materials, so that you gain an understanding of the associated risks and ensure that their strategies meet your goals, time horizons and risk tolerance.

Understand how a fund’s assets are valued. Many funds invest in highly illiquid securities that make a accurate valuation very difficult, and remember that the funds are allowed considerable leeway when they value investments. You need to find out the details.

Ask a lot of questions about fees.

Find out the fund’s limitations on redeeming shares. In many cases, funds allow redemptions just four times a year. Additionally, funds often impose a lock-up period of one year or more, a time frame in which you cannot cash in your shares.

Inquire about performance and make sure the quoted returns are net of fees. Hedge fund returns are classified as: Pro forma (assumptions, hypothetical), managed account (in which the firm manages individual accounts, outside of the existing hedge fund structure that may have existed prior to the inception of the hedge fund), estimated, confirmed, and audited. Make sure you know which return you are talking about.

As with any investment, typically the more aggressive it is, the greater the potential for more risk and return. Hedge funds come in many flavors, including: Aggressive growth, distressed securities, emerging market, funds of funds, income, macro (global economies), market neutral (arbitrage to hedge market risk), hedge; market timing, opportunistic; multi-strategy, short selling, special situations and value.

Not all are highly aggressive.  As always, know what you are buying.

Research the background of the fund’s management, their qualifications, as well as their disciplinary histories. Form ADV can be found on the Investment Adviser Public Disclosure web site:

http://www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.aspx

Or, on your state’s securities regulatory site (for funds with less than $25 million under management):

http://www.nasaa.org/QuickLinks/ContactYourRegulator.cfm

Additional information can be found on the SEC’s site:

www.sec.gov

And in the NASD’s Investor Alerts.

One last reminder: Hedge fund investors do not have the same level of disclosure that you would expect from registered investments. And it may be very difficult to determine if the representations made to you are true. While the returns of many hedge funds do offer significant investment potential, this is one area where the premise of Buyer Beware should not be neglected.

Until next week…

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


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