Guidance Regarding Investing in Hedge Funds

ecurities regulators have provided much needed advice to investors considering the purchase of a hedge fund (or the purchase of a fund of hedge funds). The SEC has published "Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds," available at www.sec.gov/answers/hedge.htm. Likewise, the National Association of Securities Dealers (NASD) has published an Investor Alert entitled, "Funds of Hedge Funds - Higher Costs and Risks for Higher Potential Returns," available at www.nasd.com/investor/alerts/alert_hedgefunds.htm. Let's summarize these publications.

First, what are hedge funds and funds of hedge funds? The NASD states that while there is no exact definition of the term "hedge fund" in federal or state securities laws, hedge funds are private investment pools for wealthy and sophisticated investors. The SEC adds that hedge funds are not subject to regular SEC oversight (unlike a mutual fund). Further, a fund of hedge funds is a relatively new product, whereby one fund invests in several other hedge funds. The SEC reports that some funds of hedge funds do register with the SEC. As a result, these registered funds of hedge funds must provide a prospectus to investors and also must file semi-annual reports with the SEC. Notably, funds of hedge funds carry much lower investment minimums than hedge funds (for example, $25,000).

Second, what kinds of investments do hedge funds purchase? Unlike mutual funds, hedge fund managers typically seek absolute, positive investment performance not relative to any benchmark such as the S&P 500, for example. To do so, the NASD reports that hedge funds use "sophisticated investment strategies and techniques" that may include:

Short selling (sale of a security that you do not own)
Arbitrage (simultaneous buying and selling of a security in different markets to profit from the difference between the prices)
Hedging (buying a security to offset a potential loss on an investment)
Leverage (borrowing money to invest)
Concentrated positions in one security or one market
Investing in distressed or bankrupt companies
Investing in derivatives (such as options or futures contracts)
Investing in volatile international markets and
Investing in privately issued securities

Third, what do investors pay in fees? The SEC publication states that hedge funds typically charge an asset management fee of 1-2% of assets, plus a "performance fee" of 20% of the hedge fund's profits. The SEC cautions that, "A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating a larger return." With respect to funds of hedge funds, investors pay two layers of fees. That is, investors typically pay another layer of asset based fees for management with some funds charging another layer of performance-based fees. The NASD finds that expenses in funds of hedge funds are "significantly higher" than most mutual funds and advises investors to be sure to understand that fee structure before they invest.

Fourth, what are the risks of investing in hedge funds or funds of hedge funds? According to the NASD, the major risks associated with hedge fund investing are that they are unregistered investments (making it difficult to assess performance and verify information) and typically, though not always, employ speculative trading strategies. Likewise, hedge funds usually are not liquid (that is, investors have difficulty or are unable to access their monies invested), and often cause adverse tax consequences (typically due to late receipt of important tax information).

Finally, what kind of due diligence can investors perform before they invest? The SEC recommends:

Read the fund's prospectus or offering memorandum before investing
Understand how the fund values its assets
Ask questions regarding fees
Understand limitations on your right to redeem shares (the liquidity issue) and
Research the qualifications and the disciplinary backgrounds of hedge fund managers

Investors should not invest until they are satisfied that the hedge fund, or fund of hedge funds, is a suitable investment for them.

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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.