Securities Regulators Issue New Round of Warnings Regarding Hedge Funds
By James J. Eccleston, Esq.
he New York Stock Exchange (NYSE) recently published, "Hedge Fund Investing — Is It a Suitable Investment For You?" That publication, available on the NYSE's website, is one of several pronouncements that securities regulators have made regarding hedge funds.
The concern is that retail investors (as distinguished from "institutional" investors) should not invest in hedge funds. Indeed, SEC Chairman Christopher Cox recently testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs that hedge funds "are not investments for Mom and Pop." Chairman Cox opined that they "are generally risky ventures that simply don't make sense for most retail investors."
What makes hedge funds unsuitable for most retail investors? Let's examine the recent NYSE publication.
As background, the NYSE describes how hedge funds have grown exponentially, prompted by investors seeking to improve on what have been low market returns. This growth has meant that hedge funds — once reserved for only a small group of wealthy, sophisticated investors — now have spread to "a wider segment of the investing public." Hedge funds, observes the NYSE, are not registered, have little regulatory oversight, and are not required to disclose "significant details" about their operations and holdings. The NYSE writes that hedge funds charge higher fees (generally 2% of assets under management and 20% of trading profits, though fees may be significantly higher) than traditional investments such as mutual funds. Likewise, hedge funds "employ trading strategies that may increase volatility across all types of asset classes, not just stocks and bonds." Another, related investment is the "fund of funds." This is a fund that invests in hedge funds and, of course, charges another layer of fees to investors, which further lowers profits.
The NYSE publication identifies six risks of hedge fund investing to which investors should pay particular attention. These risks are that hedge funds:
 Often hold investments that are illiquid;
Engage in leverage (by the use of margin) and other speculative practices;
Are not required to provide information to investors, such as regular financial reports;
May raise complex tax issues;
Often charge high fees; and
Frequently place limitations on an investor's ability to withdraw funds.
NYSE encourages investors to pose questions to the hedge fund representative, or the investment adviser or financial adviser who may be introducing or recommending the hedge fund investment. One of the questions relates to whether or not the investor has received the private placement memorandum (PPM), which will (or should) outline the hedge fund's risk factors. NYSE cautions that "often" hedge funds do not provide this important disclosure document.
Another question details the kinds of conflicts of interest that the PPM should disclose in an understandable manner. These conflicts of interest include valuation practices, which means that generally, "a hedge fund's valuation practices give rise to an inherent conflict of interest because the level of fees that the investment adviser earns is based on the value of the fund's portfolio holdings as determined by the fund's manager." A second conflict of interest can arise from the fund manager's management of multiple accounts, such as the hedge fund, and other accounts such as proprietary accounts, private accounts and registered investment companies. The NYSE cautions that this situation "may lead to inequitable allocation practices among the accounts." A third conflict of interest can exist when the hedge fund allocates certain investment opportunities among its clients. The NYSE notes that while some PPMs provide great detail as to the hedge fund's allocation policies, other PPMs may list or only briefly discuss the factors on which such allocation will be decided.
Another question focuses upon liquidity. Investors need to understand that hedge funds are not registered with the SEC and, thus, are not traded on an exchange or in the over-the-counter markets. The result is that the hedge fund may be less liquid (and harder to value) than other investments. As well, many hedge funds have imposed "lock-up" periods which force investors to hold the investment for a minimum of two years.
In conclusion, the NYSE publication is a valuable resource for those retail investors willing to expose themselves to the considerable risks of hedge fund investing.
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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.
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