Hedge Funds: What are they and are they right for me?

Hedging Your Bets:
A Heads Up on Hedge Funds and Funds of Hedge Funds

What are hedge funds?

Like mutual funds, hedge funds pool investors’ money and invest those funds in financial instruments in an effort to make a positive return. Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss.

Unlike mutual funds, however, hedge funds are not required to register with the SEC. This means that hedge funds are subject to very few regulatory controls. Because of this lack of regulatory oversight, hedge funds historically have generally been available solely to accredited investors and large institutions. Most hedge funds also have voluntarily restricted investment to wealthy investors through high investment minimums (e.g., $1 million).

Historically, most hedge fund managers have not been required to register with the SEC and therefore have not been subject to regular SEC oversight. However, in December 2004, the SEC issued a final rule and rule amendments that require certain hedge fund managers to register with the SEC as investment advisers under the Investment Advisers Act by February 1, 2006.

What are “funds of hedge funds?”

A fund of hedge funds is an investment company that invests in hedge funds — rather than investing in individual securities. Some funds of hedge funds register their securities with the SEC. These funds of hedge funds must provide investors with a prospectus and must file certain reports quarterly with the SEC.

Note: Not all funds of hedge funds register with the SEC.

Many registered funds of hedge funds have much lower investment minimums (e.g., $25,000) than individual hedge funds. Thus, some investors that would be unable to invest in a hedge fund directly may be able to purchase shares of registered funds of hedge funds.

What information should I seek if I am considering investing in a hedge fund or a fund of hedge funds?

• Read a fund’s prospectus or offering memorandum and related materials. Make sure you understand the level of risk involved in the fund’s investment strategies and ensure that they are suitable to your personal investing goals, time horizons, and risk tolerance. As with any investment, the higher the potential returns, the higher the risks you must assume.
  
• Understand how a fund’s assets are valued. Funds of hedge funds and hedge funds may invest in highly illiquid securities that may be difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing securities. You should understand a fund’s valuation process and know the extent to which a fund’s securities are valued by independent sources.
  
• Ask questions about fees. Fees impact your return on investment. Hedge funds typically charge an asset management fee of 1-2% of assets, plus a “performance fee” of 20% of a hedge fund’s profits. A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating a larger return. Funds of hedge funds typically charge a fee for managing your assets, and some may also include a performance fee based on profits. These fees are charged in addition to any fees paid to the underlying hedge funds.
  
  Tip: If you invest in hedge funds through a fund of hedge funds, you will pay two layers of fees: the fees of the fund of hedge funds and the fees charged by the underlying hedge funds.

• Understand any limitations on your right to redeem your shares. Hedge funds typically limit opportunities to redeem, or cash in, your shares (e.g., to four times a year), and often impose a “lock-up” period of one year or more, during which you cannot cash in your shares.
  
• Research the backgrounds of hedge fund managers. Know with whom you are investing. Make sure hedge fund managers are qualified to manage your money, and find out whether they have a disciplinary history within the securities industry. You can get this information (and more) by reviewing the adviser’s Form ADV. You can search for and view a firm’s Form ADV using the SEC’s Investment Adviser Public Disclosure (IAPD) website. You also can get copies of Form ADV for individual advisers and firms from the investment adviser, the SEC’s Public Reference Room, or (for advisers with less than $25 million in assets under management) the state securities regulator where the adviser’s principal place of business is located. If you don’t find the investment adviser firm in the SEC’s IAPD database, be sure to call your state securities regulator or search the FINRA’s BrokerCheck database for any information they may have.
  
• Don’t be afraid to ask questions. You are entrusting your money to someone else. You should know where your money is going, who is managing it, how it is being invested, how you can get it back, what protections are placed on your investment and what your rights are as an investor. In addition, you may wish to read FINRA’s investor alert, which describes some of the high costs and risks of investing in funds of hedge funds.

What protections do I have if I purchase a hedge fund?

Hedge fund investors do not receive all of the federal and state law protections that commonly apply to most registered investments. For example, you won’t get the same level of disclosures from a hedge fund that you’ll get from registered investments. Without the disclosures that the securities laws require for most registered investments, it can be quite difficult to verify representations you may receive from a hedge fund. You should also be aware that, while the SEC may conduct examinations of any hedge fund manager that is registered as an investment adviser under the Investment Advisers Act, the SEC and other securities regulators generally have limited ability to check routinely on hedge fund activities.

The SEC can take action against a hedge fund that defrauds investors, and we have brought a number of fraud cases involving hedge funds. Commonly in these cases, hedge fund advisers misrepresented their experience and the fund’s track record. Other cases were classic “Ponzi schemes,” where early investors were paid off to make the scheme look legitimate. In some of the cases we have brought, the hedge funds sent phony account statements to investors to camouflage the fact that their money had been stolen. That’s why it is extremely important to thoroughly check out every aspect of any hedge fund you might consider as an investment. If you’d like to see an example of hedge fund fraud, click here.

This information on Hedge Funds is courtesy of the U.S. Securities and Exchange Commission. To find out more about Hedge Funds, click here.

FINRA Reminds Members of Obligations When Selling Hedge Funds

Washington, DC — FINRA advised in a Notice to Members that it is concerned about the sales practices of some of its members, who sell direct interests in hedge funds and indirect interests through funds of hedge funds, especially given the recent surge in the popularity of the funds. The notice is available at http://www.nasdr.com/pdf-text/0308ntm.pdf.

“Brokerage firms must fulfill their investor protection obligations when selling hedge funds, including suitability and disclosure. Although we are not charged with regulating hedge funds, we will scrutinize carefully the activities of broker-dealers when they sell those products; those actions directly affect the investing public,” said Mary L. Schapiro, FINRA Vice Chairman and President of Regulatory Policy and Oversight.

A hedge fund can be described generally as a private and unregistered investment pool that accepts investors’ money and employs sophisticated hedging and arbitrage techniques using long and short positions, leverage and derivatives, and investments in many markets. Hedge funds vary in size and trading strategies, including categories such as: relative value hedge funds, event driven hedge funds, equity hedge funds, global asset allocator hedge funds, short selling hedge funds, sectoral hedge funds, and market neutral hedge funds.

As a result of a recent review of members that sell hedge funds and registered products (closed-end funds) that invest in hedge funds, FINRA has become concerned that some members may not be fulfilling their sales practice obligations when selling these instruments, especially to retail customers. Obligations of members when selling hedge funds and funds of hedge funds, include:

• Providing balanced disclosure in promotional efforts;
• Performing a reasonable-basis suitability determination;
• Performing a customer-specific suitability determination;
• Supervising associated persons selling hedge funds and funds of hedge funds; and
• Training associated persons regarding the features, risks, and suitability of hedge funds.

FINRA is the leading private-sector provider of financial regulatory services, dedicated to bringing integrity to the markets and confidence to investors through effective and efficient regulation and complementary compliance and technology-based services. FINRA touches virtually every aspect of the securities business – from registering and educating all industry participants, to examining securities firms, enforcing both FINRA rules and the federal securities laws, and administering the largest dispute resolution forum for investors and member firms. For more information, please visit our Web Site at www.nasd.com.

This information on Hedge Funds is © 2005 FINRA. All rights reserved. To find out more about Hedge Funds at FINRA, click here.

Funds of Hedge Funds – Higher Costs and Risks for Higher Potential Returns

August 23, 2002

You’ve probably read or heard of hedge funds in financial magazines or on television or the Internet. Hedge funds are growing in both number and total assets under management.

Yet, there have been celebrated cases (see below) of failures and near failures of high profile hedge funds, notably Long Term Capital Management, which needed government and Wall Street assistance to survive. Recently, the U.S. Securities and Exchange Commission (SEC) and FINRA have brought a number of cases where investors suffered substantial losses due to fraudulent activity at hedge funds.

Historically, hedge funds have been offered as unregistered securities that, because of the risks they posed, were only available to a limited number of wealthy, financially sophisticated investors. Now there are funds that are registered with the SEC and invest in unregistered, private hedge funds. These “funds of hedge funds” provide the opportunity to invest in private hedge funds through a single fund that is composed of underlying hedge funds. Registered funds of hedge funds can have lower minimum investment requirements than traditional unregistered hedge funds, and permit a greater number of investors. Even though they are registered with the SEC, they use investment strategies that involve risks similar to those of traditional hedge funds.

Before you consider investing in a registered fund of hedge funds, you should understand the features of these investments, how they are regulated, what risks are involved, and how you can get more information on them.

What are Hedge Funds?

There is no exact definition of the term “hedge fund” in federal or state securities laws. Hedge funds are basically private investment pools for wealthy, financially sophisticated investors. Traditionally, they have been organized as partnerships, with the general partner (or managing member) managing the fund’s portfolio, making investment decisions, and normally having a significant personal investment in the fund.

Hedge fund managers typically seek absolute positive investment performance. This means that hedge funds target a specific range of performance, and attempt to produce targeted returns irrespective of the underlying trends of the stock market. This stands in contrast to investments like mutual funds, where success or failure is often measured in terms of performance in relation to a stock index, like the

Dow Jones Industrial Average.

To get positive investment performance, hedge fund managers use sophisticated investment strategies and techniques that may include, among other techniques:

• short selling (sale of a security 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 for investment purposes)
• concentrating positions in securities of a single issuer or market
• investing in distressed or bankrupt companies
• investing in derivatives, such as options and futures contracts
• investing in volatile international markets
• investing in privately issued securities

Managers are paid based on the fund’s performance. Performance fees of 20% of profits are common, along with a fixed annual asset-based fee of 1 to 2%.

Because they are usually only open to limited numbers of wealthy, financially sophisticated investors and do not advertise or publicly offer their securities, private hedge funds are usually not required to register with the SEC. As a result, unregistered private hedge funds do not provide many of the investor protections that apply to registered investment products, such as mutual funds. For example, hedge funds generally are not subject to numerous mutual fund rules, such as regulations:

• requiring a certain degree of liquidity
• limiting how much can be invested in any one investment
• requiring that fund shares be redeemable
• protecting against conflicts of interests
• assuring fairness in pricing of the fund shares
• requiring disclosure of information about a fund’s management, holdings, fees and expenses, and performance
• limiting the use of leverage

The general prohibitions against securities fraud do apply.

What are Funds of Hedge Funds?

Funds of hedge funds are pooled investments in several unregistered hedge funds. Unlike the underlying private hedge funds, the fund of funds itself can register with the SEC under the Investment Company Act of 1940. In addition, the fund of fund’s securities also can be registered for sale to the public under the Securities Act of 1933. Registered funds of funds can have lower minimum investments than private hedge funds (some as low as $25,000). A registered fund of hedge funds can be offered to an unlimited number of investors. However, unlike an open-ended mutual fund, there is no investor right of redemption – shares cannot be redeemed directly with the fund unless the fund offers to redeem them. Nor are the shares usually listed on a securities exchange like exchange-traded funds (ETFs). With very limited exceptions, there is no secondary market available, so you won’t be able to sell your investment readily.

An investment in a fund of hedge funds does have some potential advantages over a direct investment in a private hedge fund. For example, a fund of funds may diversify between a number of different investment styles, strategies and hedge fund managers, in an effort to control risk.

High Fees and Expenses

Expenses in funds of hedge funds are significantly higher than most mutual funds. For example, one such fund of funds has an annual asset base fee of 2.15%. In comparison, mutual funds have expense ratios averaging 1.36%, based on data from the SEC’s Report of Mutual Fund Fees and Expenses. The manager of this fund of funds also gets 10% of any annual gain that exceeds an 8% return. Because it invests in a number of private hedge funds, a fund of funds also bears part of the fees and expenses of those underlying hedge funds as well. You should be sure you understand the fee structure of any fund of hedge funds that you consider investing in.

What are the Risks of Investing in a Fund of Hedge Funds?

Unregistered Investments

Funds of hedge funds generally invest in several private hedge funds that are not subject to the SEC’s registration and disclosure requirements. As discussed above, many of the normal investor protections that are common to most traditional registered investments are missing. This makes it difficult for both you and the fund of funds manager to assess the performance of the underlying hedge funds or independently verify information that is reported. All of this can make it easier for an unscrupulous hedge fund manager to engage in fraud.

Risky Investment Strategies

As noted, hedge funds very often use speculative investment and trading strategies. Many hedge funds are honestly managed, and balance a high risk of capital loss with a high potential for capital growth. The risks hedge funds incur, however, can wipe out your entire investment. If you can’t afford to lose your entire investment, then perhaps hedge funds and funds of hedge funds are not for you.

Lack of Liquidity

Hedge funds, both the unregistered and registered variety, are illiquid investments and are subject to restrictions on transferability and resale. Unlike mutual funds, there are no specific rules on hedge fund pricing. Registered hedge fund units may not be redeemable at the investor’s option and there is probably no secondary market for the sale of the hedge fund units. In other words, you may not be able to get the money you invested in the hedge fund back when you want out of the investment.

Adverse Tax Consequences

The tax structure of registered fund of hedge funds may be complex. There also may be delays in receiving important tax information. This may require you to obtain an extension to file your income tax return.

Additional Resources

• FINRA Notice to Members 03-07 — FINRA Reminds Members of Obligations When Selling Hedge Funds
• The Investment Company Institute’s The Differences Between Mutual Funds and Hedge Funds.
• Securities and Exchange Commission’s Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds

Recent FINRA Enforcement Actions Involving Hedge Funds

FINRA Fines Altegris Investments for Hedge Fund Sales Violations (April 22, 2003)

Recent SEC Enforcement Actions Involving Hedge Funds

SEC v. Cummings, (June 24, 2002)
SEC v. House Asset Management, L.L.C., (June 19, 2002)
SEC v. Hoover, (April 24, 2002)
SEC v. Baptiste, (January 10, 2002)
SEC v. Berger, (November 31, 2001)
SEC v. Friedlander, (January 15, 2001)
SEC v. Smirlock, (December 21, 2000)
SEC v. Ashbury Capital Partners, L.P. (October 17, 2000)
SEC v. Higgins, (May 10, 2000)
SEC v. Moabley, (February 22, 2000)

This information on Hedge Funds is © 2005 FINRA. All rights reserved. To find out more about Hedge Funds at FINRA, click here.