Hedge Funds and Funds of Hedge Funds

A hedge fund is much like a mutual fund in that it tries to profit with money pooled from a number of investors. Its main distinction is that it can pursue investment strategies—riskier strategies—that are not available to mutual fund managers, such as using leverage or selling short, and can, therefore, profit when markets are rising or falling. It can use these techniques because it is not regulated by the Securities and Exchange Commission, although most hedge fund managers have had to register as investment advisers since February, 2006, because of a December 2, 2004 change in the Investment Advisers Act of 1940.

Hedge funds are usually organized as limited partnerships, with the manager being the general partner who makes the investments decisions, and has a significant stake in the fund.

As an unregistered private offering, hedge funds cannot market the fund to the public. Only institutions or wealthy individuals, who are presumably sophisticated investors and who can afford to take significant risks, are allowed to invest in hedge funds. However, a hedge fund operated offshore may have less lax requirements. A person must have a net worth of at least $1,000,000 or had an income of greater than $200,000 ($300,000 for a couple) in the previous year. However, because most hedge funds have large minimum requirements that typically range from $250,000 to $10,000,000 or more, most investors in hedge funds usually have a lot more money than the required minimums. Although most retail investors cannot invest in hedge funds directly, they can invest indirectly by investing in so-called funds of hedge funds.

Since hedge funds are private investment pools, securities are issued as private offerings. Hedge funds do not have to register with the SEC under the Securities Act of 1933 nor do they have to issue periodic reports under the Securities Exchange Act of 1934. However, hedge funds cannot commit fraud, and managers have a fiduciary duty to their customers.

Fees are very high: an asset management fee of 1% to 2% and a performance fee of 20% or more of profits above a benchmark.

It may be difficult to value a hedge fund because of illiquidity of its investments and because there is no secondary market for the shares. Moreover, hedge fund managers have significant discretion in valuing their securities. You should understand a fund's valuation process and know the extent to which a fund's securities are valued by independent sources.

Few hedge funds do much better than the average mutual fund, especially after subtracting fees. The best hedge funds limit new money to maintain returns.

Investment Methods and Strategies

Hedge funds invest in nearly anything: stocks, bonds, private companies, real estate, commodities, and use various methods to make money regardless of what the markets are doing: investing in options and futures, distressed or bankrupt companies, privately issued securities, and international markets. They may concentrate their investments in a single company, issuer, or market for possibly greater gains. They usually use leverage to try to increase gains, but which can also result in much larger losses. They may use arbitrage for riskless profits or sell short to profit in a down market. They may also hedge their investments to protect any gains. They usually combine 1 or more of these methods in their investment strategy.

Popular strategies used by hedge funds are market-neutral strategies and statistical arbitrage. A market-neutral strategy aims to balance long positions against short positions. Long positions are taken with companies that have a high value relative to price and have earnings momentum, while overpriced companies with falling or negative earnings are shorted. In an up market, the long positions will rise more than the short positions, and in a down market, the short positions will fall farther than the long positions, leading to a profit regardless of the direction of the market—hence the name.

Statistical arbitrage studies the historical relationship between different securities, such as stocks, commodities, futures, and options, with computer programs and trades those positions that deviate significantly from past relationships. This method may fail if historical relationships are distorted by forced selling because of redemptions.

Hedge funds tend to use a lot of leverage to increases profits, but which also increases losses, and can force the closing of positions when the value of the fund falls below its margin maintenance requirement.

Funds of Hedge Funds

A fund of hedge funds is a pooled investment that invests in unregistered hedge funds. Some of these funds are registered with the SEC, and those that are must provide prospective investors with a prospectus and file semi-annual reports with the SEC. Their minimum initial investments of $25,000 to $100,000 are much less than typical hedge funds.

Another big advantage of a fund of hedge funds is that risk can be limited by investing in different hedge funds run by different managers.

However, there are numerous disadvantages:

Redemptions and Lockup Periods

Redemptions are restricted by lock-up periods and require notices well before the redemption. Many funds offer different classes of shares with different lockup periods, notice requirements for redemptions, or redemption fees. Hedge funds restrict redemptions so that the fund manager is not forced to sell or close out positions when it would be detrimental simply because investors are panicking. Sometimes the hedge funds can borrow the money to pay for redemptions, but if there are too many at one time, then the fund will have less collateral for loans, and therefore, will need to close out positions to generate the cash for redemptions. Sometimes, the banks won't accept the collateral as is occurring now (Aug, 2007) with assets based on subprime mortgages. Because funds of hedge funds invest in these hedge funds, they, too, are required to give adequate notice of redemptions, and so they must require similar notices from their own customers. In most cases, however, funds of hedge funds allow monthly or quarterly redemptions.

Hedge funds typically have an initial 1- to 5-year lockup period during which the investor cannot redeem any shares, although most funds have a lockup period of less than 3 years. Only the best performing hedge funds can demand the longer lockup periods. Some hedge funds have a lock-up period of 2 years or longer so that the managers can avoid registering with the SEC. A new SEC rule—in force since February, 2006—requires that all managers of hedge funds with a lock-up period of less 2 years to register as investment advisers. The 2-year rule was added so that venture capitalists and managers of private equity funds wouldn't have to register as investment advisers. After the lock-up period, some hedge funds limit redemptions to once a quarter, and most hedge funds require a 15- to 90-day notice for redemptions.

Longer lockups benefit the hedge fund because it offers greater stability, and a guaranteed cash flow generated by the asset management fee, which allows the funds to attract top managers by offering better pay. Longer lockups also allow a fund to invest in illiquid assets that may take time to generate good returns, such as investments in private equity.

Redemptions may reduce the performance of the fund, especially in a down market, because the fund may be forced to sell securities at a loss, and because of leverage, it may be forced to sell more securities than would otherwise be necessary to maintain its margin maintenance requirement. Redemptions may cascade into more redemptions as nervous investors bail out of the market. Losses may also mount because the hedge funds use similar methods in deciding what to buy and sell, so if 1 hedge fund needs to liquidate to pay for redemptions or because it is overleveraged, it may cause market signals that cause other hedge funds to sell or close their positions also.

Another factor that can accelerate redemptions is if investors of funds of hedge funds want to redeem their shares. Doing so, forces these funds of hedge funds to redeem their shares in the hedge funds that they invested in, which forces the hedge funds to redeem more shares and liquefy their portfolios to pay for the redemption.

There are usually many investment opportunities in a major sell-off. Only hedge funds with longer lockup periods who don't have to worry about customer redemptions can take advantage of these opportunities.

Investing in Hedge Funds

Hedge funds are not mutual funds and, as such, are not subject to the numerous regulations that apply to mutual funds for the protection of investors including regulations:

It is very important to investigate any hedge fund that you might be interested in, for there is a great deal of fraud because of the lack of legal control and transparency. Some hedge funds have used Ponzi schemes, whereby early investors were paid with money invested by later investors to increase the number of investors and the money invested, but that was later stolen. Or false account statements may be issued to investors in the hopes of getting the investment and then stealing it.

To prevent fraud, you should:


Rating Hedge Funds

Hedge funds are lightly regulated and do not have to register with the SEC, which allows shady operators to operate, as recently reported in the news, so some hedge funds are getting a rating from the rating services.

Moody's has just issued its 1st rating on a hedge fund—Sorin Capital Management LLC—giving it a rating of OQ1-, one notch below the top rating of Moody's new rating system that ranges from OQ1 to OQ5, the lowest rating. (OQ = Operational Quality?)

Ratings depend on operational risk, not risk of default or rate of return, and thus, to determine this risk, Moody's examines the following in rating a hedge fund:

WSJ.com - Moody's Offers Glimpse Inside A Hedge Fund

Hedge Fund Side-Pocket Accounts

Hedge funds use accounts known as side pockets to put illiquid investments that are hard to value and sell, and thus to mark to market for portfolio evaluation. However, some of these side-pocket accounts may be used to off-load poorly performing investments, so that it doesn't diminish the published performance of the hedge fund, since the fund managers earn a performance fee that is a percentage of the fund's performance.

This is just yet another reason to be wary of hedge funds. Because there is little regulatory oversight, there seems to be a lot of fraud or fudging with these accounts. Just recently, it was reported that some hedge funds were actually Ponzi schemes—a pyramid investment swindle—where the hedge funds were reporting stunning, but fictitious, returns, paying out high returns to early investors to attract more suckers money into the fund. Eventually, it collapses into lawsuits by the swindled, who even try to get the money paid to early investors.

I often wonder why people invest in hedge funds. They don't seem to do as well as many well regulated investments, so why take the risk?

WSJ.com - Tracking the Numbers