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 many investors. Its main distinction is it can pursue investment strategies — riskier strategies — 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, though most hedge fund managers had to register as investment advisers since February, 2006, due to 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 big 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 accredited investors, who presumably can afford to take significant risks, are allowed to invest in hedge funds. However, a hedge fund operated offshore may have lax requirements. A person must have a net worth of at least $1,000,000 or had an income exceeding $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 must they 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.

Hedge funds are hard to value due to illiquidity of their investments and the lack of a secondary market for their shares. Moreover, hedge fund managers have significant discretion in valuing their securities. Understand a fund's valuation process and know if 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 profit 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 may use leverage to try to increase gains but can also result in 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 gains. They usually combine 1 or more of these methods in their investment strategy.

Hedge funds use several strategies to profit.

• Market-neutral strategies try to balance long positions against short positions. Long positions are taken with companies with 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 strategies try to profit by studying the historical relationship between different securities, such as stocks, commodities, futures, and options, with computer programs and trade those positions that deviate significantly from past relationships. This method may fail if historical relationships are distorted by forced selling due to redemptions.
• Relative value strategies exploit arbitrage opportunities among markets in all asset classes.
• Macro strategies trade to exploit central bank policy, foreign exchange rates, and other macroeconomic and political developments.
• Event-driven strategies try to profit from events, such as corporate mergers and acquisitions, defaults, and bankruptcies.
• Activist funds try to profit by influencing corporate decisions through their voting power or by placing board members.

Hedge funds often use leverage to increases profits, 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.

Disadvantages:

• Because the underlying hedge funds are difficult to value, it is also difficult to value a fund of hedge funds.
• Shares are not listed on an exchange and there is no secondary market for the shares. Furthermore, they usually have very limited rights of redemption.
• The tax structure of the fund may be complex, and there could be delays in sending investors the necessary information to do their taxes.
• And fees are even higher than they are for hedge funds because they must be added to the 2% management fee and 20% performance fee of the underlying hedge funds. Funds of funds typically charge a 1% annual fee + 10% of profits above a benchmark on top of fees charged by the underlying hedge funds.

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. Hedge funds may borrow money to pay for redemptions, but too many redemptions at one time will reduce the collateral for loans, thus forcing sales for the cash to pay redemptions. Because funds of hedge funds invest in these hedge funds, they, too, must give adequate notice of redemptions, so they require similar notices from their own customers. However, funds of hedge funds may 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 due to 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.

A major sell-off creates many investment opportunities. Hedge funds with longer lockup periods who don't have to worry about customer redemptions can exploit these opportunities.

Investing in Hedge Funds

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

• requiring a certain degree of liquidity
• that shares be redeemable at any time
• protecting against conflicts of interest
• to assure fairness in the pricing of fund shares
• that require disclosure
• limiting leverage

It is very important to investigate any hedge fund that you might be interested in, for there is a great deal of fraud because legal controls and transparency are lacking. 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 later, the money was stolen. Or false account statements may be issued to attract investors, to steal their money.

To prevent fraud:

• Read a fund's prospectus or offering memorandum and related materials. to ensure you understand the level of risk involved in the fund's investment strategies and to ensure 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 assumed risks.
• Understand how a fund's assets are valued. Funds of hedge funds and hedge funds may invest in highly illiquid securities that are difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing securities. Understand a fund's valuation process and know if 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, + a performance fee of 20% of a hedge fund's profits. A performance fee could motivate a hedge fund manager to take greater risks, hoping to earn 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.
• Understand any restrictions on your right to redeem your shares. Hedge funds typically limit opportunities to redeem, or cash in, your shares (e.g., to 4 times a year), and often impose a lock-up period of 1 year or more, during which you cannot cash in your shares.
• Research the backgrounds of hedge fund managers. Know with whom you are investing. Ensure 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. 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.

Additional Topics

Rating Hedge Funds

Hedge funds are lightly regulated and do not have to register with the SEC, which allows shady operators to operate, many who were active during the Great Recession of 2007 to 2009, so rating agencies have started to rate hedge funds.

For instance, Moody's rating system 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:

• legal and financial structure, and regulatory compliance;
• back office and administration procedures, including risk reporting and control;
• and human resources, including background checks on the principle managers.

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

Hedge Fund Side-Pocket Accounts

Hedge funds use accounts called side pockets to put illiquid investments that are hard to value and sell, so they are marked 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. With little regulatory oversight, frauds or fudging with these accounts abound. 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, they collapse into lawsuits by the swindled, who even try to claw back payments from 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