Funds of Hedge Funds—Higher Costs and Risks for Higher Potential Returns
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. Securities regulators 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.
- Notice to Members 03-07—NASD 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
Enforcement Actions Involving Hedge Funds
- NASD Fines Altegris Investments for Hedge Fund Sales Violations (April 22, 2003)
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)
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