Hedge Fund – What is Hedge Fund
Hedge funds pool investors money and invest the money in an effort to make a positive return. Hedge funds typically have more flexible investment strategies than mutual funds.
Many hedge funds seek to profit in all kinds of markets by using leverage (in other words, borrowing to increase investment exposure as well as risk), short-selling and other speculative investment practices that are not often used by mutual funds.
Unlike mutual funds, hedge funds are not subject to some of the regulations that are designed to protect investors.
Depending on the amount of assets in the hedge funds advised by a manager, some hedge fund managers may not be required to register or to file public reports with the SEC.
Hedge funds, however, are subject to the same prohibitions against fraud as are other market participants, and their managers owe a fiduciary duty to the funds that they manage.
Hedge fund investors do not receive all of the federal and state law protections that commonly apply to most mutual funds. For example, hedge funds are not required to provide the same level of disclosure as you would receive from mutual funds. Without the disclosure that the securities laws require for most mutual funds, it can be more difficult to fully evaluate the terms of an investment in a hedge fund. It may al
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.