What Are Hedge Funds?

Hedging Your Bets:

As stock market indices have declined, some investors have begun looking for alternative forms of investments, such as hedge funds. While hedge funds have traditionally been available only to those with significant assets, they are becoming available to a broader spectrum of investors through funds of hedge funds. As with any investment, before considering an investment in a hedge fund or fund of hedge funds, it is important that you fully understand the risks, as well as the potential rewards.

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. However, unlike mutual funds, hedge funds are not registered with the SEC. This means that hedge funds are subject to very few regulatory controls. In addition, many hedge fund managers are not required to register with the SEC and therefore are not subject to regular SEC oversight. Because of this lack of regulatory oversight, hedge funds historically have been available to accredited investors and large institutions, and have limited their investors through high investment minimums (e.g., $1 million).

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.

What are "funds of hedge funds?"

A fund of hedge funds is a relatively new fund product. Rather than investing in individual securities, a fund of hedge funds invests in several hedge funds. 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 semi-annual reports with the SEC.

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

Many 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 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. The NASD recently published a Notice to Members reminding broker-dealers of their suitability obligations for selling hedge funds to investors. As with any investment, the higher the potential returns, the higher the risk you must assume.
Understand how a fund's assets are valued. Hedge funds may invest in highly illiquid securities that may be very hard 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. Therefore, 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 search the NASD's computerized database, or call your state securities regulator to find out this information.
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 the investor alert the NASD issued, which contains more information about funds of hedge funds.

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

Hedge fund investors do not receive the full set of protections commonly applied by the federal and states' securities laws to most registered investments. This means that you won't get the same level of disclosures from a hedge fund that you'll get from other 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 the SEC and other securities regulators 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, the hedge funds lied to investors about the experience of their managers and the fund's track record. Many were classic "Ponzi schemes," where the 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. And if you'd like to see a real hedge fund fraud, click here.

What should I do if I have a complaint about a hedge fund or a fund of hedge funds?

If you encounter a problem with your hedge fund or fund of hedge funds, you can send us your complaint using our online complaint form at www.sec.gov/complaint.shtml. You can also reach us by regular mail at:

Securities and Exchange Commission
Office of Investor Education and Assistance
450 Fifth Street, N.W.
Washington, D.C. 20549-0213

For more information about investing wisely and avoiding fraud, please check out the "Investor Information" section of our website at www.sec.gov/investor.shtml.

http://www.sec.gov/answers/hedge.

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