Hedging Your Bets:
A Heads Up on Hedge Funds and Funds of Hedge
Funds
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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