Chapter 2-7 Hedge Funds

Hedge funds are increasing in quantity as well as total assets under management.  However, there have been circumstances of collapses and near collapses of well known hedge funds, which required government and Wall Street help to carry on.  Securities regulators have taken to court several cases where investors endured significant losses as a result of fraudulent activity at hedge funds.

Traditionally, hedge funds have been provided as unregistered securities that, due to the risks they present, were only accessible to a restricted number of wealthy, financially refined investors.  Presently, there are funds that are registered with the SEC and invest in unregistered, private hedge funds.  These funds are known as funds of hedge funds.  They offer the chance to invest in private hedge funds by means of an individual fund that is made up of underlying hedge funds.  Registered funds of hedge funds can have reduced minimum investment stipulations than traditional unregistered hedge funds.  Despite being registered with the SEC, they utilize investment approaches that contain risks like those of traditional hedge funds.  Prior to taking into account whether to invest in a registered fund of hedge funds, you should comprehend the specifics of these investments, how they are managed, what risks are included, and how you can get more data on them.

Historically, hedge funds have been formed as partnerships, with the general partner, known as managing member, managing the fund’s portfolio, executing investment choices, and generally having a substantial individual investment in the fund.  Hedge fund managers generally look for unlimited positive investment performance.  This signifies that hedge funds zero-in on a particular spectrum of performance, and try to generate objected returns regardless of the underlying directions of the stock market.  This is different from investments like mutual funds, in which gains or losses are frequently calculated with respect to performance in connection with a stock index, such as the Dow Jones Industrial Average.

Hedge fund managers use complex investment approaches and methods to get effective investment performance.  These approaches and methods can consist of, among other methods short selling, which is the sale of a stock you do not own.  Another method used by hedge fund managers is arbitrage.  Arbitrage is the purchasing and selling of a stock at the same time in varying markets to gain from the disparity between the prices.  Hedging is another method used by hedge fund managers.  It is the purchasing of a stock to counterbalance a possible loss on an investment.  A fourth method used is leverage, which is the borrowing of money for investment reasons.  Accumulating positions in stocks of an individual issuer or market is a method that is also utilized.  A fifth strategy used by hedge fund managers is investing in troubled or bankrupt companies.  A sixth strategy that is also utilized is investing in derivatives, like options and futures contracts.  Another method used by hedge fund managers to get effective investment performance is investing in volatile international markets.  An eighth method used is to invest in privately issued securities.  Managers are paid depending on how the fund performs.  Performance fees of 20 percent of profits are likely, as well as a fixed annual asset-based fee of 1 to 2 percent.

Due to the fact that hedge funds are typically only accessible to restricted numbers of wealthy, financially refined investors and do not advertise or publicly provide their securities, private hedge funds generally do not need to register with the SEC.  Because of this, unregistered private hedge funds do not offer many of the investor safeguards that pertain to registered investment products, such as mutual funds.  Hedge funds typically are not liable to mutual fund rules, like regulations that include needing a specific amount of liquidity, restricting the amount that can be invested in any individual investment, needing that fund shares be capable of being cashed in or bought back, safeguarding against conflicts of interests, guaranteeing of reasonableness in pricing of the fund shares, needing revelation of information about a fund’s management, holdings, fees and expenses, and performance, or restricting the utilization of leverage.  However, the common bans against securities fraud do pertain.

Funds of hedge funds are combined investments in numerous unregistered hedge funds.  Different from underlying private hedge funds, the fund of funds can file with the SEC under the Investment Company Act of 1940.  Furthermore, the fund of funds securities also can be filed for sale to the public under the Securities Act of 1933.  Registered funds of funds can have lesser minimum investments than private hedge funds, some as little as $25,000.  A registered fund of hedge funds can be provided to an unrestricted number of investors.  But, different from an open-ended mutual fund, there is no investor right of redemption, which means that the shares ca not be redeemed right away with the fund except under the circumstances that the fund proposes to redeem them.  And the shares are not typically listed on a securities exchange as the exchange-traded funds (ETFs) are.  There is no secondary market accessible, only in very restricted special cases, so you are not be capable of selling your investment easily.  An investment in a fund of hedge funds does have some possible benefits over a direct investment in a private hedge fund.  For example, a fund of funds may change among a variety of investment techniques, approaches and hedge fund managers, in an attempt to hold risk in check.

Costs in funds of hedge funds are substantially more than the majority of mutual funds.  Due to the fact that funds of hedge funds invest in several private hedge funds, they also endure a portion of the fees and expenses of the underlying hedge funds.  You ought to be certain you comprehend the fee makeup of any fund of hedge funds that you consider investing in.

Funds of hedge funds typically invest in a number of private hedge funds that are not liable to the SEC’s registration and disclosure stipulations.  Several of the normal investor safeguards that are typical to the majority of traditional registered investments are lacking.  This makes it hard for you, as well as the fund of funds manager, to evaluate the performance of the underlying hedge funds or separately confirm data that is documented.  This makes it simpler for a deceitful hedge fund manager to partake in fraud.  Hedge funds often utilize risky investment and trading approaches.  A lot of hedge funds are managed fairly, and compensate for a high risk of money loss with a high possibility for growth.  But the risks hedge funds take on can eliminate your whole investment.  If you are not able to suffer the loss of your whole investment, then hedge funds and funds of hedge funds may not be suited for you.

Both unregistered and registered hedge funds are not easily converted into cash and are liable to limitations on transferring them and resale.  Different from mutual funds, there are no particular rules on the pricing of hedge funds.  Registered hedge fund shares may not be cashed in at the investor’s discretion, and there is in all likelihood no secondary market for the sale of the hedge fund shares, which means that you may not be able to receive the capital you invested in the hedge fund back when you desire to leave the investment.

Questions