CERTIFIED PUBLIC ACCOUNTANTS AND ADVISORS |
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NEW BREED OF HEDGE FUNDS OPEN TO MORE INVESTORS Hedge funds have traditionally been higher risk, generally unregulated private investment pools restricted to mostly wealthy, "sophisticated" investors. Now a new breed of hedge fund, a fund of funds called a registered hedge fund, is emerging that will allow less affluent investors to enter the hedge fund world. But should they? To understand how registered hedge funds work, you first need to understand the workings of the underlying unregistered hedge funds in which they invest. As the name suggests, hedge funds try to "hedge" against stock market risk. They have done this pretty well the past three years. Despite some well-publicized failures by individual funds, hedge funds as a whole returned an average of 11.2 percent annually the last three years, according to Van Hedge Fund Advisors during a time when corporate stocks were getting hammered. Hedge funds employ a variety of investment strategies, from selling short and arbitrage, to leveraging and investing in bankrupt companies. To follow these strategies, hedge funds don’t follow the same rules as mutual funds. They work as limited partnerships.. The general partner is free to pursue nearly any investment strategy he or she chooses, as long as it’s not prohibited in the partnership agreement (this may even include, though rare, investing the fund’s entire assets in a single stock). Hedge funds are lightly regulated, with no or limited reporting requirements for what securities they hold, and no daily reporting of their performance. Investors must meet minimum financial criteria, and minimum fund investments can be $1 million or more. In contrast, registered hedge funds must register with the Securities and Exchange Commission (SEC) and follow much stricter rules, including auditing and performance reporting. In return, they can offer their funds to an unlimited number of investors without the minimum financial qualifications, though in practice many of these funds still insist on financial minimums—in some cases, as high as those of the underlying private hedge funds in which they invest Minimum investments commonly are much lower, though still higher than most mutual funds—sometimes as low as $25,000, and in at least one case, only $5,000. While registered hedge funds are available to more investors than private hedge funds, they nonetheless carry considerable risk and cost compared with the standard or closed-end mutual fund. First, as retail funds of funds, they invest in unregistered hedge funds—typically around 15 to 25 of them, often with a mix of investment styles. While this tends to make them more diversified than the nonretail funds they hold, the fact remains that they are still investing in unregulated assets. For example, the registered hedge fund may not know much more about a particular hedge fund’s holdings or performance than individual investors. As with regular hedge funds, registered hedge funds are very illiquid. Redemption of shares is at the fund’s discretion, not on a daily basis as required for mutual funds. Redemption might only be quarterly, for example. Funds are not listed on exchanges and there are few or no secondary markets for selling shares. How and how often a given registered fund offers redemption opportunities varies greatly from fund to fund. Fees and expenses are another major issue for investors. Management fees usually run higher than those of mutual funds—typically one to two percent. In addition, registered funds usually charge incentive fees running about five to ten percent of the profits they earn. (Some charge an incentive fee only on the return earned above a minimum rate of return.) Moreover, because these are funds of funds, these fees come on top of the share of fees taken by the underlying unregistered hedge funds, which typically run even higher than those of registered hedge funds. The number of registered hedge funds is still tiny—fewer than 100 compared with thousands of hedge funds and mutual funds. But observers expect investors will hear much more about this rapidly emerging investment alternative. The biggest question for small investors who may qualify is whether these funds of funds, which are significantly riskier than many mutual funds, offer enough diversification and favorable risk and return, net of the high fees and expenses, to be an appropriate addition for their portfolio. -30- August 2003— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by McGuire & Co., LLC, a local member in good standing of the FPA. |
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