A Primer on Hedge
Funds
Not a day goes by
when the phrase "hedge fund" doesn’t appear in the headline of
some newspaper or Web site. In fact, hedge funds are so popular now that
former Federal Reserve Chairman Alan Greenspan recently described them as
"extraordinarily important… the pollinating bees of Wall
Street."
At present there are
an estimated 8,800 of those "pollinating bees" in the U.S.,
controlling some $1.2 trillion. And according to Greenspan, hedge funds,
private equity and similar investments will dominate the investment
landscape in the 21st century in the United States.
For many people,
however, there is little known about, and much fear associated with, hedge
funds, which according to the NASD are basically private investment pools
for wealthy, financially sophisticated investors. Who should use them,
when should they use them and why are just some of the questions in search
of answers.
What are hedge
funds? David A. Vaughan, a partner with Dechert LLP, in written comments
to the SEC in 2003 said a "hedge fund" is an expression believed
to have been first applied in 1949 to a fund managed by Alfred Winslow
Jones. Mr. Jones' private investment fund combined both long and short
equity positions to "hedge" the portfolio's exposure to
movements in the market.
Hedge funds today
are not necessarily defined by a particular strategy and often do not
"hedge" in the economic sense. According to the NASD Web site,
for instance, there is no exact definition of the term "hedge
fund" in federal or state securities laws. 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, the NASD
wrote.
According to the
NASD, 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 relative performance comparisons to a stock index, like the
Dow Jones Industrial Average.
To get positive
investment performance, NASD suggests that hedge fund managers use
sophisticated investment strategies and techniques that may include, among
other techniques: short selling; arbitrage; hedging; leverage; investing
in distressed or bankrupt companies; investing in derivatives, such as
options and futures contracts; investing in volatile international
markets; and investing in privately issued securities. Most funds
are dedicated to a single strategic approach, while other funds, known as
multi-strategy funds, combine two or more strategies in an attempt to
reduce risk through diversification of investment methods.
Hedge funds
generally charge two types of fees: one based on the assets, the other
based on the fund's performance. Performance fees of 20 percent of
profits are common, along with a fixed annual asset-based fee typically 2
percent, but sometimes as low as 1 percent or as high as 4 percent.
A fund charging 2 percent of assets and 20 percent of profits would be
said to charge "two and twenty."
Hedge funds are
usually only open to limited numbers of wealthy, financially sophisticated
investors or what are called accredited investors or qualified purchasers.
An accredited investor is, according to the SEC, a natural person who has
individual net worth, or joint net worth with the person’s spouse, that
exceeds $1 million at the time of the purchase or a natural person with
income exceeding $200,000 in each of the two most recent years or joint
income with a spouse exceeding $300,000 for those years and a reasonable
expectation of the same income level in the current year. In most cases,
the minimum initial investment for a hedge fund is $1 million or more. The
reason for such high minimums is that such pools are limited in the number
of investors they are allowed to have.
Hedge funds,
however, are not for everyone, even the super wealthy or super
sophisticated. According to the NASD, hedge funds are private investments,
prohibited from advertising or otherwise publicly offering their
securities and are therefore not required to register with the SEC as
investment advisers. As a result, NASD notes that unregistered private
hedge funds do not provide many of the investor protections that apply to
registered investment products, such as mutual funds. Hedge funds
generally are not subject to numerous mutual fund rules, such as
regulations: requiring that fund shares be redeemable; protecting against
conflicts of interests; requiring disclosure of information about a fund's
management, holdings, fees and expenses, and performance; and limiting the
use of leverage. Advocates of the hedge fund structure note that freedom
from these regulatory restrictions is precisely necessary in order for the
fund to pursue its strategies and that this is an important advantage of
the hedge fund manager when competing in the arena.
As for measuring
performance, there continues to be great debate with some financial
planners suggesting that it’s difficult to conduct a benchmark or
peer-to-peer comparison and others noting that there are many databases
that now track hedge fund performance.
December 2006— 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 of the FPA.
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