- Designate a chief compliance officer;
- Supply audited annual financial reports to the SEC and investors as part of the registration;
- Submit to periodic SEC examination of their records; and
- Develop a written code of ethics.
- What is the background of the fund managers?
Potential investors should conduct due diligence at the outset to learn about the credentials and experience of the funds founders and principals. This is especially important in light of the recent explosion in the number of hedge funds based both domestically and abroad.
- What is the level of risk involved in the funds investment strategy?
Due to the wide range of investment strategies that hedge funds may implement, the risks corresponding to each strategy also vary greatly. Understanding the aggressive or conservative nature of a funds strategy is critical to determining whether it meets your investing goals and tolerance for risk. Importantly, a potential investor should ask if the manager follows a comprehensive set of standards and a code of conduct.
- What are the minimum financial thresholds for investing in the fund?
While hedge funds are restricted to accredited investors and qualified purchasers, minimum thresholds for individuals were set more than 20 years ago when standards for separating the wealthy from the mainstream were a bit different. According to Rule 501(a) of Regulation D of the SEC, access to hedge funds is open to individuals with as little as $200,000 in annual income or $1 million in net worth. In addition, minimum upfront investments required by hedge funds are falling as funds of funds, which spread assets across several hedge funds, often do not require as large of an account balance.
- What is the fee structure and how are the managers compensated?
Typically, hedge funds charge a management fee of 1% to 2% of the amount invested, plus a performance-based fee of 20% of all capital gains per year. Funds of funds are subject to two levels of fees, those of the primary hedge fund manager and the sub-advisor.
- How is the value of the fund determined?
Understanding the valuation process is important, as fund managers have broad discretion over how they value the assets in the fund. This is critical because it ultimately determines the funds performance, the amount of management fees paid and the investors overall return.
- Are there limitations to ones right to redeem their shares?
Unlike mutual funds that may be bought and sold with relative ease, hedge funds typically limit the opportunities to cash in shares, and may also impose a lock-out period when investors may not redeem their shares after an initial investment.
- Standards of business conduct;
- Compliance with federal securities laws;
- Report personal securities holdings;
- Pre-approval of personal investment transactions related to IPOs and limited offerings; and
- Report code violations.
- Part 1 contains information about the advisors education, business, and an advisors disciplinary history within the last 10 years, and is filed electronically with the SEC;
- Part II has information on an advisors services, fees, and investment strategies.
Registration Required: Hedge Fund Rules Tighten
by CFA Institute
Starting February 1, 2006, advisors to the emerging hedge fund industry will be required to register with the Securities and Exchange Commission under the Investment Advisors Act of 1940.
To fulfill the requirement, the advisors must complete a revised Form ADV, which will then be available on-line through EDGAR, the SECs on-line database of company filings. Investors can now go to EDGAR to search for hedge funds that have already voluntarily filed with the regulator (www.edgaronline.com).
The new requirements apply to hedge fund advisors, not to hedge funds themselves, and only to advisors to larger hedge funds, those with $30 million or more in assets.
Among other requirements, hedge fund advisors will have to:
What Is a Hedge Fund?
Although hedge funds were once solely an investment vehicle for wealthy individuals and institutional investors, the industry has undergone enormous change over the past decade. Today, it is estimated that hedge funds manage over $900 billion in assets, due in large part to the publicity over some funds outsized returns, and falling eligibility thresholds for investors.
What is a hedge fund?
A hedge fund is similar to a mutual fund in that it is a pooled investment vehicle, but typically they engage in more aggressive strategies that are theoretically designed to do well in all kinds of market environments.
In the past they have been restricted to a limited number of investors in the U.S., typically high net worth individuals and institutions. But the investor base has expanded dramatically in recent years, as more investors have met the minimum eligibility requirements: a net worth of at least $1 million, or annual income in excess of $200,000 for the past two years (the eligibility requirements were written 20 years ago and have not been changed). Offshore, hedge funds can accept an unlimited number of non-U.S. investors.
Hedge funds usually are limited partnerships organized to invest in securities, and most are structured to award the general partners—the fund managers—a share of the profits.
The terms private investment partnership and hedge fund are often used interchangeably, but while most hedge funds are private investment partnerships, not every privateinvestment partnership is a traditional hedge fund. Offshore, hedge funds are usually corporations, but one does occasionally see pass-thru entities such as limited partnerships and LLCs.
Hedge funds are so named because, traditionally, they usually engage in both long (buying) and short (selling) positions, so the fund is theoretically positioned to profit regardless of the direction of the major market indexes. The common goal of virtually every private investing partnership or hedge fund is to produce either superior investment returns or to provide equity-type returns without general market risk, but the strategies employed and the results achieved can vary widely from one fund to another. The term hedge fund has expanded to include a wide variety of strategies, some not even using the traditional equity markets.
What is the difference between a partnership and a mutual fund?
Mutual funds can invest only in certain securities and are limited or restricted in using options, leverage, or short selling. Hedge funds and partnerships have no such restrictions; they can use the full spectrum of financial instruments.
The second major difference between mutual funds and hedge funds is how the managers are paid. Mutual fund companies managers are compensated based upon the amount of assets under management, regardless of how the individual funds perform.
Managers of private funds, in contrast, usually are motivated by and rely upon bonuses based upon the funds performance. To align their interests with those of their investors, most hedge fund managers usually invest a large majority of their money in their funds. Hedge funds also are limited to a smaller number of investors; mutual funds have no limits on the number of investors that can buy shares.
|Key Questions to Ask Before Investing in a Hedge Fund|
If you are unfamiliar with hedge funds, here are some key facts and questions to consider before investing in a hedge fund:
The hedge fund advisors SEC registration form (required starting in February of next year) will provide important background information on the managers; other information is available from a funds prospectus or offering memorandum and related materials. See the Form ADV box.
The Hedge Fund Appeal
Why do people invest in hedge funds?
The appeal of hedge funds is primarily the potential for superior investment returns, regardless of the stock market environment. Hedge funds and private partnerships enjoy several advantages over mutual funds in their relentless pursuit of investment returns.
First, hedge funds can use any financial instrument or technique that will increase returns. Whether its derivatives, shorting stocks, leverage, or extreme concentration of positions, virtually anything goes.
Another advantage is that most hedge funds run smaller amounts of money than mutual funds, and can therefore move quickly to take advantage of opportunities. In addition, many believe that providing financial incentives through a share of the profits motivates managers to produce maximum returns. This management structure emphasizes why hedge funds are so alluring.
Hedge Fund Risks
Perhaps the best illustration of hedge fund risk occurred in September 1998, when several banks had to bail out Long Term Capital Management, a flailing hedge fund that had lost heavily by betting on risky high-yield paper while shorting U.S. Treasuries, reportedly using leverage of more than 100 times its capital.
Hedge funds that use excessive leverage, do not adequately manage risk, or simply make bad judgments can blow up, wiping out investors completely. The use of leverage substantially increases risk, and can turn a modest loss into a terrible loss and a bad event into a catastrophic event.
Since hedge funds are not governed by the same regulatory requirements as mutual funds, investors must perform adequate due diligence before investing. Many hedge funds are less than forthcoming about providing information to investors, and unsuspecting investors chasing high returns can easily bite off more risk than they can chew.
The SEC believes the new registration requirement is a move in the right direction to protect investors, citing evidence that in the last five years the SEC has brought more than 50 fraud cases against hedge fund advisors who were accused of defrauding investors to the tune of $1 billion dollars.
Some regulators, including U.S. Federal Reserve Chairman Alan Greenspan, have questioned whether the registration of hedge fund advisors will be sufficient to stem the growth of reported hedge fund frauds. These frauds have usually resulted in the loss of all or most of the fund investors money. However, the SEC does not currently plan to consider requiring the funds to register under the Investment Company Act of 1940, which has much broader powers over fund managers.
Detractors of the rule—mostly hedge fund portfolio managers—have focused on the rules financial impact and believe it will place a costly burden on their companies, not to mention on the SEC itself.
Paul Roye, SEC investment-management division director, has also been quoted as saying that the SEC will be able to handle the influx of registration, but has a contingency plan of off-loading some of the work to states if registration is higher than expected.
Currently, about 40% of the hedge funds operating in the United States have voluntarily registered with the SEC, according to the Wall Street Journal. They have done so in response to the demands of their clients, including pension funds, who require this as part of their own due diligence.
Code of Ethics
The incorporation of a code of ethics into the hedge fund registration rule is designed to prevent fraud by highlighting the fiduciary principles and rules that govern the conduct of advisory firms and their staff members.
The five components of a code of ethics include:
The Asset Manager Code of Conduct covers advisors responsibilities to their clients, management of the funds, transparency, and other matters of concern to fund shareholders and beneficiaries.
The code was created to support investor protection by encouraging investment firms to voluntarily adhere to a strict set of ethical standards. For individual investors it provides, in effect, a checklist of ethical conduct that investors should expect from their asset managers, creating a higher level of confidence in asset managers that adopt and enforce the code.
You can visit www.cfacentre.org to read a copy of the Code.
To help investors who are thinking about investing in a hedge fund, the CFA Institute also recommends that you consider a series of six questions (see the box below) before making a decision.
We worry about individuals clamoring to invest in hedge funds, especially those individuals who may not be familiar with the complexity of certain investment strategies or even the asset classes many hedge funds use, said Kurt Schacht, CFA, executive director, CFA Centre for Financial Market Integrity.
Its not always apparent how risky a given strategy may be. In fact, the term hedge fund is a bit of a misnomer because investors may be led to believe the strategies are hedged to mitigate risk.
As with any investment, you need to first consider whether hedge funds are a suitable part of your long-term investment strategy. If so, it is critical to take the time to find a manager you respect and trust.
Investment advisors use Form ADV to register as an investment advisor with the SEC. This form has two parts:
CFA Institute is a nonprofit professional association of financial analysts, portfolio managers and other investment professionals in 119 countries. CFA Institute sponsors and administers the rigorous Chartered Financial Analyst® (CFA®) curriculum and examination program, sets investment performance standards, and enforces its Code of Ethics and Standards of Professional Conduct.