Hedge Funds: Extremes of Costs and Risks

The following excerpt comes from the previous edition of Eric's Mutual Funds for Dummies, 5th edition published in 2007:

Hedge funds, historically an investment reserved for big-ticket investors, are seemingly like mutual funds in that they typically invest in stocks and bonds. They have the added glamour and allure, however, of taking significant risks and gambles with their investments. Hedge funds may take risks by purchasing derivatives, or they may bet on the fall in price of particular securities by selling the securities short. (When you short sell, you borrow a security from a broker, sell it, and then hope to buy it back later at a lower price.) Some hedge funds even invest in other hedge funds.

Earlier this decade, hedge funds got lots of attention and plenty of wealthier investors were throwing big bucks into them. The allure were hedge funds claiming to have side-stepped the bear market in the early 2000s.

Hedge funds are typically a far riskier investment than your typical mutual fund. What's the hidden truth about these funds? The following list highlights some of hedge fund's dangers:

* Hedge funds have a much higher risk than mutual funds. When a hedge fund manager bets right, he can produce high returns. When he doesn't, however, the fund manager can have his head handed to him on an expensive silver platter. With short selling, because the value of the security that was sold short can rise an unlimited amount, the potential loss from buying it back at a much higher price can be horrendous. And even the most experienced investing professionals can also lose a pile of money in no time when they invest in derivatives. Hedge fund managers have also been clobbered when a previously fast rising commodity like oil, natural gas or copper futures plunges in value.

A number of hedge funds have gone belly up when their managers guessed wrong. In other words, their investments did so poorly that investors in the fund lost all their money. The odds of this happening with a mutual fund - particularly from one of the larger, more established companies - are nil.

* Hedge funds have much higher fees than mutual funds. Hedge funds charge an annual management fee of about one to two percent and a performance fee, which typically amounts to a whopping 20 percent of a fund's profits. By contrast, the best mutual funds and exchange-traded funds charge annual fees of less than one percent per year. Veteran investment observer Jack Bogle said of hedge funds and the high fees that are extracted and paid to the hedge fund's managers (and not their customers), "Hedge funds are a compensation strategy not an investment strategy."

* Hedge funds aren't subject to the same regulatory scrutiny. A Forbes article on the hedge fund industry was entitled, "The Sleaziest Show On Earth." In the piece, the magazine referred to the industry as, "...a business rife with exorbitant fees, phony numbers, and outright thievery." If that's still not enough to convince you from the perspective of one of the nation's best business magazines that caters to those affluent enough to invest in such funds, consider this: Forbes went onto say, "Hedge funds exist in a lawless and risky realm, exempt from the rules governing mutual funds, equities, and most other investments. Hedge funds aren't even required to keep audited books - and many don't. These risky funds often are guilty of inadequate disclosure of costs, overvaluation of holdings to goose reported performance and manager pay, and cozy ties between funds and brokers that often shortchange investors." (More about insufficient regulatory oversight of hedge funds in the next section.)

* Hedge funds have lower returns compared to mutual funds. Interestingly, one tracking index that I've found for the industry presents an unflattering perspective on industry returns. Created in 2003, Greenwich Alternative Investments has an index of the returns of hedge funds that institutional investors can invest in. Here's how the hedge fund returns stack up for that four-year period versus major mutual fund indexes:

The Annualized Returns for 2003-2006 for Greenwich Investable Hedge Fund Index was 10.7 percent.
By comparison, over this same four year period, diversified U.S. mutual funds returned an average of 15.9 percent per year and diversified foreign stock funds returned 23.9 percent per year according to Morningstar.

If you want riskier investments you can find aggressive mutual funds, or you can buy mutual funds on margin through a brokerage account, meaning that you make a down payment but control a larger investment (such as when you purchase a home with a mortgage).

Hedge funds aren't subject to the same regulatory scrutiny from the Securities and Exchange Commission (SEC) that mutual funds are. However, if you go against my advice and consider investing in a hedge fund, I suggest that you adhere to the advice the SEC offers. The following guidelines for evaluating hedge funds can help

Read all the important documents

Take the time to read the fund's prospectus or offering memorandum and all related materials. This will disclose the fees, managers and overall investment strategy.

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. As with any investment, the higher the potential returns, the higher the risks you must assume. Understand how a fund's assets are valued

Funds of hedge funds and hedge funds may invest in highly illiquid securities (not easily and quickly converted into cash) that may be difficult 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 percent 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. 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 redeeming your shares

Hedge funds typically limit opportunities to redeem, or cash in, your shares (for example, 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. These should be disclosed in the hedge fund's prospectus.

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 get this information (and more) by reviewing the adviser's Form ADV. You can search for and view a firm's Form ADV using the SEC's Investment Adviser Public Disclosure (IAPD) website.

You also can get copies of Form ADV for individual advisers and firms from the investment adviser, the SEC's Public Reference Room, or (for advisers with less than $25 million in assets under management) the state securities regulator where the adviser's principal place of business is located. If you don't find the investment adviser firm in the SEC's IAPD database, be sure to call your state securities regulator or FINRA's BrokerCheck database for any information they may have.

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.

The SEC goes on to provide the following comments and suggested protections for those purchasing a hedge fund:

* Hedge fund investors do not receive all of the federal and state law protections that commonly apply to most registered investments. For example, you won't get the same level of disclosures from a hedge fund that you'll get from 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, while the SEC may conduct examinations of any hedge fund manager that is registered as an investment adviser under the Investment Advisers Act, the SEC and other securities regulators generally have limited ability to check routinely on hedge fund activities.

* The SEC can take action against a hedge fund that defrauds investors, and have brought a number of fraud cases involving hedge funds. Commonly in these cases, hedge fund advisers misrepresented their experience and the fund's track record. Other cases were classic "Ponzi schemes," where early investors were paid off to make the scheme look legitimate. In some of the cases, 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.

Update: Just in case you haven't heard of enough hedge fund blow-ups and frauds to alert you, here's another one hot off the presses.