One of the primary obstacles for the average person who may be interested in hedge funds is the amount of money it takes to become involved. A minimum investment of one million dollars is not uncommon. Since hedge funds have become so popular, it is now possible to buy into certain funds with a minimum investment of as low as 100,000 dollars.
Even this is too rich a price for many small investors, which is where funds of hedge funds come in. A fund of hedge funds is exactly what it sounds like – a pooled investment in hedge fund companies. Funds of hedge funds generally register with the SEC and provide more protection and lower risk for investors.
The cost to buy into one can be as low as 25,000 dollars, much more than the minimum investment for most mutual funds but a damn sight better than the six or seven figures otherwise required to get into the hedge fund game.
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Funds of hedge funds limit risk by investing in different hedge funds with different managers, different strategies, and different areas of business, thus preventing your investment from being wiped out by the collapse of a hedge fund or an unforeseen market event.
Of course, there is a correspondingly lesser chance of making obscene profits, as a particularly well-performing hedge fund will be countered by the others. If a fund of hedge funds selects too broad a sample, it risks simply representing the entire market; the ideal number of hedge funds is around eight to fifteen.
The risk and potential returns are still considered to be greater than those of a mutual fund. Besides greater risk, there are other disadvantages to investing in a fund of hedge funds. One of these is a lack of liquidity.
A liquid asset is one that can easily be sold at any time. If your money gets tied up in a fund of hedge funds, it might not be possible to get it back out at your convenience. Funds of hedge funds will also complicate income tax returns.
Another serious problem is the lack of transparency and accountability. Hedge funds are notoriously secretive, and you may not be able to find out what exactly the hedge funds are doing with your money, which allows ample opportunity for fraud.
Hedge Fund Fraud
Investors should be aware that, because of its relatively unregulated status, fraud is more common in hedge funds than in other investment industries, at least in the United States. This is not to say that such fraud is legal; the SEC can and does take action against any company that defrauds investors. The most common fraud among hedge fund managers is to misrepresent their experience or their company’s track record or to use money from new investors to pay off old ones in classic pyramid schemes. It is important to thoroughly investigate a hedge fund before deciding to invest in it.
Fraud is more common among smaller hedge funds with relatively small minimum buy-ins and larger numbers of investors. The SEC brought fraud charges against hedge funds twenty times in 2004. Considering that thousands of hedge funds operate in the United States, this is still a low percentage.
Hedge fund fraud does not exist in Europe to anything remotely approaching this level, probably because of increased government regulation. In Great Britain, for example, the FSA (Britain’s equivalent of the SEC) requires hedge fund managers to register and to prove that they are qualified to run the fund.
Regulatory Status of Hedge Funds
Fraud, high-profile collapses, and the increasing size of the industry may be reasons why the SEC is adopting stricter control over hedge funds. Historically, hedge funds have operated largely outside of government control. They have not been required to register with the SEC or adhere to many of the rules that apply to mutual funds. This results in decreased safeguards for investors and increased flexibility in making investments.
Investors in mutual funds enjoy certain protections that do not apply to hedge funds. For example, hedge funds are not required to provide any guarantees on liquidity or redeemability of the investment, and one condition on investing may be that you cannot withdraw your investment for over a year.
There are also no guarantees on fair pricing of the fund shares. Also, because of the veneer of secrecy surrounding them, hedge funds are opaque and are not required to disclose business practices to their investors. They are also not required to disclose their holdings, fees, or performance.
This makes it difficult for investors to review the fund and determine if it is a good investment or a reckless one. Investors should take comfort, however, that the SEC’s protection against securities fraud still applies.
Hedge funds are allowed to make almost any conceivable investment, in contrast to mutual funds, which have to abide by many regulations. For example, mutual funds are limited in their use of leverage; not so with hedge funds, which can borrow up to hundreds of billions of dollars.
When Long-Term Capital Management went under, the firm had 4.72 billion dollars in equity but had leveraged an additional 125 billion dollars. Additionally, hedge funds are not restricted in how much they can invest in a single venture, nor are they restricted by concerns about conflict of interest.
In December 2004, the SEC adopted the Investment Advisors Act, requiring hedge funds operating assets of more than 25 million dollars to register by February 1, 2006. This will enable the SEC to deny registration to unqualified managers or those with a criminal record.
It will also subject hedge funds to some of the same regulations governing mutual funds, such as the implementation of a code of ethics and preventing the fund from misusing personal information about its clients.
The new legislation may not have a significant effect on the tactics of hedge funds, as the SEC says it does not have the staff or the inclination to actively monitor the internal practices of every hedge fund and has given such assurances to hedge fund managers. Primarily, they will be looking into irregular trading practices that threaten investors and the financial stability of the marketplace.