FPA Financial Planning Perspectives
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.
August 2003— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Rich Chambers, CFP®, and Julie Schatz, Financial Planner, local members in good standing of the FPA.
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