Hedge Funds: Investor Beware

Hedge funds are investment vehicles that use alternative or non-traditional investment strategies to manage investors’ money. These strategies are broad-ranged and include the use of short sales, arbitrage, leverage, or derivatives. Have I lost you? If so, you probably shouldn’t be investing in these funds.

Hedge funds have become popular investment vehicles over the last few years. It wasn’t that long ago that most investors in hedge funds were wealthy and financially sophisticated. In fact, I remember a fellow corporate board member telling me about the remarkable returns he was earning on his hedge-fund investment. I was invited to join the hedge fund so long as I had the required large minimum investment.

Now, almost anyone can invest in a hedge fund no matter what their level of sophistication or the amount of money they can afford to risk.

Greed Drives Popularity

What has caused this explosion in hedge fund popularity? The simple answer is greed. The greedy people are the small investors looking for outsized gains, and investment advisors and fund managers who have entered this lucrative field in order to garner substantial fees and profit-participation arrangements from unwary investors.

At one time, the wealthy and sophisticated investors who participated in hedge funds realized that although they might be taking some extra risks by investing in these vehicles, they could expect above-average returns for their troubles. And, by and large, they were not disappointed.

Today, the market has become so saturated with these funds that the returns have fallen accordingly. In fact, I recently read that there are approximately 8,000 hedge funds in existence. My feeling is that the number of funds will increase further. Chalk that up to Madison Avenue’s marketing of these funds, rather than the actual performance and safety of them.

Easy to Criticize

Why am I so critical of hedge funds for the average investor? There are two reasons:

First, they are poorly regulated. In fact, the SEC is finally about to begin better regulation of these funds. This coming February, hedge fund advisers will have to provide the Commission with some minimal background on themselves, such as their addresses, professional histories, and records of infractions. They will also be subject to random audits.

Knowing how overburdened the SEC is, I don’t expect these new regulations to drive fear into the hearts of hedge fund managers.

Second, many hedge funds charge extraordinarily high fees to the investor. Not only do they charge a base fee that can be augmented by churning (buying and selling) the securities in the fund, but they also can charge a profit-participation fee based upon a healthy percentage of the fund’s gains. To add insult to injury, the accounting techniques used to compute profit leave generally accepted accounting principles out of the equation. This type of profit participation computation is tantamount to having the fox guarding the hen house. It just doesn’t make sense.

Lucrative for Fund Managers, Advisors

Hedge funds are very lucrative ventures for the advisors and fund managers who garner the profits from them. In fact, we now have what is called a fund of funds. This means that advisors and managers earn a fee simply by piling one hedge fund on to another. In effect, the investor ultimately pays substantially more in fees because the fund of funds charges a base fee plus profit participation fee even though the funds in which it invests are also charging these two types of fees. It therefore becomes quite difficult to earn any decent return from this type of hedge fund. There are simply too many fees.

The industry as it exists today is a very inviting place for the unscrupulous and/or incompetent hedge fund manager. To read about some concrete examples of this, just do a Google search on the Bayou Group, the KL Group, or Wood River Partners. You’ll see how some hedge fund cowboys have bilked the informed as well as the uninformed investor. In fact, if you just scratch the surface of who invested in these funds, you’ll find that it wasn’t only the “average Joe,” but it also includes major investment houses. Very embarrassing!

Solutions to Abuses

What can be done to correct this situation? In my opinion, there are several things that the regulators can do. Hedge funds could be restricted to high net worth individuals who are presumably sophisticated enough to handle the risk of such investments. This alone could eliminate many of the smaller investors who have, relatively speaking, the most to lose.

I would then eliminate the use of so-called funds of funds. This is, pure and simple, a rip-off of the small investor. These funds are so overloaded with fees that it becomes almost impossible to garner a decent return.

Finally, I would increase the SEC scrutiny of hedge funds and their managers. These managers should be held to a high standard of professionalism, and the funds themselves should become more transparent so that we don’t end up with a hedge fund debacle of Enron proportions.

The old adage is: “If it’s too good to be true, it probably isn’t.” Hedge funds aren’t for everyone. If you are considering participating in one, talk with a trusted and competent investment advisor. In fact, speak with more than one. Become an informed investor. If not fully informed, become a conservative investor. You’ll be happy you did. Finally, while you’re at it, take a look at my article entitled Investing: An Alternative Approach.

And, good luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which deals in bringing small-cap companies public. He also is a frequent speaker on the subject of financial advice for small businesses as well as the IPO process. He can be contacted at [email protected].

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