Hedge funds are a type of private investment in which investors’ monies are pooled and then reinvested in various other investments or investment strategies. Hedge funds are not required to register with the SEC or file periodic reports with the SEC. Hedge funds are however, subject to the anti-fraud provisions of the securities laws, and their managers have the same fiduciary duties as other investment advisors. Moreover, securities brokerage firms that sell hedge fund investments owe the same duties to investors that they have when recommending any investment.
An excellent book on alternative investments, The Only Guide to Alternative Investments You’ll Ever Need, by Larry E. Swedroe and Jared Kizer, characterizes hedge funds as “bad” alternative investments and concludes: “historical evidence demonstrates that once viewed on a risk adjusted basis, the average hedge fund has a hard time keeping pace with Treasury bill returns.”
Investors often invest in hedge funds for the wrong reasons. Investors are reportedly attracted to hedge funds because they (i) are dissatisfied with volatile, low-return environments or (ii) are seeking diversification during bad economic climates. They want better returns and protection against downside risks. Hedge funds often promise high-octane returns plus downside protection regardless of economic and investment conditions. With regard to downside protection, many hedge funds claim to be an alternative and non-correlated investment hedge against the price movements of equities and bonds. In theory, volatility is reduced as a hedge fund tends to move up when equities and bonds move down, and vice versa. Many hedge funds also claim to provide downside protection by using quantitative (mathematical) strategies, long/short strategies, and the like.
Unfortunately, statistical studies do not support the claims made by most hedge funds. During recent difficult economic times, most hedge funds have shown high correlations to other asset classes and have experienced significant losses.
Hedge funds suffer from the array of risks that are associated with all alternative investments – they are extremely complex (often using advanced mathematical strategies and sophisticated computer programs); they are not transparent but are opaque; they have very little liquidity; they have expensive fee structures; and they are neither understood by nor suitable for most investors. Investors should be aware of the following general risks impacting hedge funds:
- Hedge funds typically charge high fees. Investors routinely pay the fund manager a base management fee of 2% or more of total assets, plus a performance fee of 20% of the profits or more.
- The high fees and expenses associated with hedge funds can erode returns and incentivize risk taking by management to match or exceed the return that an investor in an unmanaged index fund receives. In addition to the management fees (described above), hedge funds often charge administrative expenses equal to another 2% of total assets. (By contrast, many no-load mutual funds have expense ratios of 2% or less.) Finally, the high turnover associated with hedge funds (typically over 100%) can result in higher ordinary income taxes for the investor. Aside from the higher taxes, a hedge fund has to generate a return of 16.2% just to match a pre-tax return of 9.8% from an unmanaged stock index fund (assuming the historic 10% annual return of stocks less index fund expenses of 0.2%).
- Funds of hedge funds add another layer to the cost structure. In other words, investors in a fund of hedge funds end up paying both the fund of fund’s expenses and the underlying hedge fund’s fees and expenses.
- Agency risk involves a conflict of interest that the fund manager has to take risks to increase the return in order to receive the typical 20% performance fee. The performance fee is typically only paid if the manager exceeds a certain benchmark. If a manger takes big risks to exceed the benchmark and succeeds, he will be rewarded. If he fails, he loses nothing (except for his capital stake in the fund, if any). There is often no incentive for the manager to hedge risk or invest prudently. Investors bear all the risk.
- Hedge funds are opaque. Unlike mutual funds, there is no transparency with regard to the hedge fund’s holdings. Due diligence is virtually impossible. Hedge funds can invest in virtually anything, can concentrate holdings as much as they wish, and use as much leverage (borrowed money) as they wish. In addition, the reported values of hedge funds may be questionable, since the holdings typically include untraded investments that can only be valued by models and guesswork.
- Hedge funds are illiquid. While mutual fund investors can withdraw their money daily, hedge fund investors are subject to lock-up periods and other restrictions on their ability to withdraw their money.
- Much of the performance data on hedge funds is biased and the returns are often overstated. The number of hedge funds that shut down and the number that do not report performance data (especially the failure of a dying fund to report its last returns) makes the performance data that exists unreliable.
- Last but not least, the risk of fraud and outright theft is always present in opaque investments like hedge funds. The hedge fund managed by Bernard Madoff is a prime example.
Wall Street has convinced many investors that by paying a large incentive fee to hedge fund managers, the managers will make more money for investors. Many experts say there is no evidence that any hedge fund manager has been able to consistently beat an appropriate benchmark. Those experts contend that the occasional successes do not go beyond random successes attributable to luck.
One reason for this is the efficiency of financial markets. According to the efficient market hypothesis, while inefficiencies can exist and be exploited by active managers, the very act of exploiting inefficiencies causes them to vanish. This is particularly true when multiple hedge funds employ the same basic strategy at the same time.
That was the case with the MAT/ASTA municipal arbitrage hedge funds sold by Citigroup Fixed Income Alternatives. They provide an example of the risks of hedge funds. The MAT/ASATA hedge funds were sold to conservative investors as a low-risk, fixed income investment alternatives, but they were nothing of the kind. The funds imploded in early 2008 resulting in huge losses to investors. The funds were based on a quantitative strategy that was difficult to understand, and was especially risky in volatile markets. The investment was far more risky than anyone let on to investors. As Barclays put it, fixed income arbitrage is really like “picking up nickels in front of a steamroller.”
If you have investment losses or problems involving hedge funds, call the lawyers at Page Perry for experienced representation at (770) 673-0047 or (877) 673-0047 (toll free).