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A Primer on Hedge Funds
Not a day goes by when the phrase "hedge fund"
doesn't appear in the headline of some newspaper or web site. In
fact, hedge funds are so popular now that former Federal Reserve
Chairman Alan Greenspan recently described them as
"extraordinarily important… the pollinating bees of Wall
Street."
At present there are an estimated 8,800 of those
"pollinating bees" in the U.S., controlling some $1.2
trillion. And according to Greenspan, hedge funds, private
equity and similar investments will dominate the investment
landscape in the 21st century in the United States.
For many people, however, there is little known about, and
much fear associated with, hedge funds, which according to the
NASD are basically private investment pools for wealthy,
financially sophisticated investors. Who should use them, when
should they use them, and why are just some of the questions in
search of answers.
What are hedge funds? David A. Vaughan, a partner with
Dechert LLP, in written comments to the SEC in 2003 said a
"hedge fund" is an expression believed to have been
first applied in 1949 to a fund managed by Alfred Winslow Jones.
Mr. Jones' private investment fund combined both long and short
equity positions to "hedge" the portfolio's exposure
to movements in the market.
Hedge funds today are not necessarily defined by a particular
strategy and often do not "hedge" in the economic
sense. According to the NASD web site, for instance, there is no
exact definition of the term "hedge fund" in federal
or state securities laws. Traditionally, they have been
organized as partnerships, with the general partner (or managing
member) managing the fund's portfolio, making investment
decisions, and normally having a significant personal investment
in the fund, the NASD wrote.
According to the NASD, hedge fund managers typically seek
absolute positive investment performance. This means that hedge
funds target a specific range of performance, and attempt to
produce targeted returns irrespective of the underlying trends
of the stock market. This stands in contrast to investments like
mutual funds, where success or failure is often measured in
terms of relative performance comparisons to a stock index, like
the Dow Jones Industrial Average.
To get positive investment performance, NASD suggests that
hedge fund managers use sophisticated investment strategies and
techniques that may include, among other techniques: short
selling; arbitrage; hedging; leverage; investing in distressed
or bankrupt companies; investing in derivatives, such as options
and futures contracts; investing in volatile international
markets; and investing in privately issued securities. Most
funds are dedicated to a single strategic approach, while other
funds, known as multi-strategy funds, combine two or more
strategies in an attempt to reduce risk through diversification
of investment methods.
Hedge funds generally charge two types of fees: one based on
the assets, the other based on the fund's performance.
Performance fees of 20 percent of profits are common, along with
a fixed annual asset-based fee typically 2 percent, but
sometimes as low as 1 percent or as high as 4 percent. A fund
charging 2 percent of assets and 20 percent of profits would be
said to charge "two and twenty."
Hedge funds are usually only open to limited numbers of
wealthy, financially sophisticated investors or what are called
accredited investors or qualified purchasers. An accredited
investor is, according to the SEC, a natural person who has
individual net worth, or joint net worth with the person's
spouse, that exceeds $1 million at the time of the purchase or a
natural person with income exceeding $200,000 in each of the two
most recent years or joint income with a spouse exceeding
$300,000 for those years and a reasonable expectation of the
same income level in the current year. In most cases, the
minimum initial investment for a hedge fund is $1 million or
more. The reason for such high minimums is that such pools are
limited in the number of investors they are allowed to have.
Hedge funds, however, are not for everyone, even the super
wealthy or super sophisticated. According to the NASD, hedge
funds are private investments, prohibited from advertising or
otherwise publicly offering their securities and are therefore
not required to register with the SEC as investment advisers. As
a result, NASD notes that unregistered private hedge funds do
not provide many of the investor protections that apply to
registered investment products, such as mutual funds. Hedge
funds generally are not subject to numerous mutual fund rules,
such as regulations: requiring that fund shares be redeemable;
protecting against conflicts of interests; requiring disclosure
of information about a fund's management, holdings, fees and
expenses, and performance; and limiting the use of leverage.
Advocates of the hedge fund structure note that freedom from
these regulatory restrictions is precisely necessary in order
for the fund to pursue its strategies and that this is an
important advantage of the hedge fund manager when competing in
the arena.
As for measuring performance, there continues to be great
debate with some financial planners suggesting that it's
difficult to conduct a benchmark or peer-to-peer comparison and
others noting that there are many databases that now track hedge
fund performance.
December 2006 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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