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Investing in Hedge Funds

The Basics

Hedge funds are similar to mutual funds in that they pool and invest investors' money in an effort to earn a positive return. However, hedge funds have more flexible investment strategies than mutual funds. Many hedge funds seek to profit in all kinds of markets by using leverage, short-selling, and other speculative investment practices that are not typically used by mutual funds. Unlike mutual funds, hedge funds are not subject to some of the regulations that are designed to protect investors. In addition, depending on the amount of assets in a hedge fund, some hedge fund managers may not be required to register or to file public reports with the SEC. Fortunately for investors, hedge funds are subject to the same laws and rules against fraud as are other market participants, and their managers owe a fiduciary duty to the funds that they manage.

Hedge funds are not required to follow any standard procedure when calculating performance, and they may invest in securities that are illiquid and difficult to value. On the other hand, federal securities laws specifically prescribe a mutual fund's methodology for advertising and calculating current yield, tax-equivalent yield, average annual total return, and after-tax return. Mutual funds must also have detailed requirements for the types of disclosure that must accompany any performance data. Any investor provided with performance data for a hedge fund, should verify whether it reflects cash or assets actually received by the fund as opposed to the manager's estimate of the change in value of fund assets and whether the data includes deductions for fees.

The Risks

Hedge fund investing can pose several risks for inexperienced and risk averse investors. One of the primary risks associated with hedge fund investing is management's use of leverage. Generally speaking, leverage is the use of borrowed money to make an investment. Hedge funds manager use borrowed money along with capital provided by investors to make investments with an objective to exponentially increase the potential returns of the fund. Conversely, the use of leverage can magnify the potential loss if an investment strategy fails to work. This can turn a generally conservative investment into an extremely risky investment. Hedge funds also invest in other non-conventional securities such as derivatives (options and futures), and they engage in short-selling strategies (selling a security it does not own), which can likewise increase the potential for major losses to its investors.

Another risk associated with hedge fund investing is the limitation placed on investors' rights to redeem shares. Hedge funds typically limit opportunities to redeem (cash in) shares to monthly, quarterly, or even annual windows, and they often impose "lock up" periods of one year or more, which prohibits investors from cashing in shares during the stated period. During the time it takes investors to redeem shares, the value of the fund could diminish significantly, which in turn could leave investors with a worthless investment. In addition, hedge funds are able to suspend redemptions in certain scenarios, including in times of market distress or when their investments cannot be quickly or easily liquidated. Furthermore, hedge funds may charge investors a redemption fee before allowing them to cash in shares.

Hedge funds may also invest in highly illiquid securities. An illiquid security can be difficult to value if the security is thinly traded, or if there is a lack of a secondary market for the security. Hedge funds have wide discretion in valuing illiquid securities, and they oftentimes tend to overstate the securities' true intrinsic value. This poses a significant risk for investors because they may refrain from redeeming shares if they believe the value of the illiquid security is holding strong, when it could be worth much less. Investors are encouraged to fully understand a hedge fund's valuation process and know the extent to which a fund's securities are valued by independent sources. Investors should also keep in mind that valuations of fund asset will affect the fees that the manager charges.

The Costs

Investors should be well informed of the fees and expenses charged before investing in a hedge fund. Fees and expenses significantly affect the return on a hedge fund's investment. They typically charge an annual asset management fee that ranges between 1 and 2 percent of assets as well as a "performance fee" of 20 percent of the fund's profit. The peril in such high performance fees is that the manager may make riskier investment decisions to generate a heftier profit for herself. This two layered fee structure stands for the obvious notion that hedge fund profits tend to benefit its managers instead of its investors.

It pays and saves to do one's homework before investing in a hedge fund. Prospective hedge fund investors should start out by researching a hedge fund manager's background and qualifications. Managers should have a solid investment track record, which proves that they are qualified to effectively manage money, and they should have a clean disciplinary history within the securities industry. In addition, investors should determine whether a potential conflict of interest exists before investing. If an adviser recommending a hedge fund that is managed by the adviser, it may be motivated to recommend the fund because it may earn higher fees from an investor's investment in the fund than from other available investment opportunities. Hedge funds can be liable to investors for fraudulent activity just as an investment adviser can be liable for wrongfully recommending a hedge fund. Investors who have suffered losses in a hedge fund are encouraged to consult a hedge fund attorney to discuss any possible claims that may lead to a significant recovery of lost capital.

The most important of investors' rights is the right to be informed! This article on hedge funds is by the Law Offices of Robert Wayne Pearce, P.A., located in Boca Raton, Florida. For over 40 years, Attorney Pearce has tried, arbitrated, and mediated hundreds of disputes involving complex securities, commodities and investment law issues. The lawyers at our law firm are devoted to protecting investors' rights throughout the United States and internationally! Please visit our blog, post a comment, call 800-732-2889, or email Mr. Pearce at for answers to any of your questions about losses you may have suffered in hedge funds and/or any related matter.

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