Gallery:Step 3|Stock Pickers Graveyard

Hedge Fund Warnings from the SEC

Gallery:Step 3|Stock Pickers Graveyard

Anyone who is contemplating investing in a hedge fund would do well to read the SEC's Investor Bulletin: Hedge Funds. This document instructs potential investors to not only read the fund's offering memorandum but also to make sure they understand the fund's investment strategy, particularly the extent to which techniques like leverage, derivatives, and short-selling are used and the potential risks to the fund's investors. For someone who is not a trained investment professional, however, this can be a tall order to fill. The SEC also wants potential investors to understand how a hedge fund values its assets, a vital consideration for illiquid assets, such as private equity and real estate. Of course, the methods used by the hedge fund managers to value the fund's assets will determine the returns reported by the fund. Unlike hedge funds, mutual funds that invest only in publicly traded securities have no such flexibility in reporting their net asset value or their historical returns.

While mutual fund investors may sell their shares on any given day, hedge fund investors can only redeem their shares in accordance with the rules set down by the fund managers. Lock-up periods of a year or more are not uncommon. The SEC reminds potential investors to review these rules before investing. Furthermore, the SEC encourages investors to research the backgrounds of hedge fund managers using resources such as the SEC's Investment Adviser Public Disclosure (IAPD) and FINRA's BrokerCheck database. The due diligence does not stop there. Investors need to know the fund's fees and expenses and whether reported returns are net of those fees. As we have pointed out before, the typical hedge fund fees of 2% of assets plus a 20% "performance fee" create a perverse incentive for hedge fund managers to take extraordinary high levels of risk. Furthermore, investors in funds of hedge funds should determine if both the fund and the underlying hedge funds are collecting asset and performance fees, as this would create a virtually insurmountable headwind.

To prevent investors from getting ensnared in a Ponzi scheme, the SEC admonishes potential hedge fund investors to determine where the fund’s assets are held and whether an independent third party (an auditor) confirms the existence of the assets. Unfortunately, even when the hedge fund managers are well-intentioned, investors can still suffer heavy losses if the prime broker utilized by the hedge fund becomes insolvent. This Bloomberg story recounts the hits taken by hedge fund investors as a result of the Lehman bankruptcy. It is worth noting that in the entire history of mutual funds since 1934, there has not been a single case of a duly registered mutual fund devolving into a Ponzi scheme, nor have mutual fund investors lost their assets due to a bankruptcy of a mutual fund company or a custodial bank. This does not, of course, excuse some of the awful things that have occurred in the mutual fund industry such as the late-trading scandal of 2003.

To give color to all their general warnings, the SEC provides examples of some recent enforcement actions. In SEC vs. GEI Financial Services, Inc., the SEC alleged that a hedge fund manager failed to disclose that the state of Illinois had barred him from acting as an investment adviser, and he withdrew excessive fees from the hedge fund he managed. In SEC vs. Lion Capital Management, LLC, the SEC alleged that a manager used his hedge fund as a ruse to misappropriate over $550,000 from a retired schoolteacher who considered the manager to be a close family friend. Similar to Madoff, the manager allegedly provided false account statements to the schoolteacher reflecting nonexistent investment gains. Finally, the SEC shares details of two hedge fund-based Ponzi schemes with losses of $37 million and $17 million. Undoubtedly, we will be hearing more about these cases on future episodes of CNBC's American Greed.

To summarize, given all the hoops that a potential hedge fund investor has to jump through, not to mention the exposure to additional risks that are not present with most mutual funds, one has to question whether the potential extra return is worth pursuing. Thanks to the diligent research of Simon Lack, the author of The Hedge Fund Mirage, we now know that hedge fund investors as a group would have done better with Treasury Bills, the quintessential risk-free investment. Thus, the answer appears to be an unequivocal no. If the sleaziest show on earth must go on, then let it go on with somebody else. Wise investors will steer clear.