Hedge Funds: What Investors Need to Know

Edited by Michael Kyrou  CFA

Vice President

CFA Society of Cyprus 

 

 

Although hedge funds were once solely an investment vehicle for wealthy individuals and institutional investors, the industry has undergone enormous change over the past decade. Today, the SEC estimates that hedge funds collectively manage an estimated US$650-900 billion in assets, perhaps due in large part to the lure of outsized returns and falling thresholds for investors. For those individuals unfamiliar with hedge funds, CFA Institute, which administers the prestigious Chartered Financial Analyst (CFA) program worldwide, has compiled key facts and questions to consider before investing in a hedge fund.

“We worry about individuals clamoring to invest in hedge funds, especially those individuals who may not be familiar with the complexity of certain investment strategies or even the asset classes many hedge funds use,” says Kurt Schacht, CFA, executive director of the CFA Centre for Financial Market Integrity. The CFA Centre is the thought leadership and policy setting arm of CFA Institute. “It’s not always apparent how risky a given strategy may be. In fact, the term ‘hedge fund’ is a bit of a misnomer because investors may be led to believe  that strategies are hedged to mitigate risk.”

To help investors who are thinking about investing in a hedge fund, CFA Institute recommends considering the following six questions before making a decision:

1. What is the background of the fund managers? Potential investors should conduct due diligence at the outset to learn about the credentials and experience of the fund’s founders and principals. This is especially important in light of the recent explosion in the number of hedge funds based both domestically and abroad.

2. What is the level of risk involved in the fund’s investment strategy?  Due to the wide range of investment strategies hedge funds may implement, the risks that correspond to each strategy also vary greatly. Understanding the aggressive or conservative nature of a fund’s strategy is critical to determining whether it meets one’s investing goals and tolerance for risk. Importantly, a potential investor should ask if the manager follows a comprehensive set of standards and a code of conduct.

3. What are the minimum financial thresholds for investing in the fund? While hedge funds are restricted to “accredited investors” and “qualified purchasers,” minimum thresholds for individuals were set more than 20 years ago when standards for separating the wealthy from the mainstream were a bit different. According to Rule 501(a) of Regulation D of the SEC, access to hedge funds is open to individuals with as little as $200,000 in annual income or $1 million in net worth. In addition, minimum upfront investments required by hedge funds are falling as “funds of funds,” which spread assets across several hedge funds, often do not require as large of an account balance.

4. What is the fee structure and how are the managers compensated? Typically, hedge funds charge a management fee of one to two percent of the amount invested plus a performance-based fee of 20 percent of all capital gains per year. “Funds of funds” are subject to two levels of fees, those of the primary hedge fund manager and the sub-advisor.

5. How is the value of the fund determined? Understanding the valuation process is important as fund managers have broad discretion over how they value the assets in the fund  This is critical because it ultimately determines the fund’s performance, the amount of management fees paid and the investor’s overall return.

6. Are there limitations to one’s right to redeem their shares? Unlike mutual funds that may be bought and sold with relative ease, hedge funds typically limit the opportunities to cash in shares, and may also impose a “lock-out period” when investors may not redeem their shares after an initial investment.

As with any investment, individuals need to first consider whether hedge funds are a suitable part of their long-term investment strategy. If so, it is critical to take the time to find a manager they respect and trust.

“While hedge funds are growing in popularity, they escape easy definition,” said Schacht.

“While we all may think we are sophisticated investors, it’s imperative that investors make sure they fully understand the structure and attributes of the vehicle in which they are investing in.”

Similar to mutual funds, hedge funds are pooled investment vehicles that often invest in publicly traded securities.  But much of the similarity ends there. Hedge funds are fundamentally different in many ways:

• Hedge funds seek absolute returns regardless of market conditions as opposed to mutual funds that generally seek returns comparable to market indexes or benchmarks.

• Hedge funds may engage in more aggressive strategies, including short selling, taking on significant debt, and employing hedging and price-monitoring techniques.

• Hedge funds also commonly invest in lesser-known securities such as fixed-income, convertible securities, currencies, exchange-traded futures, over-the-counter derivatives, futures and commodity options.

The CFA Society of Cyprus is a member society of CFA Institute, an international, nonprofit member organization of more than 82,000 investment practitioners and educators in 124 countries. The CFA Institute awards the Chartered Financial Analyst (CFA) professional qualification, the designation of professional excellence within the global investment community. For more information on the CFA designation, visit www.cfainstitute.org or the CFA Society of Cyprus web page on www.cfacyprus.com .