Hedge fund investing: current advice for financial advisers and planners.

Hedge funds are one of the hottest investment opportunities in today's stock market. They have been very prominent in the financial news, attracting a lot of attention from investors, brokerage firms, the SEC and the attorney general of the state of New York. To help CPAs who provide financial and investment advice to clients, this article describes the nature of hedge funds and reviews the latest news about them.

THE RISE AND FALL OF HEDGE FUNDS

Started in the late 1940s by Alfred W Jones, hedge funds have always attracted investors who wanted higher returns than traditional mutual funds typically offer. Since the start of the bear market in stocks four years ago, hedge funds have been growing at a rate of 20% per year. A total of 8,500 such funds controls $1.0 trillion, up from $400 billion five years ago and $100 billion 10 years ago; the hedge fund market is expected to increase to $1.5 trillion in the next two to five years. (See "What is a Hedge Fund?" and "Types of Hedge Funds," page 53.)

Hedge funds started to become highly visible during the fall of 1998 with the near-collapse of the giant Long Term Capital Management LP (LTCM) hedge fund. Eighty investors, including U.S. government officials and top officers of some of the largest New York investment and brokerage houses, contributed a minimum of $10 million each to LTCM. Of its initial equity capital of nearly $1 billion, LTCM lost about 90% in less than two months. The crisis threatened U.S. financial markets and, in an unprecedented move to bail out private investors, the Federal Reserve Bank of New York arranged a $3.63 billion rescue plan. Given such risks, CPAs should be aware that investments in hedge funds should represent discretionary capital reserved for speculative investments. Clients must be able to bear the risks of these investments.

The near-collapse of LTCM wasn't an isolated instance; several other large hedge funds have failed since 1998, and the rate of attrition in hedge funds is now about 20% a year. This life cycle makes it more difficult to find good long-term hedge fund investments, and means that investors must carefully monitor market developments and quickly respond to changes (see "Long Term Capital Management," page 55).

A recent development has made hedge funds available to potentially less affluent investors: A new breed--the "funds of funds"--that allowed investors to invest as little as $25,000, compared with the previous typical minimum of $250,000, became popular in 2003. These vehicles work like mutual funds, spreading investments across numerous hedge funds. Funds of funds have become very popular with investors looking for better returns; the number doubled to 1,600 in 2004 from 800 in 2000. There is no minimum net worth or income requirement to invest in a fund of funds. (See "To Hedge or Not to Hedge," page 56.)

NEW SEC REGULATIONS

In light of the heightened visibility and importance of hedge funds and their vulnerability to financial collapse due to their greater risk compared to mutual funds, SEC Chairman William Donaldson expressed interest in improving the regulation of hedge funds when he started his job, and the SEC has begun to do that. However, it was New York State Attorney General Eliot Spitzer who first focused the public's attention on hedge funds in September 2003, when he charged that the manager of Canary Investment Management LLC had arranged with several mutual funds to improperly trade their shares. Without admitting or denying wrongdoing, the fund agreed to pay a $10 million fine and $30 million in restitution, which caused Canary to fail. Shortly afterward, as part of his investigation, Spitzer subpoenaed executives of a number of hedge funds and mutual funds to provide information about mutual fund trading. Within a month, a top trader at Millennium Partners LP, a $4 billion hedge fund, admitted illegal late trading of mutual fund shares. (Late trading occurs when investors receive a stock or fund's closing price, usually set at 4 p.m., for orders submitted as much as several hours later.)

In early 2004 the SEC required brokerage firms to provide information on how they help hedge funds recruit new investors and, shortly thereafter, began investigating about 20 cases in which hedge funds might have used insider information to profit from upcoming private stock offerings. The SEC believed brokerage firms recruited new investors for hedge funds from their clients (a technique known as "capital introductions.")

Also in 2004, in the state of New York, Spitzer filed criminal and civil charges against a former trading executive at Canadian Imperial Bank of Commerce, a major Canadian bank. He charged the bank's executive with telling hedge fund clients how they could disguise their trading activities to avoid scrutiny for operating illegally.

Two earlier events, during the fall of 2003, had already tarnished the image of hedge funds. The first was an FBI undercover operation in New York to infiltrate foreign exchange and securities scams. The FBI set up a fake hedge fund to collect evidence to break up an alleged fraud ring. Separately, in an unprecedented move, the SEC took action against a manager of an unregistered hedge fund, charging a "failure to supervise." This sent a signal even unregistered hedge funds were subject to the same rules.

In July 2004 the SEC adopted a new regulation for hedge funds, requiring registration with the commission by advisers who manage more than $25 million of hedge fund assets for 15 or more clients (that is, larger hedge funds), and establishing routine inspections by SEC examiners. This regulation will become effective in 2006. Currently about 60% of hedge fund managers have not voluntarily registered with the SEC; they would have to register under the new regulation. All hedge fund managers will be subject to regular SEC inspections and examinations, allowing the SEC to collect basic information about their activities. The new regulation also increases the minimum net worth and net income requirements for investors-hedge fund minimums have not been updated in several decades--to $750,000 in annual income or net worth of $1.5 million.

The interesting confluence of hedge fund popularity and notoriety has caused some to label the situation as the "hedge fund bubble" or the "hedge fund conundrum."

WHAT INVESTORS SHOULD KNOW

Investors always are looking for investments that offer greater returns than mutual funds (see "Comparison of Hedge and Mutual Funds," above). But investors must recognize that hedge funds are riskier, may charge higher fees and may have greater leverage than mutual funds. In light of the increased risk, advisers and clients should thoroughly review the fund's offering documents and evaluate them against the investor's investment objectives, financial and tax situations. They should pay particular attention to the compensation of the hedge fund management and the fees and expenses. Multiple fees may be charged for investment advice at a number of levels in the fund. For example, hedge fund managers typically earn a share of fund profits as well as management fees based on the value of the assets under management and fees for security trades.

Hedge funds can be highly leveraged; that is, they often use borrowed funds to acquire securities. The degree of leverage should be considered as a risk factor, as it could cause volatile performance. Although hedge funds represent only 4% of the stock market's value, they recently have accounted for nearly a quarter of daily trading volume.

There is no secondary market for some investments in hedge funds; thus an investment may prove to be illiquid. Additionally, some hedge funds severely restrict the transfer of interests or withdrawal of funds. These aspects must be considered when investing in such funds.

Many of the risks associated with hedge funds are common to other investments. Among these risks are

* Political risk. When an investment is made in a foreign nation and under the laws and sovereignty of that nation, the risk is loss due to possible nationalization.

* Transfer risk. This occurs when a foreign government restricts the delivery of a foreign currency.

* Settlement risk. A dispute between the parties to a contract could prevent the fulfillment of the contract in accordance with its stated terms.

* Credit risk. This happens when the counter party to a contract does not perform due to insolvency.

* Legal risk. This occurs when the contract is declared unenforceable due to legal problems.

* Market risk. Market movements can cause losses.

* Liquidity risk. This occurs when a market dries up and it becomes impossible to liquidate a position.

* Operations risk. Clerical errors can cause risk.

CURRENT REGULATIONS

Although hedge funds are subject to a variety of laws, those with fewer than 100 accredited investors are exempt from regulation under the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Company Act of 1940. (Accredited investors are defined in SEC regulation D, rule 501.) An individual must have at least $1 million in net worth and more than $200,000 in income in order to invest in a hedge fund. (These minimums are effective until the new ones go into effect in 2006.) If the hedge fund trades commodities, the manager must register as a commodity pool operator with the Commodity Futures Trading Commission. General hedge fund partners technically are not required to register as investment advisers under the Investment Advisors Act of 1940, but some do. A leveraged hedge fund may be subject to the Federal Reserve's regulation T, which specifies the amount of money a brokerage fund can lend its clients to trade on margin.

MAKE INFORMED DECISIONS

As investors seek higher returns, amounts invested in hedge funds are growing, making such funds a popular investment vehicle. As hedge funds proliferate, investors and their advisers need to be informed of the issues. CPAs who provide financial and investment advice to clients must consider the nature of hedge funds, how they work, the associated risks and the latest financial developments to make informed decisions. The financial risks are great and the lesson taught by the example of LTCM is that even the most promising hedge fund can fail.

RELATED ARTICLE: Comparison of hedge and mutual funds.

Characteristic                  Hedge Fund         Mutual Fund

Expected returns                Higher             Lower
Risk of investment              Higher             Lower
Fees charged                    Higher             Lower
Leverage                        Higher             Lower
Trading volume                  Higher             Lower
Secondary market                Limited            Widely available
Transfer and withdrawal rules   Very               Not generally
                                restrictive        restrictive

RELATED ARTICLE: Types of hedge funds.

* Relative value (or "arbitrage")funds combine long positions in securities with offsetting short positions to obtain returns that are independent of market movements. For example, the portfolio of a relative value fund might contain 30 undervalued (long) U.S. pharmaceutical stocks and 30 overvalued (short) pharmaceutical stocks. These funds attempt to limit market risk while earning 3% to 5% per year above the risk-free return on a three-month U.S. Treasury bill.

* Event-driven funds are long positions that focus on specific corporate transactions, such as mergers, acquisitions and tender offers. A fund of this type may hold long positions in the stock of a company that is a prime takeover target, hoping the acquirer will pay a premium over the current market price.

* Equity funds take long and short positions in equity securities and focus on strong turnaround companies with upward potential.

* Global asset allocator (or "macro") funds are the most diverse and complex global investments, combining stocks, futures, forward contracts, options and commodities. A fund of this type might take a long position in a currency that is undervalued and an equal, short position in another currency that is overvalued.

* Short-selling funds trade in securities or currencies they consider to be overpriced but do not own, hoping to buy them back at lower prices and thus to generate gains.

RELATED ARTICLE: What is a hedge fund?

A hedge fund is a private investment club, usually a partnership open to a small number of wealthy investors, that invests in a variety of securities. The name "hedge fund" is misleading since hedge funds do not necessarily hedge. Instead, they use a combination of market philosophies and analytical techniques to develop financial models that identify and evaluate market opportunities. Very often, the financial models are very sophisticated, highly quantitative and proprietary to the fund. From the investor's standpoint, the use of a single investment strategy can limit diversification and increase risk. Therefore, investment advisers should evaluate each fund's investment strategy and consider its suitability to clients' investment objectives.

Traditionally, hedge funds have been off-limits for many mutual fund investors. Because of the risks involved and to avoid regulation, they were sold almost exclusively as unregistered securities only to high-net-worth investors with at least $1 million in net worth or more than $200,000 in annual income. However, the recent rise in real estate values has made these thresholds easier to reach than in the past.

Hedge funds differ from mutual funds in many ways: They can buy a wider variety of securities; they are restricted to fewer investors; they can try to produce a gain irrespective of whether stock and bond markets are rising or falling; they have not been subject to strict SEC regulations and disclosure requirements (except for the new "funds of funds" discussed in the text of the article); they tend to concentrate their portfolios in fewer investments; they have more leeway to "time" the market; they cannot advertise; they can limit the number of contributions and withdrawals; their compensation method is based on incentive and management fees that usually are much higher than those for mutual funds; and they can invest in long, short and leveraged securities.

RELATED ARTICLE: Long Term Capital Management.

The financial crisis at Long Term Capital Management vaulted hedge funds into the spotlight. LTCM was created in March 1994 by former Salomon Brothers' trader, John Meriwether, who wanted to start an exclusive private investment company. Meriwether put together a top-notch team of physicists, mathematicians, computer experts and two Nobel-Prize-winning economists, Robert C. Merton and Myron Scholes. He marketed LTCM to high-income investors as a market-neutral investment company that would deliver big returns at low risk and achieve equity-like returns independent of market swings. Eighty investors, including U.S. government officials and top officers of some of the largest New York investment and brokerage houses, contributed a minimum of $10 million each.

Compensation. As in most hedge funds, LTCM managers invested their own money in the fund; they also earned fees and received performance incentives. (Typically the management fees for hedge funds are double the usual rate for mutual funds.)

Trading strategy. LTCM started as an arbitrage fund but later became more of a global asset allocator fund specializing in bond trading. As an arbitrage fund, it had used sophisticated models to detect pricing differences for securities or currencies in different markets, offsetting long investments in one security with short sales of another. Using mathematical models designed to analyze fixed-income security markets and identify which bonds were over--or under-priced in comparison with others, it placed and hedged millions of dollars of bets on the movement of bond prices.

LTCM tried to take advantage of tiny movements in prices through "pool trading," that is, buying and selling $1 million blocks of U.S. Treasury bonds, FNMAs or GNMAs. This strategy required very large investments to generate profits often as small as $500 per trade.

Initial success. Meriwether's company had instant and spectacular success. In its first three years (1994--97), it almost doubled the original investment of its owners. The firm earned returns of more than 40% in 1995 and 1996; every $10 million invested in 1994 was worth $18.2 million in 1997. By August 1998, though, markets began to move against its strategy. LTCM's historical models were ill-prepared for the Asian financial crisis or the free fall in Russian bonds.

LTCM's excessive leverage compounded these losses: At its peak it had contracts involving $160 billion worth of securities, approximately 30 times its capital. Most hedge funds, by contrast, leverage themselves at two times capital. By early September 1998, LTCM had lost 50% of its $4.1 billion capital and margin calls cascaded in. By the end of the month, approximately 90% of the fund had been lost.

The rescue. On September 23, 1998, the Federal Reserve Bank of New York arranged a $3.63 billion rescue package to stave off the possibility of LTCM's dumping its bond portfolio on already weakened markets and thus aggravating the financial crisis. The rescue used private-sector funds from 14 financial institutions.

The moral. The near-collapse of LTCM demonstrates that even with the combination of a highly successful securities trader, huge capital base, experienced money managers, highly intelligent and prominent investors and sophisticated computer models, hedge funds can fail.

RELATED ARTICLE: To hedge or not to hedge.

Most CPA financial advisers are familiar with modern portfolio theory (MPT) with respect to diversifying investments. Under MPT, funds are invested among asset classes in a "long only" fashion to achieve a targeted rate of return given a certain level of risk. In addition to the "long" orientation, MPT usually involves being 100% invested in various asset classes regardless of prevailing market conditions.

The last few years have clearly demonstrated the risk (volatility) of being fully invested in equities--even with a diversified portfolio--over the short term. The old saying "You're invested for the long term" rang hollow when clients were looking for some defensive action to protect their principal as the Nasdaq fell to nearly 1,100 from more than 5,000. Two of the main requirements for MPT to achieve targeted rates of return are a lengthy time frame and investor patience to stay the course.

The necessary time frame for allowing market cycles to run their course for a "buy and hold, long only" equity investor is 15 plus years. Funds with a time frame of less than five years are best invested in a laddered bond portfolio or short term bond funds, with only a minor equity allocation. The real challenge, therefore, is to have an equity and bond strategy that can best achieve expected returns during a 5-to-15-year time frame. For many investors, this time frame requires a more dynamic investment approach (especially on the equity side) and should incorporate some element of hedging or risk management. Recovering from a 30% to 50% decline in equity values to achieve a targeted 8% to 9% expected return is difficult to accomplish during a relatively short 5-to-15-year time frame.

To assist our clients who wanted a degree of downside protection for their equity holdings, during 2002, we employed a hedging strategy using the ProFunds Ultra Bear Fund. Although not a hedge fund per se, this no-load mutual fund utilizes leverage to seek investment results that inversely correlate to 200% of the performance of the S&P 500. This allowed our clients to continue to hold (hedge) long positions in their small--and mid-cap value funds, which we considered to be of less risk. Our clients were appreciative of the fact we were seeking to reduce volatility and achieve absolute returns instead of merely accepting relative loss returns. For those clients who had become concerned about the impact of rising interest rates on their bond holdings, we utilized the Rydex Juno fund to hedge interest rate risk. Rydex Juno seeks to inversely correlate to the price movement of the 30-year Treasury bond by selling 30-year Treasuries at the end of each day.

At this time we are not currently recommending specific hedge fund managers to our clients, and we may never be truly comfortable with the lack of transparency, limited liquidity, and risk to a specific strategy inherent in individual hedge funds. However, we are beginning to perform due diligence on "hedge funds of funds" offerings. These funds provide a higher degree of liquidity and diversification than any one specific hedging strategy. They typically invest in a variety of strategies, such as arbitrage strategies (fixed income, convertibles), event-driven strategies (mergers) and tactical strategies (long/short). However, given the significant risks of hedge funds (even a hedge fund of funds), we expect our overall allocation to this asset class to be less than 10% of the equity component.

KEN A. DODSON, CPA, PFS, is a principal in King Dodson Armstrong Financial Advisors Inc. of Columbus, Ohio, a member of the AICPA Personal Financial Planning Executive Committee and the technical editor of Prudent Investment Practices, a handbook for investment fiduciaries. His e-mail address is [e-mail].

Investments in Hedge Funds

Worldwide investment inflows for hedge funds reached a record $106.6 billion for the first three quarters of 2004, more than the total for all of 2003.

Source: Tremont Capital Management, www.tremontcapitalgroup.com, 2004.

EXECUTIVE SUMMARY

* SINCE THE BEAR MARKET IN STOCKS STARTLED FOUR years ago, hedge funds have become one of the hottest investment vehicles, growing at a rate of 20% a year. The hedge fund market is expected to increase to $1.5 trillion in the next two to five years.

* A HEDGE FUND IS A PRIVATE INVESTMENT CLUB, usually a partnership, open to a small number of wealthy investors, that invests in a variety of securities. The name "hedge fund" is misleading since hedge funds do not necessarily hedge.

* A NEW BREED OF HEDGE FUNDS, called funds of funds, allows investors to invest as little as $25,000, compared with the previous typical minimum of $250,000.

* HEDGE FUNDS CAN BE HIGHLY LEVERAGED, often using borrowed funds to acquire securities. The degree of leverage should be considered as a risk factor in judging the volatility of a fund's performance.

* IN LIGHT OF THE INCREASED VISIBILITY AND IMPORTANCE of hedge funds and their vulnerability to financial collapse, the SEC has issued new regulations that require hedge fund managers to register with the commission by 2006.

* CPAs MAKING INVESTMENT RECOMMENDATIONS to clients should consider how hedge funds differ from mutual funds in terms of risk: There may be no secondary market for investments in hedge funds, highly leveraged funds can be especially volatile and some hedge funds severely restrict withdrawals.

PRACTICAL TIPS TO REMEMBER

* Recommend clients investing in hedge funds employ only discretionary capital reserved for speculative investments.

* Thoroughly review a hedge fund's offering documents and compare them with the client's investment objectives, financial condition and tax situation before recommending investment in such funds.

* Make clients aware that, because a majority of hedge funds today are not registered (the SEC requirement takes effect in 2006), the investment risk is even greater.

* Explain to clients who are hedge fund investors the importance of carefully monitoring market developments and being able to quickly respond to changes.

RESOURCES

Publications

* Fundamentals of Hedge Fund Investing, W. Crerend, McGraw-Hill, 1998.

* Trend Watching, R. Insana, Harper Collins, 2002.

Web sites

* Capital Management Partners, Inc., www.capmgt.com.

* Hedge Funds Consistency Index, www.hedgefund-index.com.

* SEC Proposal to Regulate Hedge Funds, www.sec.gov/rules/proposed/ia-2266.htm#P536_196627.

* Tremont Capital Management, www.tremontcapitalgroup.com.

THOMAS G. EVANS, PhD, is professor of accounting at the University of Central Florida School of Accounting in Orlando. His e-mail address is [e-mail]. STAN ATKINSON, PhD, is a retired associate professor of finance of the University of Central Florida. CHARLES H. CHO, CPA, is a doctoral student in the School of Accounting at the University of Central Florida. His e-mail address is [e-mail].