Fall 2006 issue of Horizons

INDUSTRY PUBLIC SECTOR Deposit and Investment Risks For Your Money

Hedge Funds: What, Why, How and Considerations

Mike Ferman, CPA

In the past few years, the interest in “hedge funds” has grown considerably. However, the level of understanding about what hedge funds are, why investors use them, how they work, and the issues an investor should consider before investing varies greatly. Therefore, I would like to cover some of the basics in this article to help you gain a better understanding of this pop- ular investment product. The Securities and Exchange Commission defines hedge funds as “a pool of investors' money that invests in financial instruments in an effort to make a positive return. Many hedge funds seek to profit in all kinds of markets by pursuing lever- aging and other speculative investment practices that may increase the risk of investment loss.” The term hedge fund is a bit misleading in that a hedge fund does not have to hedge - that is, engage in risk reduction strategies. Instead, the term hedge fund now means any type of private investment part- nership. Hedge funds are similar to mutual funds in that they pool investors' money and invest it collectively. However, hedge funds differ significantly from mutual funds because hedge funds are not required to register under the Federal Securities laws. They are not required to register because they general- ly accept as partners financially sophisticated investors (“accredited”) and large institutions, and they do not publicly offer their partnership interests.

requiring a certain degree of liquidity, that partnership units be redeemable at any time, avoidance of conflicts of interest, fairness of pricing of fund units, disclosure regulations, limits and the use of leverage, and diversification. Hedge funds are, however, subject to the antifraud provisions of the Securities laws, but they are not directly subject to examination by the Securities and Exchange Commission. Hedge funds, unlike mutual funds, do not have boards of direc- tors or have to report their results in a standardized format. Hedge funds also pay both an asset-based fee (typically 1 or 2 percent of assets) and a performance fee that is typically 20 percent or more of the hedge fund's annual profits (realized or not), but often may be paid only if the hedge fund's performance exceeds a benchmark set forth in the fund's offer- ing documents. The allure of hedge funds lies in that they typically seek absolute returns rather than relative returns. What does this mean? Most mutual funds invest in a predetermined style, e.g., “small cap value” or in a particular sector. The fund's goal is to outperform its style benchmark or peer group. This return is rel- ative to its benchmark, peer group or index. If your fund is down 7 percent and its index or benchmark is down 10 percent, the fund is considered a success. Hedge funds, on the other hand, seek absolute positive returns regardless of what an index or sector benchmark does. Unlike mutual funds, which are “long only” (make buy and sell decisions only), a hedge fund engages in more aggressive strategies and positions, such as short selling, trading in derivative instruments like options and forward contracts, and using leverage.

Accordingly, hedge funds are subject to few regulatory con- trols. Such controls, if required, might include, among others,

5 • summer 2006 issue