A Primer on Hedge Funds

Fortnightly Magazine - April 2006

“Hedge funds … are unregistered private investment partnerships, funds, or pools that may invest and trade in many different markets, strategies, and instruments (including securities, non-securities, and derivatives) and are NOT subject to the same regulatory requirements as mutual funds, including mutual fund requirements to provide certain periodic and standardized pricing and valuation information to investors. There are substantial risks in investing in Hedge Funds.” 1

Hedge funds are not mutual funds—a common misconception. Hedge funds are alternative, private investment companies characterized by heightened risk/reward portfolios. Unlike mutual funds, hedge funds use a multitude of strategies to achieve above-average rates of return, primarily by (but not exclusively) taking advantage of market inefficien- cies and dislocations. By operating free of disclosure, managers can pursue aggressive and flexible investment policies. Some funds use borrowing to leverage their portfolios. Stiff dollar entry hurdles and dazzling rates of return have given hedge funds a “wholly-other” or mysterious quality (Otto’s “mysterium”).

An energy fund is speculative and is not for the average person because of its higher risk than mutuall funds. To avoid individuals financially unable to assume hedge fund risks, managers rely upon two investor exemptions: the first comes under the Investment Company Act of 1940, section 3 (c) 1 and the second under the Investment Company Act of 1996 section 3 (c) 7. The premise behind both 3 (c) 1 and 3 (c) 7 is that affluent investors inherently understand risk and do not need federal and state securities laws protection.

Together these exclusions stipulate:

1. No numerical limit on the number of investors;

2. The size and nature of the investments;

3. Investors in funds are by definition qualified purchasers;

4. High net-worth individuals with certain specified investments must have an excess of $5 million; and

5. Those who are qualified institutional investors.

These are deemed “suitable investors” while non-qualified investors are dissuaded from high-risk ventures. Until this y ear, hedge-fund managers were free to operate with latitude and secrecy, affording them a competitive advantage over “mutual funds,” which have substantial reporting obligations.

Participation in a hedge fund usually requires a substantial initial investment, perhaps a minimum of $1 million. The ability to withdraw funds is severely restricted, thereby assuming the manager of a steady and reliable balance of money provides these partnerships with the luxury of waiting for investments to achieve desired returns. Therefore, hedge funds are best suited for wealthy, long-term investors.

A Northern Trust 2 survey published Feb. 27, 2006, sheds some light on the investor makeup of alternative investment participants. Of the 1,014 people polled, the following allocation was designated to alternative investments:

1. Of those with more than $1 million in investable assets, 70 percent have a portion placed in hedge funds, private equity, and real estate.

2. Of this group, among those 35 years old and younger, 27 percent are participating, while at the same time having 19 percent of their portfolios in cash.

3. Investors with more than $5 million have 26 percent allocated and 16 percent in cash.

4. Half of the investors with $5 million