The Hedge Fund Mystique

BEWARE WHAT YOU DON’T KNOW

CPAs have begun to introduce hedge funds to some of their clients. Broadly speaking, hedge funds are unregulated investment pools. They generally are more nimble and dynamic in their trading strategies than other investment funds. These strategies can be very sophisticated. Before recommending a client invest in a hedge fund, CPAs should understand some basic facts about the funds. Contrary to the old saying, what you don’t know can hurt you.

Hedge funds are private entities, typically organized as limited partnerships or as limited liability corporations. Because the funds are private, they have tremendous flexibility in the types of investments they can make and the strategies they can follow. This flexibility is what makes it possible for hedge funds to offset risks against each other and perform well under all kinds of market conditions.

CPAs used to the vast amounts of information available about mutual funds will find some critical differences. Because hedge funds are private, they aren’t required to report returns, don’t generally have to disclose their security holdings and sometimes lock up investors’ money for a year or more. In contrast, mutual funds post their net asset values daily, disclose their holdings quarterly or semiannually and can easily be bought and sold on a daily basis.

Hedge funds truly are a hush-hush business. Since they are nonpublic offerings, securities regulations prohibit them from advertising. They can’t cold-call prospective investors. In fact, they can’t even contact your client without a prior introduction. Hedge funds typically secure investors by word of mouth and through referrals from investment consultants, registered representatives, stockbrokers and other financial professionals. Courting even a small group of investors can be tricky, since hedge funds are technically required by federal securities laws to have preexisting relationships with all of them.

Hedge fund managers typically earn 1% to 2% of assets under management, plus 20% of any gains annually. That meant a $1 billion hedge fund returning 20% would earn $60 million in annual fees. Funds of funds, which invest in other hedge funds, normally charge a management fee of 1% to 1.5% and a performance fee of 5% to 10%. That’s much higher than conventional mutual funds, which don’t seek performance fees and tend to charge only 0.5% to 3% in annual management fees.

Traditional hedge funds have high minimum-investment requirements of $1 million or more. The typical hedge fund investor has a high net worth with $1 million to $5 million to invest. However, some mutual fund families are offering this once unpublicized investment for the superrich to semiaffluent investors for minimum account sizes as low as $25,000.

CPAs may find they face problems in selecting a hedge fund for their client. The private nature of hedge funds makes virtually every aspect of the process more difficult than choosing a mutual fund—locating a manager, evaluating his or her investment style, assessing performance and monitoring the fund long term. Since many hedge funds are not very tax efficient, reported returns have to be reduced not only by fees but by taxes as well. Fund managers can hide volatility by taking infrequent measurements so quarterly or annual numbers alone generally will not provide CPAs with sufficient data to judge a hedge fund’s performance. Monitoring a fund is made even more difficult by the fact that most managers don’t disclose their holdings to investors. All clients get are the results of an annual audit.

THE SPECIFIC RISKS

Hedge fund investors face a variety of risks that aren’t typically present with investments in mutual funds or individual securities:

Liquidity risk. The most dangerous potential risk is the possibility of a liquidity squeeze in moving markets. Many trading and hedging models and programs imply steadily flowing market swings. But these models stop functioning when price jumps and gaps occur due to market crashes or government intervention. A dynamic hedge—a strategy where the fund establishes an option position whose value varies with changes in the price of the underlying security—works only as long as the fund can adjust both sides of the trade at any time at fair prices. In a bear market, supply can dominate demand to such a large extent that some products have no bid prices or can be sold only at large discounts. Liquidity can disappear almost instantaneously. The October 1987 Wall Street crash resulted in the collapse of many portfolio insurance and program-trading programs when investors couldn’t get out of their stock positions quickly enough.

Margin call risk is another liquidity problem. It results from highly leveraged positions. When markets move in the wrong direction, the hedge fund must satisfy additional margin calls. This may put an enormous strain on its liquid positions. There also is a certain cash match risk from very illiquid positions such as exotic OTC derivatives, distressed securities or positions in other funds with longer redemption periods. If too many investors want to redeem very quickly, the hedge fund’s cash reserves may not be sufficient and it may have to liquidate some illiquid positions at large losses.

Access to invested funds can also present a liquidity problem for some clients. Many hedge funds don’t allow investors to withdraw their initial investment for at least 12 months. After that, withdrawals may be permitted only quarterly—with advance written notice. Clients who miss the quarterly withdrawal opportunity even by one day will have to wait until the beginning of the next quarter. CPAs should advise clients not to put any money in a hedge fund that they expect to need in the next 12 to 18 months.

Mark-to-market risk. It’s not easy for a hedge fund to objectively value some illiquid positions at market prices since there is no efficient market for certain securities. It may simply not be possible for a hedge fund to call up several independent brokers to get an average price for a security or a position, let alone do so on a regular (daily or weekly) basis. Many pricing models imply assumptions that are not valid for all market conditions. A net asset value (NAV) quote may therefore not reflect the “real” market price of a position. Between audits, a hedge fund manager has a lot of freedom in valuing his or her positions. If, during his or her due diligence, an investor is uncomfortable with the pricing model a hedge fund uses to value its securities, it’s probably best the investor not invest in that fund.

Human risk. A hedge fund is only as good as its managers and traders. The human factor is therefore very important. Investors must rely on the managers’ integrity and fairness. After a period of success, hubris is a concern; greed and false pride may prevent a manager from closing positions and realizing losses after a disaster. A fund must have an adequate structure to manage its traders, salespeople and back office and risk control staff. Since investors generally invest in the hedge fund’s ability to perform well pursuing a certain strategy, the departure of one or more head traders (perhaps to start their own fund) can hurt performance. A fund can insulate itself against some of these problems by adopting measures designed to prevent or minimize the impact of manager changes. These include a long-term incentive compensation system, systemizing trading know-how by developing proprietary trading program software and encouraging frequent oral exchange of knowledge among managers, traders and staff.

Change of strategy risk. An investor typically buys a fund in a certain strategy category because it fits well with his or her portfolio. A benefit of hedge funds is they provide investors with an investment portfolio with lower levels of risk and can deliver returns uncorrelated with the performance of the stock market. The investor expects that strategy to remain relatively stable. Since strategy was an important reason for the client’s decision to invest, CPAs should make sure the fund follows the strategy management promotes—even in hard times. If a manager changes his or her strategy without telling investors, volatility may increase. Furthermore, performance can no longer be compared with past performance and other funds’ performance. A change in strategy may be enticing in times of bad performance, of changing markets (especially for quantitative programs) and after important traders depart. Typical indications of a change of strategy are sudden drops or rises of performance or increasing volatility.

Size risk. As a fund grows, especially if the growth is sudden, some negative effects become apparent. The larger the fund, the more difficult it is to move in and out of positions and fast executions are possible only at large transaction costs. Strategies that worked in smaller environments don’t necessarily work with large positions. The blockage and liquidity risk increases. The growth in assets may force the fund manager to look for new strategies and markets as opportunities in the original trading area shrink. He or she may not succeed in these new markets. In addition, the manager can no longer focus exclusively on trading but must spend time on administrative, organizational and managerial matters, delegating many trading decisions. To solve this problem, some hedge funds are not only declining to accept new investors but also are refusing to take additional funds from existing investors. A survey of hedge funds earlier this year indicated the industry could absorb substantial new assets if investors allocated them incrementally, to avoid the funnel effect of too much money coming in too fast.

Given all the drawbacks, what can a CPA recommend to help clients cope with these risks? CPAs and investors must carefully examine the hedge fund’s offering memorandum and its Form ADV, which describes the manager’s business practices and background. You should also ask for audited financial results, ask about the fund’s performance history and get a clear overview of the fund’s strategy, including its style, projected size and self-imposed leverage limits.

WHY HEDGE FUNDS?

Hedge funds attract investors of all kinds. Pension funds, endowments, insurance companies, private banks and high net worth individuals and families all invest to minimize overall portfolio volatility and enhance returns. Many sophisticated clients find hedge funds a comfortable complement to their core investment holdings.

A November 2000 research paper from Morgan Stanley Dean Witter said hedge funds have “produced risk-adjusted returns that are superior to traditional investments.” Incorporating several databases for the period January to June 2000, the company concluded that all hedge funds had a composite annualized return of 18.9%, compared with the S&P 500 stock index, which returned 17.2%. Annualized volatility was less than half of traditional markets. All in all, hedge funds have been subject to much scrutiny in the past few years yet they have consistently outperformed traditional markets on a risk-adjusted basis. Recent investor curiosity means CPAs need to better understand the industry and the strategies it uses. A portfolio of hedge funds or a fund of funds can offer investors attractive risk-adjusted rates of return with little or no correlation to most traditional portfolios—and less volatility.

The obvious question for CPAs to ask is why a client should invest in hedge funds:

The minimal connection between alternative and traditional asset classes offers the benefit of increased portfolio diversification.

Noncorrelation across strategies and among managers following the same strategies allows for attractive risk-adjusted returns.

A wide variety of hedge fund substrategies makes it easier for clients to put together a customized investment program.

Hedge fund managers seek absolute returns rather than trying to outperform an index. This means managers are seeking profits in all market environments rather than being satisfied with beating an index, but still earning a negative return.

The economics of hedge funds motivates the best-of-the-best asset managers to establish hedge funds, giving investors access to a superior talent pool only available in hedge funds.

DON’T THROW CAUTION TO THE WIND

In seeking to understand hedge funds and the risks they present, CPAs should remember these funds are an investment structure, not an investment style. They enable investors to gain access to different markets facilitated by the fund’s organization and employment of a good manager. Many hedge fund investors commit large amounts of money without fully understanding the risks the fund presents. CPAs should not allow their clients to make this mistake. Rather, they should make sure clients fully understand the investment they are making and its risks. (See exhibit 1, below for some Internet resources on hedge funds.) The old advice that you shouldn’t invest any money in a hedge fund you can’t afford to lose may be particularly good guidance for new investors who need to better understand this alternative before committing more money.

Given the complexity of selecting and monitoring hedge funds, CPAs would be well advised to make sure the client’s overall portfolio has a sufficient foundation in other, relatively safe liquid investments. CPAs should also recommend that clients commit assets to any investment—including hedge funds—only after thorough research and due diligence. (See exhibit 2, below.) Knowing and understanding the characteristics of the many different hedge fund strategies is essential to capitalizing on the investment opportunities they provide.