By Dan Barufaldi
As mentioned earlier in this tutorial, hedge funds have a few similarities to mutual funds, but there are a larger number of differences, and in this section of the tutorial we'll briefly go over some of the most important. (To learn more about mutual funds, check out Special Feature: Mutual Funds.)
For starters, hedge funds are not regulated. There are limits to what they can do, such as the number of investors they can have (mentioned earlier), or the fact they cannot advertise to the general public, but they are not regulated by the SEC per se. The implications of this are that an investor should be properly informed about a hedge fund, its strategy and the character of the principals before investing. (Learn more about the SEC in Policing The Securities Markets: An Overview Of The SEC.)
This is probably one of the main reasons why hedge funds are thought to be more risky than a traditional mutual fund investment. However, the strategies that hedge funds use are constantly being characterized as very risky, and in many cases, hedge funds have more conservative strategies than other traditional investments. For the purposes of this tutorial, it will suffice to say that there is no federal or state regulator overseeing the operations of hedge funds, and therefore proper due diligence is critical.
One of the other implications of not being regulated is that hedge funds are neither required to report their underlying positions to the general public nor to any regulatory agency. Even though more and more investors are demanding increased transparency from hedge funds, the really talented hedge fund managers do not want to reveal any of their positions, and often get away with not providing any. Investors, fearful of not participating in the potential returns the manager can generate, often give in and make an investment regardless. In some cases, an investor is large enough to demand position details, in which case a hedge fund manager may take certain precautions, such as the signing of a confidentiality agreement.
When the hedge fund industry was in its infancy, hedge fund managers were the most talented money managers around. It makes sense that it would be the most talented that would strike out on their own, produce the best returns over time, and charge high fees for doing so. Many hedge fund managers had worked for one or several of the large institutions before striking out on their own, and investors were more than happy to move their investments along with them. (Read more about the early days in A Brief History Of The Hedge Fund.)
Over the years, however, an increasing number of mediocre managers have launched hedge funds with the lure of making huge sums of money. For this reason, it is important for an investor to properly evaluate a hedge fund before making an investment. Whereas the term "hedge fund manager" was historically indicative of a manager's talent, that is no longer the case.
Hedge Fund Strategies
Finally, many hedge funds adhere to certain strategies, some of which were discussed earlier in this tutorial. Initially, the offering memorandum that was provided to an investor set specific guidelines regarding a hedge fund's investment strategy and the type of securities it can invest in. Recently, however, with the increase in hedge funds and the whittling away of previously very lucrative profits in certain strategies, hedge funds have begun to expand their investment mandate, allowing them much more flexibility to seek out opportunities.
This means that a U.S. long/short equity manager who makes investments only in stocks traded on U.S. exchanges can now seek out and make investments in fixed-income and derivatives and expand their investments to other countries. Although most managers stick to what they know, an investor should be wary of the flexibility inherent in a manager's strategy and monitor any deviations from the strategy. With little to no transparency, this can be difficult, but large deviations from historical performance can be a good reason to investigate further.
This section of the tutorial gave you a taste of the different characteristics of hedge funds. We have seen acceleration in the rate of change in the hedge fund industry so that many of the characteristics currently prevalent may be altered significantly or change altogether. There has been mention of a reduction in fees, increased regulation, the creation of mutual funds with hedge fund strategies, and a variety of other dynamics that will surely change the characteristics of these vehicles.
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