Consider this a warning.
The SEC (Securities and Exchange Commission) is relaxing the rules on how hedge funds can market.
It’s a mistake because it means you’re about to be bombarded with advertisements from these entities. The ads will be slick. They’ll be enticing. They will be touting returns that most people can only dream of.
And your job is to turn away.
Take a page from Homer’s Odyssey… Odysseus had his crew tie him to the mast so he wouldn’t be able to steer towards the Sirens and shipwreck on the rocks.
Okay, maybe you don’t need to be tied down, but definitely turn the page, change the channel or do anything else to stay away from these funds! They can be destructive to your wealth.
A short (true) story on how messed up things can become will show why most people have no business in such investments.
In 1999 there was a hedge fund that rode the Internet craze to dizzying heights. The fund was up 332% in that one year alone… and up another 53% in the first couple of months of 2000. Then the wheels came off.
By the middle of April 2000, the fund was down 89% for that year. Think about what would have happened if you were an investor in that fund.
You put in $100,000 on January 1, 1999. By the end of the year your account showed $432,000, at which point you owed the manager his fee, 2% of the account value for management plus 20% of the profits. That equates to $75,000. Still, you have $357,000 left, which is a 257% gain. Not too shabby.
But by early April the fund has fallen 89% for the year, bringing your account down to $39,270 (89% of the ending 1999 balance of $357,000). That’s awful… but it gets worse.
You see, this is a hedge fund, so it’s a partnership. As a partner, you’re distributed paper profits every year, even if you don’t take them out of your account.
Because this was a short-term trading fund, let’s assume you were allocated all the profits in your account at the end of 1999… so $257,000. Your tax bill at the 35% rate would be about $90,000. Unfortunately, your account is now only worth $39,270. So your hedge fund investment went from $100,000 to $39,270, to… a negative $50,730. Ouch!
Don’t get me wrong, there is nothing inherently wrong with hedge funds. The problem is that few investors actually understand how they work, so when they invest in them it’s like they’re jumping into a very dark pool. If everything goes well, then no problem, but when things go wrong, hedge funds can be a very frustrating investment.
That said, there are a few things you should know that will help you steer clear of danger.
Hedge funds are misnamed. Most of them don’t “hedge” at all. They instead tend to be focused bets on very narrow slices of a sector or industry. They can also be exceptionally broad, giving the investment manager the ability to buy anything on the planet.
If you’re considering a hedge fund, check to see if the investment objective and investment parameters have any limitations on them at all. If not, your money could end up being used for a Peruvian brothel or a wind farm in Africa.
Also, hedge funds are typically set up as partnerships (as I mentioned earlier), where investors become limited partners. They’re not corporations where investors become shareholders. Because these are partnership interests, there’s no marketplace where you can go to sell your investment. Usually you have to sell the interests back to the partnership itself, which might or might not want to buy it.
So cashing out can be a challenge. While the partnership might not want to buy your interests back, typically the operating agreement lists out the conditions under which the hedge fund has to cash you out. Pay particular attention to these details… they are important!
And understand the terms…
First, there is a “Lock Up.” That is the initial period during which you can’t get your money back. This can be anywhere from a day (very unusual) to 18 months. The normal lock up is a year.
Think about that.
You’ll be separated from your money for at least a year. After that, you have to request redemption at the end of a calendar quarter, and usually you must make the request at least 45 days, if not 90 days, in advance.
There is no selling on the day you feel bad about the markets, or just want your money back for other purposes. You have to plan on when you want the funds returned.
Then there is the “Gate.”
Normally people don’t want out of good performing funds, they want out of bad ones. The problem is that if too many investors want out at the same time, then the manager has to sell assets rapidly, which could force down the value of whatever it is he holds. This is particularly true if the investment manager has invested in illiquid assets like real estate or art, or thinly traded securities.
If too many people ask for redemption at the same time, usually more than 10% of the fund, the manager can throw down a “gate,” and only redeem a small percentage of all requests, holding off on the rest of the requests until a later date. This is fully at the discretion of the manager.
The last term of note is “in-kind.” That’s almost a four-letter word in the investment community. If a hedge fund is holding a bunch of illiquid, poorly performing assets, and many investors want out, the hedge fund manager can send investors their share of the investments instead of cash.
So if a hedge fund manager is holding notes on a bunch of real estate that no one wants and he gets overrun with redemption requests, he can send you your share of the notes. As an investor, you now have to deal with trying to get a bid and get out of this stuff.
All of these things come into play in hedge funds, but (with the exception of K-1s on Master Limited Partnerships) don’t apply to what we think of as traditional stock and bond investments.
There is a reason hedge fund investments are limited to accredited investors. People should be financially and legally sophisticated before locking up their money in such vehicles.
Think about all the documents put in front of you for signature in everyday life: credit card applications, mortgages, membership applications, school documents for kids, car loans, etc. Did you really read them all? Do you know what you are liable for and what are the consequences if something goes wrong?
If you don’t typically read fine print, and you’re not comfortable giving some manager the ability to do whatever he or she wants with your money, then steer clear! It could be one of the best “decide-not-to-invest” decisions you’ll ever make.
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