Hedge funds can expose investors to high levels of fraud and investment risk, according to the SEC. How can hedge fund investors protect themselves?
Hedge funds can pose a high level fraud and investment risk, according to federal regulators who want to ensure investors are equipped to deal in this complicated, high-stakes world.
“Hedge fund investments generally perform differently, involve higher fees and less liquidity, and may carry greater investment and fraud risk than the mutual funds that investors are accustomed to,” said Lori J. Schock, head of the Office of Investor Education and Advocacy at the U.S. Securities and Exchange Commission.
The SEC should know. The federal agency has filed more than 100 complaints over the past two years against hedge funds that have lied to and stole from clients, charged excessive fees, run Ponzi schemes or perpetrated other forms of financial fraud . Most recently, a San Francisco hedge fund took $550,000 from a retired school teacher and used it to pay a home mortgage, office rent and staff salaries, according to the SEC. The teacher had been led to believe she was investing in a long/short hedge fund strategy and was provided false account statements showing non-existent investment gains.
“The most serious hedge fund frauds involve advisers who play fast and loose with investor money,” said Bruce Karpati, head of the Asset Management Unit of the SEC enforcement division. In addition to the increased risk of fraud, hedge fund investors can also face a high level of investment risk.
Hedge funds are pooled investments that can use speculative investment strategies – such as leverage and short-selling – to earn a high return. Hedge funds are typically off-limits to all but accredited investors, those deemed by the SEC to have the sophistication and resources needed to invest in more opaque and less regulated products.
An accredited investor is defined by wealth and must have a net worth of $1 million, not including primary residence, or an income of $200,000 for the two most recent years and a reasonable maintaining that income in the current year. But according to the SEC, accredited investors can and do get burned by hedge funds.
“These hedge fund frauds have lured even the most sophisticated investors using the siren song of outsized returns or secured and guaranteed investments,” Robert Khuzami, head of the enforcement division at the SEC. How can investors seeking higher yields protect themselves against potential pitfalls of hedge funds? The SEC offers the following tips:
· Read All Related Documents: A hedge fund’s offering memorandum will explain the fund strategies and risks, fees and expenses. Make sure you understand the level of risk posed by the fund strategy and are willing to take on that risk. Leverage, for example, can turn an otherwise conservative investment into an extremely risky one. Hedge funds may also invest in derivatives or engage in short-selling, which increase the potential for losses as well as returns. Where are fund assets held? Does the fund undergo an independent audit on an annual basis?
· Understand how value and performance are determined: Hedge fund assets may be highly illiquid and difficult to value, yet a fund’s valuation will affect the fees a manager can charge. What is the valuation process? How is fund performance determined? Performance data can reflect cash or assets received by the fund, or the manager’s estimate of a change in the value of the fund assets. Does the data include deductions for fees?
· Learn your rights to redeem shares: Hedge funds typically limit opportunities to cash in on hedge fund investments. What is the redemption schedule? Is there a lock up period? What are the redemption fees? Can the hedge fund suspend redemptions.
· Research hedge fund managers. Are they qualified? Have they been disciplined by enforcement agencies, such as the SEC, the Financial Industry Regulatory Authority or state securities regulators?
Recent Millionaire Corner research shows that ultra wealthy investors, those with more than $25 million, have cooled to hedge funds over the past two years.