Hedge Fund Information for Investors

Hedge funds are minimally regulated private investment partnerships that historically accept only high-wealth investors. The theory behind their creation was that high-wealth investors are financially sophisticated and therefore did not need or want to incur the additional administrative expense of reporting to a regulatory agency. The label hedge fund is not a specific legal term, but rather is used to describe an investment vehicle with great flexibility in the investment strategies it can adopt; many of these strategies are unavailable to traditional mutual funds. Hedge funds can invest in equities, bonds, options, futures, commodities, arbitrage and derivative contracts, as well as illiquid investments such as real estate. This gives hedge funds the potential to profit in times of market volatility. Hedge fund managers are compensated on a contingency-based fee structure, which typically earns them a 1 percent management fee plus an incentive fee of 20 percent of annual profits.

Although the exact number of hedge funds is difficult to quantify due to a lack of centralized reporting requirements, it is clear that hedge funds have grown exponentially in the last ten years. Industry trade publications indicate that hedge funds have quadrupled in number (from approximately 2,100 in 1996 to approximately 8,800 in 2006), have over $1.3 trillion under management and account for 20 percent to 50 percent of the daily trading volume on the New York Stock Exchange.

Hedge funds offer many benefits, but because of the volume of assets under management, they draw special attention when they fail. Hedge funds can fail for a variety of reasons. A hedge fund with a small asset base can experience crippling cash flow problems following a period of poor returns on investment. Excessive leverage can precipitate sudden capital depletion when investing in volatile financial instruments or commodities. Of most importance to law enforcement and regulators, however, is when hedge funds fail due to fraud. Debate continues among civil regulatory agencies and in Congress as to what, if anything, should be done to regulate the industry to control potential fraud and abuse.

The current investment climate, which lacks regulatory scrutiny, may tempt unscrupulous hedge fund managers to commit fraud. Hedge funds themselves are not illegal; they are simply the vehicle that facilitates fraudulent activity by managers. The FBI has investigated a variety of frauds that involve hedge funds. In the Daedalus Capital Partners case, for example, a classic advanced fee scheme was perpetrated by the hedge fund manager; investors received false financial statements claiming large profits, when in fact the money was being siphoned off and used to finance the manager’s lavish lifestyle. In the Global Time Capital Growth Fund case, on the other hand, the hedge fund manager was convicted of trading on material non-public information regarding an impending bank merger—a classic example of insider trading. Finally, in the Bayou Management LLC case, the hedge fund principals created a legitimate hedge fund, suffered losses in trading and later issued false financials to their investors to hide those trading loses.

Civil regulatory agencies like the Securities and Exchange Commission and the Commodity Futures Trading Commission have identified several indicators of fraud in hedge funds:

• Lack of trading independence: hedge fund managers trading through affiliated brokerdealers
• Investor complaints: investors being unable to redeem their investments in a timely fashion
• Audit issues: lack of audits by reputable independent accounting firms
• Litigation: hedge funds being sued civilly by investors alleging fraud
• Unusually strong performance claims: hedge fund performance claims are better than market average over a long period of time (they can’t always win, but if they do, possible indicator of insider information or false reporting)
• Illiquid investments: investing in a commodity which is not easy to value (incentive to overvalue investment to earn a larger commission)
• Valuation issues: use of related parties to value illiquid investments or use of a non-independent fund administrator
• Personal trading: hedge fund managers trading in their own accounts
• Aggressive Bear Shorting: hedge funds take a short position in a stock (bet it will go down) and orchestrate efforts to disseminate unfounded or materially false negative information about the stock, eroding the price and allowing the perpetrators to profit on the short position

Investor Due Dilligence — Red Flags

Depending upon its investment strategy, each hedge fund has its own unique investment risk and must be assessed based upon its own merits. Investors should fully understand the risk in investing in hedge funds and should conduct appropriate due diligence before investing.

Examples of due diligence could include:

• Reviewing www.SEC.Gov for past regulatory actions against the fund manager;

File a Complaint (links)

If you feel you have been the victim of illegal activity in a hedge fund, you can file a complaint with the following organizations:

• Securities and Exchange Commission Enforcement: www.enforcement@sec.gov
• NASD Investor Complaint Center: www.nasd.com/InvestorInformation/InvestorProtection
• Commodity Futures Trading Commission toll free complaint line: 866-FON-CFTC
• FBI: www.tips.fbi.gov