EXECUTIVE SUMMARY

SINCE THE BEAR MARKET IN STOCKS STARTED FOUR years ago, hedge funds have become one of the hottest investment vehicles, growing at a rate of 20% a year. The hedge fund market is expected to increase to $1.5 trillion in the next two to five years.

A HEDGE FUND IS A PRIVATE INVESTMENT CLUB, usually a partnership, open to a small number of wealthy investors, that invests in a variety of securities. The name “hedge fund” is misleading since hedge funds do not necessarily hedge.

A NEW BREED OF HEDGE FUNDS, called funds of funds, allows investors to invest as little as $25,000, compared with the previous typical minimum of $250,000.

HEDGE FUNDS CAN BE HIGHLY LEVERAGED, often using borrowed funds to acquire securities. The degree of leverage should be considered as a risk factor in judging the volatility of a fund’s performance.

IN LIGHT OF THE INCREASED VISIBILITY AND IMPORTANCE of hedge funds and their vulnerability to financial collapse, the SEC has issued new regulations that require hedge fund managers to register with the commission by 2006.

CPAs MAKING INVESTMENT RECOMMENDATIONS to clients should consider how hedge funds differ from mutual funds in terms of risk: There may be no secondary market for investments in hedge funds, highly leveraged funds can be especially volatile and some hedge funds severely restrict withdrawals.

THOMAS G. EVANS, PhD, is professor of accounting at the University of Central Florida School of Accounting in Orlando. His e-mail address is tevans@bus.ucf.edu. STAN ATKINSON, PhD, is a retired associate professor of finance of the University of Central Florida. CHARLES H. CHO, CPA, is a doctoral student in the School of Accounting at the University of Central Florida. His e-mail address is ccho@bus.ucf.edu.

edge funds are one of the hottest investment opportunities in today’s stock market. They have been very prominent in the financial news, attracting a lot of attention from investors, brokerage firms, the SEC and the attorney general of the state of New York. To help CPAs who provide financial and investment advice to clients, this article describes the nature of hedge funds and reviews the latest news about them.

THE RISE AND FALL OF HEDGE FUNDS

Started in the late 1940s by Alfred W. Jones, hedge funds have always attracted investors who wanted higher returns than traditional mutual funds typically offer. Since the start of the bear market in stocks four years ago, hedge funds have been growing at a rate of 20% per year. A total of 8,500 such funds controls $1.0 trillion, up from $400 billion five years ago and $100 billion 10 years ago; the hedge fund market is expected to increase to $1.5 trillion in the next two to five years. (See “ What is a Hedge Fund? ” and “ Types of Hedge Funds. ”)

Hedge funds started to become highly visible during the fall of 1998 with the near-collapse of the giant Long Term Capital Management LP (LTCM) hedge fund. Eighty investors, including U.S. government officials and top officers of some of the largest New York investment and brokerage houses, contributed a minimum of $10 million each to LTCM. Of its initial equity capital of nearly $1 billion, LTCM lost about 90% in less than two months. The crisis threatened U.S. financial markets and, in an unprecedented move to bail out private investors, the Federal Reserve Bank of New York arranged a $3.63 billion rescue plan. Given such risks, CPAs should be aware that investments in hedge funds should represent discretionary capital reserved for speculative investments. Clients must be able to bear the risks of these investments.

Investments in Hedge Funds

Worldwide investment inflows for hedge funds reached a record $106.6 billion for the first three quarters of 2004, more than the total for all of 2003.

Source: Tremont Capital Management, www.tremontcapitalgroup.com. 2004.

The near-collapse of LTCM wasn’t an isolated instance; several other large hedge funds have failed since 1998, and the rate of attrition in hedge funds is now about 20% a year. This life cycle makes it more difficult to find good long-term hedge fund investments, and means that investors must carefully monitor market developments and quickly respond to changes (see “ Long Term Capital Management ”).

A recent development has made hedge funds available to potentially less affluent investors: A new breed—the “funds of funds”—that allowed investors to invest as little as $25,000, compared with the previous typical minimum of $250,000, became popular in 2003. These vehicles work like mutual funds, spreading investments across numerous hedge funds. Funds of funds have become very popular with investors looking for better returns; the number doubled to 1,600 in 2004 from 800 in 2000. There is no minimum net worth or income requirement to invest in a fund of funds. (See “ To Hedge or Not to Hedge .”)

A hedge fund is a private investment club, usually a partnership open to a small number of wealthy investors, that invests in a variety of securities. The name “hedge fund” is misleading since hedge funds do not necessarily hedge. Instead, they use a combination of market philosophies and analytical techniques to develop financial models that identify and evaluate market opportunities. Very often, the financial models are very sophisticated, highly quantitative and proprietary to the fund. From the investor’s standpoint, the use of a single investment strategy can limit diversification and increase risk. Therefore, investment advisers should evaluate each fund’s investment strategy and consider its suitability to clients’ investment objectives.

Traditionally, hedge funds have been off-limits for many mutual fund investors. Because of the risks involved and to avoid regulation, they were sold almost exclusively as unregistered securities only to high-net-worth investors with at least $1 million in net worth or more than $200,000 in annual income. However, the recent rise in real estate values has made these thresholds easier to reach than in the past.

Hedge funds differ from mutual funds in many ways: They can buy a wider variety of securities; they are restricted to fewer investors; they can try to produce a gain irrespective of whether stock and bond markets are rising or falling; they have not been subject to strict SEC regulations and disclosure requirements (except for the new “funds of funds” discussed in the text of the article); they tend to concentrate their portfolios in fewer investments; they have more leeway to “time” the market; they cannot advertise; they can limit the number of contributions and withdrawals; their compensation method is based on incentive and management fees that usually are much higher than those for mutual funds; and they can invest in long, short and leveraged securities.