The hedge fund industry is estimated to be a $875 billion business and growing at about 20% per year, with more than 8,000 active hedge funds. Most hedge funds are highly specialized, relying on the specific expertise of the manager or management team. A hedge fund manager might employ investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. In general, hedge funds are not regulated nor are they subject to regulatory oversight.
The recent bankruptcies of two Bear Stearns hedge funds, the High Grade Structured Credit Strategies Master Fund and the High Grade Structured Credit Strategies Enhanced Leverage Master Fund, demonstrates how dangerous hedge funds can be. It has been estimated that Wall Street took in at least $27 billion in revenues from selling and trading risky Mortgage Backed Securities (MBS) during the housing boom. Hedge fund managers purchased questionable securities like Collaterialized Mortgage Obligations (CMOs) and Collateralized Debt Obligations (CDOs) that contained large concentrations in subprime and Alt-A mortgages. Many of the CMOs were represented as investment grade, when in fact they were highly speculative investments that were designed to drive the Wall Street money machine.
The combination of risky strategies, large investments and lack of regulation have lead to catastrophic hedge fund disasters. The most visible was the failure of Long-Term Capital Management, a hedge fund whose founders included two Nobel laureates. Long-Term Capital Management turned a $4.8 billion into $125 billion prior to its failure in the summer of 1998. Long-Term Capital Management investors were virtually wiped out having lost 92% of their assets.
Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded. Hedge funds are flexible in their investment options and may use short selling, leverage, derivatives such as call options, put options, index options or futures to mitigate risk.
Not all hedge funds are the same. Investment returns, volatility and risk vary among the different hedge funds strategies. Some strategies, which are not correlated to equity markets, are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds. These defensive strategies mean that hedge funds may out perform benchmark indexes during down years.
A result of the lack of regulatory oversight means that hedge funds are approved and monitored almost exclusively by the brokerage firms or banks that sell them. As a result, hedge funds are particularly prone to sales practice abuse or fraudulent sales practices. The pre-sale due diligence done by the brokerage firm is critical. The firm has a responsibility to ask the right questions and review pertinent documents to ensure that selling representations to the customer are consistent with the funds track record, management and investment philosophy.
Brokerage firms also have a continuing duty to monitor hedge funds they recommend. Pre-sale and subsequent due diligence are conducted by the brokerage firm’s due diligence department personnel.
Hedge funds are sometimes sold with restrictions on an investor’s ability to liquidate their accounts. As a result of manager strategies some funds may impose lock up periods of one year.
Hedge funds charge costly incentive fees of approximately 20 percent. Incentive fees are split by the hedge fund manager and the brokerage firm selling the fund. A key reason for the high failure rate of hedge funds is the high-water-mark fee arrangement. If a fund loses investor money, it cannot collect its incentive fee until it regains the assets lost in the previous year and surpasses its previous high point. This can lead to an exodus of talented mangers and staff who leave for other funds not subject to the high-water-mark problem. This can lead fund managers who are in the red at midyear to take extraordinary risks to get back above water. Given that brokerage firms solicit hedge funds as a investment vehicle to reduce or mitigate market risk, this type of situation is problematic.