Making Sense of Hedge-Fund Marketing

Consider this: Members of the Securities and Exchange Commission (SEC) recently voted 4-1 in favor of allowing advertising for private investment vehicles.

This includes startups, other small companies looking to raise money, and yes, hedge funds. Previously, advertising for such private investments was prohibited by laws that go back 80 years. There are pros and cons to lifting the ban. Some think it will make it easier for small companies to raise money, expand, and create jobs. But there is also potential for fraudsters to exploit this marketing opportunity.

As of now, the SEC does not have a formal policy to define what’s okay and what’s not. It plans to keep a watchful eye on advertisements and to address investor protections in a separate public-comment process.

As we head into this new paradigm where hedge funds can advertise, here’s what you need to know to consider advertisements in proper context, so that you can make prudent investment choices.

Who Can Invest? Accredited Investors.

Hedge funds are still restricted to accredited investors. According to the law, you can qualify as an accredited investor if your net worth is greater than $1 million (not including your primary residence), or your annual income has been at least $200,000 in each of the past two years. According to the SEC, 7.4% of US households qualify. Theoretically, these criteria mean you understand the risks and can withstand a bad outcome. If you are an accredited investor, at the minimum, you should understand the fee structure, the lock-up, the use of leverage, and the risks of the investing strategy before you sign on the dotted line.

How do the fees work? Two & Twenty

Hedge funds usually charge their investors two types of fees – a base fee, calculated as a percentage of assets, and a profit incentive, calculated as a percentage of a fund’s increase in value. These fees vary, but commonly are about 2% of assets plus 20% of the increase, respectively.

Often these fees are assessed in quarterly installments, but let’s keep it simple for the purpose of illustrating how it works. Say you invest $200,000 in a hedge fund with a 2 & 20 fee structure. Over the course of a year, one investment gains total $50,000. The managers would end up collecting about $14,000 for that year, so your year-end balance would be $236,000 net of fees. Here’s an example:

The Math: Base & Incentive Fee

So at first it may seem like your rock-star hedge-fund managers earned you a 25% return. After fees, however, your return amounts to 18%.

The 2 & 20 fee structure has its plusses and minuses. One obvious negative: $14,000 is a hefty fee when compared to a mutual fund (usually mutual-fund fees and expenses amount to about 2%, or $4,000 in this case) or passively investing in the S&P 500 index (which can cost as little as a fraction of a percent per year).

One positive: the profit incentive (the 20) clearly motivates the managers of the fund to achieve high returns. By contrast, mutual-fund managers are more focused on signing up new investors than investing the existing capital to achieve superior returns.

The key point here is: Always consider performance after fees. And make sure you understand how the fee structure works.

High-water what?

Huh? Great, more financial jargon. Probably code for something else you should avoid, right? Wrong. This one’s actually fantastic, and you should make sure the hedge fund you are considering has this provision in the agreement.

The high-water mark basically prevents hedge-fund managers from collecting their profit incentive multiple times when the fund’s performance oscillates up and down, and then back up again.

For example, let’s continue with the scenario described above. (In year one your $200,000 investment grows to $250,000, or $236,000 after fees.) Let’s say that in year two your investment declines back to $204,720 before fees. Year two fees would be 2% of $236,000, or $4,720, so, the net value of your account after year two is right back where you started, $200,000. Now, suppose in year three your account value rises to $230,000 net of fees. The high-water-mark provision would prevent the fund managers from collecting the incentive fee, since they really need to get your account value back to where it was at the end of year one before they start patting themselves on the back again.

The Math:  High Water Mark

A high-water mark means that only profit above and beyond levels that have already been achieved in past periods can be subject to the profit-incentive fee. The managers can’t just keep collecting that 20 percent each and every time the account goes up – only when the investment gain breaks into new territory.

The key point here is: Make sure the fund you’re considering has a high-water-mark provision.

What is a lock-up?

Hedge funds typically require investors to lock up their money for a minimum period of time. Two or three years are standard. The idea here is to give the managers of the fund time to implement a long-term strategy, without worrying about whether short-term performance over the next quarter or two might cause investors to panic and withdraw their money.

In this respect, a lock-up can actually be a good thing, saving investors from being whipsawed by the market’s ups and downs. A lock-up can also be good in that it protects investor A from the potentially ill effects of investor B panicking and withdrawing from the fund. Otherwise, unanticipated redemptions might require that the fund managers sell positions when they don’t want to sell them, which could negatively affect the performance of the fund.

Of course, a lock-up can be a bad thing, too. Suppose you want to use that money for something else. A vacation. Another investment. A summer home. A really, really, really nice meal. Or suppose after a year of reading the updates and dealing with these purported financial gurus you aren’t as enthusiastic about the strategy as you once were. Well, you’ll just have to wait and withdrawal your money according to the painstakingly deliberate, multi-year process outlined in the legal documents.

The key point here is: Make sure you understand how long the lock-up is, how withdrawals work under normal circumstances, and what exceptions there might be (e.g. medical emergency, etc.). And make sure you maintain enough liquidity among your other assets to serve all of your cash flow needs during the lock-up period.

Look out for leverage

Most investing – be it in a brokerage account, a retirement account, or a mutual fund – does not use financial leverage. That is, there is no borrowing. You have $10,000 in your account, so you buy up to $10,000 worth of stocks.

However, hedge funds often (not always, but often) use debt to leverage their returns. Here’s how it works: Let’s say the hedge fund has 10 investors who each put in $1 million. Total capital is $10 million. They then go to a bank and get a loan, so that the fund can actually purchase not $10 million of securities, but $20 million, $30 million, perhaps even $100 million, even though the initial capital from investors was only $10 million.

This is a great way to magnify returns. That stock they picked which rose 8%… Well, instead of just earning 8%, they were able to earn much more than that because they bought a lot more of it.

Fantastic, you say! Leverage away!

But here’s the rub: While financial leverage can magnify returns when things are going up, it can also cause big problems when things are going down. Let’s say the market value of the stock goes down, and the bank that lent the money gets nervous. They might demand that the hedge fund pay off the loan. When this happens, things can get ugly in a hurry. To pay off the loan, the fund is forced to sell stocks at low prices and investors can get crushed. For example, look what happened to a fund called LTCM, Long-Term Capital Management, which was run by some super brainy guys in the mid-to-late 1990s. Two Nobel Prize winners on the board of directors helped the firm rack up 40% annual returns for its early years… until they lost $4.6 billion in four months! Yikes.

The key point here is: Find out whether your fund uses financial leverage. If they do, make sure you really understand the risks involved. Make sure the managers don’t use it too aggressively, as they can tend to do when they are chasing high returns using OPM (other people’s money).

Does the Investing Strategy Make Sense?

Hedge funds offer a dizzying diversity of strategies. Here are a few just to get a flavor.

• Hedge funds can invest in all sorts of securities: common stocks, put or call options, futures contracts and other derivatives, high-yield bonds, and foreign currencies.
• Hedge funds may be long only, short only, or market neutral. Taking a long position means investing based on the expectation that a company’s value will rise. Taking a short position means investing with the expectation that a company’s value will decline. Market neutral means taking a balance of long and short positions.
• Funds might focus on mergers and acquisitions, spinoffs, and other special situations.
• They might only invest in companies of a particular size (e.g. small cap, mid cap, or large cap).
• Some funds focus on a particular industry, such as healthcare, energy, technology, or commodities.
• Some funds hold positions for years, others for fractions of a second. The frequency of trading activity can have implications for costs such as commissions. The holding period for positions can also affect the tax rate for the investor (greater than one year usually means a lower tax rate).

The key point here is: Make sure you truly understand the strategy of the fund. Don’t be afraid to ask questions. Make sure the strategy does not involve unnecessary complexity. Make sure the fund managers’ actions match their rhetoric, that their trading behavior is consistent with the strategy they pitch, and that a significant portion of their own wealth is invested right alongside yours.

Ask the right questions

Whether you’re a billionaire or someone of more modest means, investing is serious business. Now that hedge funds are allowed to advertise, consumers should consider the marketing messages with scrutiny. The SEC may eventually enact policies that raise the bar for honesty and accountability. Meanwhile, consumers should take control and ask the right questions:

• Are the historical returns they’re showing you after fees have been subtracted?
• How do those high-return numbers relate to historical returns and to the present and the future?
• What is the strategy? What is the investment process? Do you understand the process?
• Is the same strategy being implemented going forward that was used in the past?
• Has the economy, the financial environment, or the regulatory context changed in ways that might impact the expected returns of this strategy going forward?
• Have the fund managers disclosed to you all of the returns from all of the different strategies they have tried, or are they conveniently failing to mention other attempts that don’t showcase their abilities as flatteringly?
• Does the fund use debt to leverage returns? How much? Are there limits defined in the partnership agreement?
• Do the fund managers eat their own cooking? Is a significant portion of their own wealth invested alongside yours? Or are they willing to risk your capital but not their own?
• What are the tax implications of the investing strategy?
• What is the fee structure? How often are fees assessed? Quarterly?
• Is there a high-water-mark provision?
• How does the lock up work? Under what circumstances would you be exempt from the lock up? If you wanted to withdraw money, when could you do that? All at once or in installments?
• Most importantly, consult an independent financial advisor, who does not have a stake in the outcome.