Hedge funds are limited to a specific group of sophisticated investors mainly because they are thought to have more experience with markets and investing. However, hedge funds aren’t without risk. While you can’t control market conditions, you can control who you choose to handle your money. Weeding out the bad apples can be one of the most important aspects in choosing a hedge fund. All investors should perform due diligence or hire a company that specializes in due diligence on funds they are interested in. According to the Securities and Exchange Commission, there are six major areas that should be looked into before investing in any fund.
1. Read a fund’s prospectus or offering memorandum and related materials
The offering memorandum is a set of documents constructed by the legal counsel of the fund. It outlines investment strategies, lists all of the fees associated with the fund, goes over the time line, lists the services providers, and is the basic operating manual for the fund. Make sure you familiarize yourself with the basic principles of the fund so there are no surprises along the way.
2. Understand how a fund’s assets are valued
Depending on what the hedge fund invests in, the fund may be either liquid, or high illiquid. When the fund invests in illiquid securities, many times, they are hard to value. Hedge funds that invest in exotic securities require a much more intense understand of the strategy and the investment, so that you can better gauge the fluctuation of value.
3. Ask questions about fees
Typically, hedge funds charge a management fee as well as a performance fee. A standard fee structure would be 2/20 where the fund manager charges 2% managing the assets and 20% of the fund’s performance. These numbers can change, with some managers only charging 1% to manage the assets, or no fee at all. Performance fees can go as high as 45% on occasions. It all depends on the manager, so make sure you are well aware of the fee structure before going into the fund. If you invest in a fund of hedge fund, you may be charged a double layer of fees, with one going to hedge fund manager, and the other going to the fund of fund manager. Also check to see if there is a high water mark, or hurdle rate, which will also affect the fee structure. Ask if there is a penalty fee for leaving the fund early, as well.
4. Understand any limitations on your right to redeem your shares
Find out if there is a “lock-up” period, which is a period where you cannot redeem your investment. This may be a year or two. Remember, even if there is no spoken lock-up period or penalty for cashing in early, hedge fund managers sometimes can freeze redemptions without any notice, making it impossible for investors to redeem cash. However, this usually is a red flag, and many times when redemptions are stifled, the fund’s demise comes shortly thereafter. Or, as in some cases, redemptions are only frozen until market conditions become more desirable for the fund.
5. Research the backgrounds of hedge fund managers
Everyday it seems, there are headlines that detail fraudulent hedge funds or scheming hedge fund managers. When choosing a hedge fund, and thus choosing a hedge fund manager, its important to find out, did the manger run any previous funds? What is the manager’s performance record, with both this fund, and the last? What is the managers employment history? Has the manager ever been convicted of a crime? Was the manager let go from his previous position and why? Does the manager have sufficient experience with this kind of strategy? Because hedge funds enjoy light regulation, a manager can tank a fund, close its door, and open up a new one with a different fund name, without a problem. That’s why background checks are crucial. After all, a hedge fund is only as good as its manager.
6. Don’t be afraid to ask questions
It’s your money. You should know exactly where it is going, when you can get it back, and what you expect to gain from this investment. Hedge fund managers many times have years of experience on Wall Street along with a financial background. This can make for some pretty complicated investments. If you don’t share a repertoire in finance, you may have to dig a little in order to fully understand the strategy and where exactly your money is going.