Funds of hedge funds

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Historically, hedge funds have been offered as unregistered securities that, because of the risks they posed, were only available to a limited number of wealthy, financially sophisticated investors. Now there are funds that are registered with the SEC and invest in unregistered, private hedge funds. These "funds of hedge funds" provide the opportunity to invest in private hedge funds through a single fund that is composed of underlying hedge funds.

What are Hedge Funds?

There is no exact definition of the term "hedge fund" in federal or state securities laws. Hedge funds are basically private investment pools for wealthy, financially sophisticated investors. Traditionally, they have been organized as partnerships, with the general partner (or managing member) managing the fund's portfolio, making investment decisions, and normally having a significant personal investment in the fund.

Hedge fund managers typically seek absolute positive investment performance. This means that hedge funds target a specific range of performance, and attempt to produce targeted returns irrespective of the underlying trends of the stock market. This stands in contrast to investments like mutual funds, where success or failure is often measured in terms of performance in relation to a stock index, like the Dow Jones Industrial Average.

Because they are usually only open to limited numbers of wealthy, financially sophisticated investors and do not advertise or publicly offer their securities, private hedge funds are usually not required to register with the SEC. As a result, unregistered private hedge funds do not provide many of the investor protections that apply to registered investment products, such as mutual funds.

What are Funds of Hedge Funds?

Funds of hedge funds are pooled investments in several unregistered hedge funds. Unlike the underlying private hedge funds, the fund of hedge funds itself can register with the SEC under the Investment Company Act of 1940. In addition, the fund of fund's securities also can be registered for sale to the public under the Securities Act of 1933. Registered funds of funds can have lower minimum investments than private hedge funds (some as low as $25,000). A registered fund of hedge funds can be offered to an unlimited number of investors. However, unlike an open-ended mutual fund, there is no investor right of redemption - shares cannot be redeemed directly with the fund unless the fund offers to redeem them. Nor are the shares usually listed on a securities exchange like exchange-traded funds (ETFs). With very limited exceptions, there is no secondary market available, so you won't be able to sell your investment readily.

An investment in a fund of hedge funds does have some potential advantages over a direct investment in a private hedge fund. For example, a fund of funds may diversify between a number of different investment styles, strategies and hedge fund managers, in an effort to control risk.

High Fees and Expenses

Expenses in funds of hedge funds are significantly higher than most mutual funds. For example, one such fund of funds has an annual asset base fee of 2.15%. In comparison, mutual funds have expense ratios averaging 1.36%, based on data from the SEC's Report of Mutual Fund Fees and Expenses. The manager of this fund of funds also gets 10% of any annual gain that exceeds an 8% return. Because it invests in a number of private hedge funds, a fund of funds also bears part of the fees and expenses of those underlying hedge funds as well. You should be sure you understand the fee structure of any fund of hedge funds that you consider investing in.

What are the Risks of Investing in a Fund of Hedge Funds?

Unregistered Investments
Funds of hedge funds generally invest in several private hedge funds that are not subject to the SEC's registration and disclosure requirements. As discussed above, many of the normal investor protections that are common to most traditional registered investments are missing. This makes it difficult for both you and the fund of funds manager to assess the performance of the underlying hedge funds or independently verify information that is reported. All of this can make it easier for an unscrupulous hedge fund manager to engage in fraud.

Risky Investment Strategies
As noted, hedge funds very often use speculative investment and trading strategies. Many hedge funds are honestly managed, and balance a high risk of capital loss with a high potential for capital growth. The risks hedge funds incur, however, can wipe out your entire investment. If you can't afford to lose your entire investment, then perhaps hedge funds and funds of hedge funds are not for you.

Lack of Liquidity
Hedge funds, both the unregistered and registered variety, are illiquid investments and are subject to restrictions on transferability and resale. Unlike mutual funds, there are no specific rules on hedge fund pricing. Registered hedge fund units may not be redeemable at the investor's option and there is probably no secondary market for the sale of the hedge fund units. In other words, you may not be able to get the money you invested in the hedge fund back when you want out of the investment.

Adverse Tax Consequences
The tax structure of registered fund of hedge funds may be complex. There also may be delays in receiving important tax information. This ay require you to obtain an extension to file your income tax return.