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Problems with Hedge Funds
Funds of Hedge Funds
One of the primary obstacles for the average person who may be interested
in hedge funds is the amount of money it takes to become involved.
A minimum investment of one million dollars is not uncommon. Since
hedge funds have become so popular, it is now possible to buy into
certain funds with a minimum investment of as low as 100,000 dollars.
Even this is too rich a price for many small investors, which is
where funds of hedge funds come in. A fund of hedge funds is exactly
what it sounds like – a pooled investment in hedge fund companies.
Funds of hedge funds generally register with the SEC and provide more
protection and lower risk for investors. The cost to buy into one
can be as low as 25,000 dollars, much more than the minimum investment
for most mutual funds but a damn sight better than the six or seven
figures otherwise required to get into the hedge fund game.
Funds of hedge funds limit risk by investing in different hedge
funds with different managers, different strategies, and different
areas of business, thus preventing your investment from being wiped
out by the collapse of a hedge fund or an unforeseen market event.
Of course, there is correspondingly lesser chance of making obscene
profits, as a particularly well-performing hedge fund will be countered
by the others. If a fund of hedge funds selects too broad a sample,
it risks simply representing the entire market; the ideal number of
hedge funds is around eight to fifteen.
The risk and potential returns are still considered to be greater
than those of a mutual fund. Besides greater risk, there are other
disadvantages to investing in a fund of hedge funds. One of these
is a lack of liquidity. A liquid asset is one that can easily be sold
at any time. If your money gets tied up in a fund of hedge funds,
it might not be possible to get it back out at your convenience. Funds
of hedge funds will also complicate income tax returns.
Another serious problem is lack of transparency and accountability.
Hedge funds are notoriously secretive, and you may not be able to
find out what exactly the hedge funds are doing with your money, which
allows ample opportunity for fraud.
Hedge Fund Fraud
Because of lax regulation, fraud is more common in hedge funds than
in other investment industries, at least in the United States. This
is not to say that such fraud is legal; the SEC can and does take
action against any company that defrauds investors. The most common
fraud among hedge fund managers is to misrepresent their experience
or their company’s track record, or to use money from new investors
to pay off old ones in classic pyramid schemes. It is important to
thoroughly investigate a hedge fund before deciding to invest in it.
Fraud is more common among smaller hedge funds with relatively small
minimum buy-ins and larger numbers of investors. The SEC brought fraud
charges against hedge funds twenty times in 2004. Considering that
thousands of hedge funds operate in the United States, this is still
a low percentage.
Hedge fund fraud does not exist in Europe to anything remotely approaching
this level, probably because of increased government regulation. In
Great Britain, for example, the FSA (Britain’s equivalent of the SEC)
requires hedge fund managers to register and to prove that they are
qualified to run the fund.
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