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Preparing Clients for New Hedge Fund Advertising

These very complex funds may be sold aggressively and look attractive to investors who don't understand the risks.

Helen Modly, CFP, ChFC, 10/10/2013

The SEC has reversed an 80-year ban and will now allow hedge funds to solicit deposits not only from sophisticated investors who can afford to lose money, but from any investor who meets a minimum standard of $1 million in net worth or annual income of $200,000.

Many of us worry that these very complex funds may be attractive to investors who don't understand the risks, and with their high fees, they will prove irresistible to aggressive salespeople. How best to communicate this issue to our clients?

Karen Keatley, founder of Keatley Wealth Management in Charlotte, N.C., has graciously allowed me to share the client letter she developed to explain to her clients why they would not be seeing hedge funds on their statements:

What Are Hedge Funds and Why We Don't Invest in Them?
For decades, hedge funds have been shrouded in mystery and only available to certain privileged, well-connected investors, which make them seem intriguing to many people. However, that is about to change, and we will likely be seeing ad campaigns in print and on television. Some in the industry think this will benefit investors by de-mystifying hedge funds. I disagree and am concerned that advertising to individual investors will create confusion, perpetuate a lot of myths about investing, and put more people at risk of making very bad decisions with their money.

What is a hedge fund and how are they different from mutual funds? People talk about hedge funds as if they are an asset class, like stocks or bonds. In reality, this is not the case. Hedge funds can take investment positions in almost anything: stocks, bonds, derivatives, commodities, foreign currencies, and collectibles. Not only can they make bets for and against a wide variety of assets, hedge funds often use leverage (borrowed money) to amplify the impact of their trading decisions. Aside from their extremely broad latitude on how to invest, they are different from mutual funds in several other important ways.

Hedge funds can be purchased only by accredited investors, defined as those with a minimum net worth, excluding their home, of $1 million and income over $200,000 per year. I think the theory here is that high-net-worth investors are "sophisticated" and therefore able to correctly evaluate investment risk. Hmmmm. It is worth noting that these limits were established in 1982; if adjusted for inflation, the net worth requirement would be $2.3 million.

Hedge Fund Costs
Hedge funds are, as Warren Buffett has concluded, not really investment vehicles but "compensation schemes." Unlike mutual funds, hedge fund fees are quite high and have typically been around 2% per year plus 20% of profits. (The Wall Street Journal reported recently that fees are declining to 1.8%/18% due to pressure from disappointed investors over the past few years.) You might think having the fund managers keep a percentage of the profits is a good idea because they will be incentivized to make profits. However, since the managers don't participate in losses, I would suggest that they are really just incentivized to take more risk. If things work out, they get their 18%-20% bonus; if not, oh well. It's a great deal for the hedge fund managers: Heads, you win and they win. Tails, you lose and they still win.

Hedge fund returns are often quite volatile, much more so than typical stock mutual funds, due to their use of derivatives and leverage, as well as their willingness to "go all in" on an idea. As a result, investment results are often really good or really bad. It is easy to see how hedge fund manager compensation would encourage that outcome. If the fund does well, the managers get a great payday. If it does poorly, the managers still get their 2%. They can liquidate the fund, return whatever is left back to investors, and then start a new hedge fund.

Helen Modly, CFP, ChFC, is executive vice president and director of investment services for Focus Wealth Management, a fee-only registered investment advisor in Middleburg, Va. Modly has more than 20 years of experience providing wealth-management services. She is a member of NAPFA and FPA. She can be reached at info@focus-wealth.com. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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