A Closer Look at Alternative Investments: Hedge Funds

By Michael Williford, Spring 2016 Student Intern

Let’s turn our attention to perhaps the best known of all alternative investment vehicles: the hedge fund. We’ve all heard about the celebrated and vilified hedge fund manager. But what exactly does a hedge fund do, and what are the risks associated with hedge fund investment?

In February of 2013, the SEC issued an investor bulletin that explains that hedge funds “pool investors’ money and invest the money in an effort to make a positive return. Hedge funds typically have more flexible investment strategies than, for example, mutual funds.” Sounds pretty good. The bulletin goes on to highlight some of the risks with hedge funds; among them, that “hedge funds are not subject to some of the regulations that are designed to protect investors.” It also states that “some hedge fund managers may not be required to register or to file public reports with the SEC.” The overall message is that hedge funds are not subject to the same kind of industry regulation as more traditional investments like mutual funds or even individual stocks a broker may recommend to you.

Nor do hedge diffuse risk in the way index funds do. According to the SEC bulletin, often times hedge funds employ leverage—they utilize borrowed money to increase the potential return, thereby also increasing the risk of potential loss.

Finally, hedge funds don’t have the same level of transparency as mutual funds, index funds, or even individual stocks, whose parent companies issue annual reports. Hedge funds are not required to file public reports with the SEC, depending on the amount of money invested in the funds. Although federal securities laws dictate how mutual funds can advertise their performance, there are not the same strict requirements for hedge funds. Because many of the underlying investments are often relatively illiquid, it can be difficult to gauge their value.

As a result, the SEC recommends doing your due diligence to make sure the fund’s strategy lies within your tolerance for risk, and that you understand the fund’s investments strategy—whether the fund is leveraged, what the underlying investments are, and how the fund’s performance is measured. Most importantly, educate yourself. Read the fund’s offering memorandum and related materials so you can ask the right questions before you invest.

Be on the lookout for the next post, when I’ll highlight private equity investments.