What is a Hedge Fund?
While there is no concrete definition of a hedge fund, a hedge fund can be simply defined as a private pool of investor money that a manager uses to make investments. Traditionally, the term hedge fund was used to indicate an investment strategy of “hedging” the risks of the broader market. Today’s hedge funds often engage in highly speculative trading strategies without any such hedging. Due to these speculative investment strategies, hedge funds and other investment funds are only suitable for wealthy investors that can afford to lose their entire investment.
Hedge funds and other investment funds operate like mutual funds in that a manager makes the investment decisions for the fund. The key difference between hedge funds and mutual funds is that your participation in a hedge fund or other investment fund is a private securities transaction. Since hedge funds and other investment funds are private offerings, some of their activity is unregulated. This places more responsibility on the investor to research the fund, its managers, financials, track record, investment strategy, and the risks associated with that strategy to determine whether the hedge fund or investment fund is a sound and prudent investment.
To help perform the proper due diligence before investing, you should be provided a private placement memorandum (PPM) or some similar document that fully discloses the information discussed above. Like a mutual fund’s prospectus, a hedge fund’s disclosure document should be substantial in length (typically 30 to 60 pages). Investors should carefully read the document to understand the details of the investment. Also, investors should contact the Utah Division of Securities before investing to verify the security is legitimate and the fund manager is properly licensed.
A few common problems with hedge funds and other investment funds offered in Utah include:
Any person or company that seeks to pool investor money has created a security that must be:
- properly registered under Utah law;
- exempt from registration under Utah law; or
- be a federal covered security notice filed in Utah.
In many cases, hedge funds and other investment funds fail to properly follow securities laws and offer unregistered securities to Utah investors, which is a violation of the law.
Many hedge funds and investment funds either fail to provide investors with a disclosure document as described above or provide inadequate disclosure in their document. Some hedge funds and investment funds even mislead or misrepresent information in their disclosure documents. The omission or misrepresentation of material information in the offer or sale of a security is considered securities fraud. Sometimes investors trust the person selling the investment and rely on that relationship rather than the written disclosures, which is often a strategy known as affinity fraud.
By making the investment decisions for the hedge fund or investment fund, the manager will typically be required to license as an investment adviser. When a fund manager licenses as an investment adviser, additional information about the fund is available that can assist prospective investors seeking to research the fund. Licensing as an investment adviser also ensures that the manager’s fees will not exceed industry standards.
Additionally, if a third party is compensated for introducing the issuer and investor, that third party needs to be licensed as an issuer-agent, broker-dealer agent, or investment adviser representative depending on the specific arrangements.
Ponzi Scheme Concerns
Investors usually do not question whether they are investing in a Ponzi scheme. They believe the reports and statements issued by the fund manager. But those documents can be easily faked. Many Ponzi schemes issue reports and statements that reassure investors their money is held in an account and the fund has been earning a good rate of return. To verify this information, validate the institution has physical custody of the funds, obtain independently-audited financials of the hedge fund, and discuss the financials of the company with their accountant. A common red flag to identify a Ponzi scheme is whether the fund manager simply invests in another investment fund or actually invests in a business that generates revenue through the sale of a product or service.
Multilevel Marketing/Feeder Fund Concerns
Some hedge funds and other investment funds have been created merely so they can qualify to invest in some other hedge fund. While there may be technical concerns for the hedge fund that accepts pooled money from these feeder funds, investors should be aware that their investment is with the feeder fund and not the ultimate hedge fund that may be boasted. Often these feeder funds are sold in the same fashion as a multilevel marketing scheme where investors are asked to create their own pool of other investors in a partnership or limited liability company of their own. This practice is particularly concerning because each feeder fund is its own securities offering and must meet regulatory requirements to be done appropriately.
Blind Pool Concerns
Some hedge funds may claim they do not need to be licensed as an investment adviser. This may be inaccurate if the fund fails to limit itself to specific investments that are not securities. The hedge fund or investment fund may call such open investment arrangements a “blind pool” in which the fund manager has complete discretion of what investments to make. In nearly every instance, these fund managers are required to license as investment advisers and failure to do so is against the law. To determine if a fund manager needs to be licensed, please contact the Utah Division of Securities at (801) 530-6600.