There are caveats when dealing with an unregistered hedge fund. The Securities and Exchange Commission has seen a dramatic rise in enforcement actions against hedge funds, and warns that this is despite its limited ability to take action against these investments.
In fact, the SEC staff recommended in a report released in late September that the commission consider revising its rules to require that hedge fund advisors register with the SEC under the Investment Advisers Act of 1940. The committee stopped short of recommending that hedge funds themselves be required to register.
Registration of hedge fund advisors would mean they would be subject to the SEC's regular inspections and examinations program. The SEC says it then could collect meaningful information about the funds and could require advisors to disclose information important to investors. Registration would effectively increase the minimum investment requirement for direct investors in some funds.
The long-awaited report was the result of an SEC fact-finding investigation spurred by concerns about the lack of information regarding hedge funds, the increased incidence of enforcement actions regarding hedge fund advisors and the potential for less sophisticated investors to become involved with the funds. The SEC estimates 6,000 to 7,000 hedge funds operate in the United States, managing approximately $600 billion to $650 billion in assets. In the next five years, hedge fund assets are predicted to top $1 trillion, it adds.
Currently, about 25% of all hedge fund managers are registered as investment advisors. Will registration of hedge fund managers under the Investment Advisors Act of 1940 have an impact on a fund's performance?
No, says Graves. He says there is no difference in the performance of hedge funds that have managers registered as RIAs and those that do not.
"It isn't performance related," says Graves. "(The Investment Advisers Act of 1940 is) for compliance and antifraud. The act contains various antifraud provisions, and requires advisors to meet record keeping, reporting and other requirements."
With limited public information available on hedge funds, it's important for financial advisors interested in them to do exhaustive due diligence.
"Hedge funds will perform better than open-end [hedge-like mutual] funds because they have no restrictions," says Matthew Rich, a former hedge fund manager who just launched the Technical Chart Fund, a registered open-end long/short fund. "I didn't realize how much of a difference there is between the investments. When I ran the [unregistered] hedge fund for Kauser Capital, I could short more stocks than I could with my Technical Charts Fund. I could use more leverage to boost returns. Plus, when you run a mutual fund, you have to find ways to keep the trading costs down."
But registered open-end funds may be an attractive alternative for those who are not accredited investors or for skeptical investors who are uncomfortable with unregistered investments. For example, over three years ending in 2002, the seven hedge-fund-like mutual funds tracked by Morningstar and Hedgefund.net on average gained 27%. By contrast, the S&P 500 lost 43%.