Academic journal article Journal of Accountancy

Hedge Fund Investing: Current Advice for Financial Advisers and Planners

Academic journal article Journal of Accountancy

Hedge Fund Investing: Current Advice for Financial Advisers and Planners

Article excerpt

Hedge funds are one of the hottest investment opportunities in today's stock market. They have been very prominent in the financial news, attracting a lot of attention from investors, brokerage firms, the SEC and the attorney general of the state of New York. To help CPAs who provide financial and investment advice to clients, this article describes the nature of hedge funds and reviews the latest news about them.

THE RISE AND FALL OF HEDGE FUNDS

Started in the late 1940s by Alfred W Jones, hedge funds have always attracted investors who wanted higher returns than traditional mutual funds typically offer. Since the start of the bear market in stocks four years ago, hedge funds have been growing at a rate of 20% per year. A total of 8,500 such funds controls $1.0 trillion, up from $400 billion five years ago and $100 billion 10 years ago; the hedge fund market is expected to increase to $1.5 trillion in the next two to five years. (See "What is a Hedge Fund?" and "Types of Hedge Funds," page 53.)

Hedge funds started to become highly visible during the fall of 1998 with the near-collapse of the giant Long Term Capital Management LP (LTCM) hedge fund. Eighty investors, including U.S. government officials and top officers of some of the largest New York investment and brokerage houses, contributed a minimum of $10 million each to LTCM. Of its initial equity capital of nearly $1 billion, LTCM lost about 90% in less than two months. The crisis threatened U.S. financial markets and, in an unprecedented move to bail out private investors, the Federal Reserve Bank of New York arranged a $3.63 billion rescue plan. Given such risks, CPAs should be aware that investments in hedge funds should represent discretionary capital reserved for speculative investments. Clients must be able to bear the risks of these investments.

The near-collapse of LTCM wasn't an isolated instance; several other large hedge funds have failed since 1998, and the rate of attrition in hedge funds is now about 20% a year. This life cycle makes it more difficult to find good long-term hedge fund investments, and means that investors must carefully monitor market developments and quickly respond to changes (see "Long Term Capital Management," page 55).

A recent development has made hedge funds available to potentially less affluent investors: A new breed--the "funds of funds"--that allowed investors to invest as little as $25,000, compared with the previous typical minimum of $250,000, became popular in 2003. These vehicles work like mutual funds, spreading investments across numerous hedge funds. Funds of funds have become very popular with investors looking for better returns; the number doubled to 1,600 in 2004 from 800 in 2000. There is no minimum net worth or income requirement to invest in a fund of funds. (See "To Hedge or Not to Hedge," page 56.)

NEW SEC REGULATIONS

In light of the heightened visibility and importance of hedge funds and their vulnerability to financial collapse due to their greater risk compared to mutual funds, SEC Chairman William Donaldson expressed interest in improving the regulation of hedge funds when he started his job, and the SEC has begun to do that. However, it was New York State Attorney General Eliot Spitzer who first focused the public's attention on hedge funds in September 2003, when he charged that the manager of Canary Investment Management LLC had arranged with several mutual funds to improperly trade their shares. Without admitting or denying wrongdoing, the fund agreed to pay a $10 million fine and $30 million in restitution, which caused Canary to fail. Shortly afterward, as part of his investigation, Spitzer subpoenaed executives of a number of hedge funds and mutual funds to provide information about mutual fund trading. Within a month, a top trader at Millennium Partners LP, a $4 billion hedge fund, admitted illegal late trading of mutual fund shares. …

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