SEC’s task for advisers: Tending to the hedges

The Securities and Exchange Commission just handed financial advisers a homework assignment: Become more familiar with hedge funds and learn how to keep on top of that constantly changing universe.

The SEC dropped this task into advisers’ laps by proposing a rule that would let issuers of private offerings advertise them and solicit the public. Hedge funds are among the biggest issuers of private offerings.

At present, hedge funds can’t advertise in the general media, creating a situation in which investors wishing to participate must not only have the wealth and sophistication to meet the requirements of the funds, but also the savvy or professional guidance to access them.

If the rule is approved after the comment period, as seems likely, advertising probably will induce more investors to explore hedge funds.

WHAT’S THE ALLURE?

While most of the approximately $2.1 trillion in assets managed by hedge funds comes from institutional investors such as pension funds, endowments and foundations, the widely publicized Forbes World Billionaires List includes 36 people who made their money investing in such funds.

Many investors have the impression that hedge funds are high-return/low-risk investments while, in fact, many are leveraged.

Moreover, hedge fund managers often are quoted in the press and appear on TV discussing the economy and the investment scene. The advertising of hedge funds in the media will only increase managers’ exposure.

If hedge funds are so successful, what is the problem with more affluent investors getting into them?

First, many hedge funds aren’t successful. Many start, raise substantial sums to pursue intriguing strategies, fail and disappear without a trace, taking all their investors’ money with them.

Second, some return little value because investors don’t break even after fees. Academic research suggests that hedge fund investors earn average returns that are no better than the S&P 500 on a risk-adjusted basis after fees and expenses.

Performance databases showing superior returns from hedge funds are skewed by the fact that many funds don’t report poor returns, providing an upward bias.

Even with expert help, institutional investors often pick the wrong hedge funds. But they usually diversify with several funds, minimizing the effect of the failure of one fund. Smaller investors generally aren’t able to do that.

UP TO SPEED

If the proposal takes effect, advisers must have a thorough understanding of the many investment approaches hedge funds take.

It isn’t enough to understand the five main investing strategies: global macro, directional, event driven, relative value (arbitrage) and managed futures. Advisers must have a grasp of the many variations on each of these themes, as well as their risk and return profiles.

Advisers must learn how to examine the hedge funds clients bring to them. They must weigh how funds fit into clients’ investment strategies and whether they add or reduce risk.

That’s a lot for advisers to take on, in addition to all the work they should be doing to prepare clients for the tax changes that likely are coming.

Meanwhile, the SEC must examine whether the criteria for accredited investors — annual income of $200,000 ($300,000 for couples) and net worth of $1 million, excluding a primary residence — are sufficiently high or should be raised.