The SEC’s Office of Investor Education and Advocacy is issuing this Investor Bulletin to educate individual investors about hedge funds.
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. Many hedge funds seek to profit in all kinds of markets by using leverage (in other words, borrowing to increase investment exposure as well as risk), short-selling and other speculative investment practices that are not often used by mutual funds.
You generally must be an accredited investor, which means having a minimum level of income or assets, to invest in hedge funds. Typical investors include institutional investors, such as pension funds and insurance companies, and wealthy individuals. Hedge funds are not subject to some of the regulations that are designed to protect investors. Depending on the amount of assets in the hedge funds advised by a manager, some hedge fund managers may not be required to register or to file public reports with the SEC. Hedge funds, however, are subject to the same prohibitions against fraud as are other market participants, and their managers owe a fiduciary duty to the funds that they manage.
|Disciplinary history. In a recent action, SEC v. GEI Financial Services, Inc., the SEC alleged that a hedge fund manager failed to disclose to his advisory clients that the State of Illinois had barred him from acting as an investment adviser.|
What questions should I ask the hedge fund manager before investing?
Excessive fees. In GEI Financial Services, the SEC also alleged that the hedge fund manager withdrew excessive fees from the hedge fund he managed. The amounts withdrawn allegedly were based on fee calculations that substantially differed from what the manager initially told investors about how the fees were to be calculated.
Tip. A fund of hedge funds is an investment company that invests in hedge funds—rather than investing in individual securities. Funds of hedge funds typically charge a fee for managing your assets, and some may also include a performance fee based on profits. These fees are charged in addition to any fees paid to the underlying hedge funds and, therefore, you will be paying two layers of fees. You may wish to read FINRA’s investor alert, which describes some of the costs and risks of investing in funds of hedge funds.
Manager malfeasance. In a recent action, In the Matter of Gerasimowicz, the SEC’s Enforcement Division alleged that, unbeknownst to investors, a hedge fund manager over the course of several years invested the majority of a fund’s assets into a private business owned by the manager’s affiliated company. The fund was marketed as being invested primarily in public equity securities with the aim of constructing a “diversified portfolio” and employing “controlled risk diversification.” The manager allegedly failed to inform investors of this substantial investment in a private business or the conflict of interest resulting from the manager’s substantial personal investments in the business. The business ultimately filed for bankruptcy, and a distribution to the fund to recover its investment in the business is uncertain and could be very small. Audited financial statements that were months late in being prepared and delivered to investors, if delivered at all, allegedly failed to timely alert investors to the investment.
In another recent action, SEC v. Lion Capital Management, LLC, the SEC alleged that a manager used his hedge fund as a ruse to misappropriate over $550,000 from a retired schoolteacher. The schoolteacher considered the manager a close family friend and believed him to be a successful money manager. Instead of investing as he represented, the manager allegedly used the funds for personal and office expenses, including his residential mortgage, office rent and staff salaries. The manager allegedly provided false account statements to the schoolteacher reflecting nonexistent gains on her investment.
What protections do I have if I purchase a hedge fund? Hedge fund investors do not receive all of the federal and state law protections that commonly apply to most mutual funds. For example, hedge funds are not required to provide the same level of disclosure as you would receive from mutual funds. Without the disclosure that the securities laws require for most mutual funds, it can be more difficult to fully evaluate the terms of an investment in a hedge fund. It may also be difficult to verify representations you receive from a hedge fund.
The SEC can take action against a hedge fund or a manager that defrauds investors, and the SEC has brought a number of fraud cases involving hedge funds. For example, a number of these cases involved hedge fund managers misrepresenting their experience and the fund's track record. Other cases involved "Ponzi schemes," where returns to existing investors were paid with funds contributed by new investors. In some of the cases the SEC has brought, the hedge funds sent phony account statements to investors to cover up the fact that their money had been stolen. That's why it is extremely important to thoroughly check out every aspect of any hedge fund you might consider as an investment.
Ponzi schemes. In a recent action, SEC v. Jawed, the SEC alleged that a hedge fund manager operated a long-running, $37 million Ponzi scheme. Instead of investing in securities as he represented to investors, the manager allegedly used most of his investors’ money to pay back old investors, to pay himself, to travel and to create an illusion of achievement by hiring professionals and educated personnel. The manager allegedly hid the Ponzi scheme by creating fake, illiquid investments. With increasing redemption requests, the manager and others he hired manufactured a sham buyout of the funds to make investors think their hedge fund interests would soon be redeemed.
In another recent action, SEC v. Alleca, the SEC alleged that a hedge fund manager caused investor losses of $17 million as he engaged in a Ponzi scheme to cover-up losses from his undisclosed trading. The manager created a fund of hedge funds—a hedge fund that would be invested in other hedge funds. Instead of investing in other hedge funds, the manager allegedly engaged in active securities trading and incurred substantial losses. To satisfy redemption requests and conceal losses, the manager created two additional funds and allegedly siphoned investors’ money from these funds to satisfy redemptions on the first fund.
If you have a question or concern about an investment, or you think you have encountered fraud, please contact the SEC, FINRA or your state securities regulator to report the fraud and to get assistance.
U.S. Securities and Exchange Commission
Office of Investor Education and Advocacy
100 F Street, NE
Washington, D.C. 20549-0213
Telephone: (800) 732-0330
Fax: (202) 772-9295
Financial Industry Regulatory Authority (FINRA)
FINRA Complaints and Tips
9509 Key West Avenue
Rockville, Maryland 20850
Telephone: (301) 590-6500
Fax: (866) 397-3290
North American Securities Administrators Association (NASAA)
750 First Street, NE
Washington, D.C. 20002
Telephone: (202) 737-0900
Fax: (202) 783-3571
For FINRA’s BrokerCheck resource, visit www.finra.org/Investors/ToolsCalculators/BrokerCheck/.
To determine the contact information for your state securities regulator, visit http://www.nasaa.org/about-us/contact-us/contact-your-regulator/.
For FINRA’s investor alert regarding hedge funds, visit www.finra.org/Investors/ProtectYourself/InvestorAlerts/MutualFunds/P006028.
For the SEC’s press releases regarding the recent actions brought against hedge fund managers, visit http://www.sec.gov/news/press/2012/2012-192.htm, http://www.sec.gov/news/press/2012/2012-206.htm and http://www.sec.gov/litigation/litreleases/2012/lr22487.htm.
For additional investor educational information, see the SEC’s website for individual investors, www.investor.gov.
The Office of Investor Education and Advocacy has provided this information as a service to investors. It is neither a legal interpretation nor a statement of SEC policy. If you have questions concerning the meaning or application of a particular law or rule, please consult with an attorney who specializes in securities law.