Quite recently, President Barack Obama signed the Jumpstart Our Business Startups (JOBS) Act and provisions in it that will allow hedge funds to advertise responsibly to investors through normal channels, i.e. TV, radio, print and other media.
Thus far, hedge funds have been banned from soliciting or advertising their private offerings to the general public in exchange for being exempt from having to register with the Securities and Exchange Commission under Rule 506 of Regulation D. The lack of a clear definition of a solicitation has created confusion about what hedge fund managers can disclose in their marketing materials, at conferences or in the media. As an example, when I spoke at hedge fund conferences in the past, I could speak about investing topics from an educational and informational perspective, but could not give any specifics about my own hedge fund.
It is expected that hedge funds will be allowed to advertise shortly after the Securities & Exchange Commission adopts final rules, which is expected to occur within 90 days of the signing of the JOBS Act. However, hedge funds will still be restricted to selling their securities to accredited investors such as individuals with a minimum $1 million net worth and qualified institutional investors (companies that manage a minimum $100 million in assets).
Lifting the ban on advertising will certainly benefit all hedge funds, large and small. The larger hedge funds will be able to take advantage of the media to the fullest as they have the deeper pockets to access TV and radio. But the smaller hedge funds will also benefit as they will utilize the internet where banner advertising and pay-per-click campaigns are a lot cheaper.
Now this does not mean that the content of those advertisements will not be monitored by the regulators. The SEC will still ensure that the messaging is compliant with the rules and enough warnings are placed about the suitability of the products. And let us not forget that the SEC has 90 days to water down this provision and place in further investor safeguards.
One of the dangers of advertising that is being discussed in the legal and financial circles is the lack of rules and controls in the performance advertising. Hedge funds could easily embellish their performance results and thereby mislead the investors.
But there are several other risks being posed by this recent regulation that the investor needs to be aware of. In my book, The Future of Hedge Fund Investing (Wiley, 09), I discussed the risks faced by investors who are considering alternative investments. In this article I will highlight some of those risks.
There have been several instances where investors have invested into hedge funds with little or no due diligence, relying entirely on hearsay, reputation of the manager, or even worse, the manic desire to belong to an exclusive club. The propensity for this behavior will get magnified as some very glib advertising starts hitting the air waves soon.
As a first step of due diligence on a hedge fund manager, the investor should check the manager's background to uncover any legal or regulatory actions and conduct a full operational due diligence to ensure that the hedge fund is properly set up with reputable auditors, brokers, and administrators. This level of due diligence ensures that the hedge fund manager is not a crook and will not run away with the investors' capital.
In chapter 8 of my book, I highlighted the five inviolable commandments of operational due diligence, which would ensure the required transparency and veracity of the information coming out of a hedge fund.
1. An independent industry-recognized auditor.
2. An independent industry-recognized administrator/custodian.
3. Trade execution via independent entities, like prime brokers.
4. Fund valuations conducted independently by a third party, like an administrator.
5. A hedge fund manager who is willing to talk at length and in depth about his strategy and provide regular risk and return reporting.
Once the above ingredients are in place, then begins the true due diligence, the strategy-level due diligence. While the operational due diligence is very important, it ranks a distant second to strategy-level due diligence, which in my opinion is not being conducted effectively by the hedge fund investors, retail or institutional. It is the strategy-level due diligence that will ensure that hedge fund collapses such as Amaranth Advisors, Vega Asset Management, or Long Term Capital Management do not wipe out investors' capital either.
More hedge fund investors have incurred massive losses on their investments due to a breakdown of trader discipline than to outright fraud. Ongoing strategy-level due diligence performed correctly would have prevented those cases and would have spotted charlatans like Bernie Madoff as well.
While an exhaustive discussion is presented in my book, it is outside the scope of this article. Nevertheless, I will highlight a few points that the investors should be aware of when they are bombarded by the upcoming onslaught of hedge fund advertising.
1. Uselessness of historical data crunching
When an investor is looking at a hedge fund's historical returns, it is important to note that unless the strategy is driven by systematic algorithmic models, historical returns are quite useless in predicting future returns.
2. Quest for steady returns leads to destruction of alpha
A hedge fund manager should be left to produce alpha, regardless of the volatility of those returns. It is the job of the investor to construct the right portfolio that reduces the volatility of the portfolio.
3. Bucketing by asset class or geography is a flawed concept
Hoping to reduce volatility in a portfolio by diversifying across asset classes and geography is a yesteryear concept. Given the high degree of correlation between the asset classes and the world's markets, diversification is gained by analyzing the hedge fund's trading patterns rather than the geography and asset classes deployed.
4. Do not pay high fees for beta strategies
In my analysis of the hedge fund universe, I find that a lot of hedge funds are in fact leveraged mutual funds masquerading as hedge funds so they can charge high fees. A thorough analysis of a hedge fund's strategy and its returns is needed to ensure that high fees are not being paid for pure beta strategies.
5. Hedge fund manager's experience needs to match his strategy
Successful traders usually have the requisite education and years of hands-on experience in their field. It is not a skill that is acquired overnight or as a hobby. A careful look at the trader's background is necessary to ensure the sustainability of the manager's strategy.