Hedge-fund investing is freewheeling, takes big bucks to play

Rapid growth in assets has regulators calling for more transparency

Your Money

July 03, 2005|By Andrew Leckey

In the $1 trillion world of hedge funds, almost anything goes.

You can invest if you have lots of money, there are few restrictions on where fund managers can put it and they typically make big bets.

But the impact of hedge funds extends beyond those wealthy investors.

Hedge funds have been blamed for volatility in crude oil markets by using derivatives to bet on prices. Their buying and selling of U.S. Treasuries often surprises central banks.

They launch billion-dollar takeover bids and fan the flames of other deals. Something fishy in small-caps, emerging markets or late trading in mutual funds? Maybe hedge funds were behind it.

Now that pension funds, charities and endowments invest in them, hedge funds have come closer to home for average folks. More individuals also are meeting regulators' wealth requirements to invest in them. A tripling of hedge fund assets in five years has governments demanding more transparency.

"Hedge funds aren't appropriate for an average investor because they are difficult to understand and you can't get performance data on a daily basis," said Maria Scott, editor of the AAII Journal of the American Association of Individual Investors in Chicago. "Investors drawn to them usually heard a hedge fund had spectacular returns, but don't understand all the reasons why."

These investments don't attempt to match market benchmarks and often employ options, short selling and leverage.

"If I go to Las Vegas, I'm going to play blackjack or poker, not sit there and pull a slot machine handle, which is pretty much what investing in an index fund is like," said Phillip Goldstein, portfolio manager for the $85 million hedge fund Opportunity Partners LP in Pleasantville, N.Y., up roughly 3 percent this year after fees.

Goldstein, whose 12-year-old hedge fund invests in distressed companies, pledges to do "everything legally and morally" acceptable to increase the value of investors' money:

He helped persuade catalog retailer Blair Corp., whose stock was at $25, to sell its credit-card portfolio and initiate a stock tender buyback for more than half its shares. This drove the price to about $40 a share.

His pressure on rural telephone company Hector Communications Corp. to improve shareholder return resulted in its hiring an investment banker to potentially help it sell the company.

After his threat of a proxy fight to stop its expansion into the charter business, air cargo carrier AirNet Systems Inc. hired an investment banker to help it sell the firm.

To try to halt a controversial Securities and Exchange Commission hedge fund reporting rule from going into effect in February, Goldstein filed a lawsuit that contends the cost of compliance wasn't properly studied.

The rule requires hedge fund advisers with at least $25 million in assets and more than 14 investors to register under the Investment Advisors Act, providing basic information and naming a compliance officer. Industry members complain the SEC underestimated the cost to funds at $50,000 and that the $25 million threshold is too low.

"A damaging effect of this rule will be the significant barrier to entry," said John Gaine, president of the Managed Funds Association, the industry trade association in Washington. "Many hedge funds grew from one or two people and this would really hurt that type of firm."

The SEC approved the rule 3-2 in October, supported by then-SEC Chairman William H. Donaldson. It remains to be seen whether the likely new SEC chairman, Christopher Cox, would reverse it.

The agency doesn't have staff to monitor hedge funds effectively, critics say. It would, however, scrutinize those who run funds, possibly looking at how many funds they manage, their assets and types of clients. "Remember, it's not the hedge funds that must register, but their advisers," SEC spokesman John Heine said.

Despite an estimated 8,000 hedge funds, a top tier of funds makes much of the money.

The Van Global Hedge Fund Index was up 0.2 percent this year through the end of May, outperforming the broader stock market, which was down almost 2 percent.

The hedge fund index's stronger gain of 0.9 percent during May came from declining U.S. long-term interest rates, strong stock markets and a surging dollar. Those results, released two weeks after the end of each month, are after fees.

"Because they're active traders, hedge funds help keep market pricing efficient," said Kevin Campbell, vice president of research at Van Hedge Fund Advisers International, a Nashville, Tenn., consulting firm that computes the index. "Returns of hedge funds have been OK this year, not great, though it was nice to see a May rebound."

Hedge fund investing requires some bucks: Under SEC rules, you must have $1 million in net worth or income of $200,000 for two consecutive years if you're single, or $300,000 if married. But for hedge funds that charge a fee based on performance - which is most of them - investors must have $1.5 million.

Most hedge funds used to have investment minimums of $1 million, but some lowered that to $50,000 or less so long as an investor meets SEC threshold requirements. Fees are a drawback: A standard annual fee for a hedge fund is 2 percent of assets and 20 percent of profits.

Andrew Leckey is a Tribune Media Services columnist.

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