The Securities and Exchange Commission has voted to lift an 80-year ban on advertising by hedge funds and private equity groups, and the secretive funds are likely to become more visible soon. But there are a few things investors should know that are not likely to be a big part of the high-end funds’ ad campaigns.
The reason the ban is being lifted is because of a new law that will potentially broaden the market for the funds.
What are hedge funds? Hedge funds invest in a variety of strategies and are only open to accredited investors. Despite the perception that these funds are held only by high net worth individuals, the bar is relatively low. An accredited investor is defined as someone with $1 million in net worth (excluding your primary residence) and $200,000 in annual income ($300,000 for a couple). While these are both a lot of money, there are millions of people who meet those qualifications.
Hedge funds and alternative investments have gained rock-star status in many circles in large part due to the solid returns achieved by the Yale Endowment and similar large institutions. Yale has the staff and the resources to fully vet and manage these investments. I’m guessing most individual investors do not.
Financial adviser Michael Zhanug warns investors away from the funds in his blog, The Investment Fiduciary. He notes that “Hedge fund fees totaled $440 billion versus $9 billion total profits for investors.”
While hedge funds won their reputation for the big returns they brought for some institutional investors like Yale, my concern is that hedge funds and other private equity investments will advertise directly to the public in order to raise funds. They will not have the same ability to research the funds they chose to buy into. As a financial adviser, I see a lot of mainstream folks who would qualify as accredited investors. In fact, the accredited investor standards were set in 1982. Allowing for inflation, the income level should have risen to $500,000.
Hedge funds come in many flavors. including equity-based strategies, gold, merger arbitrage and others. Given the creativity of advertisers, I’m concerned some investors will invest in hedge funds via an ad they saw when in fact these investments are not appropriate for them. I’m wondering if they will engage celebrity spokespeople to peddle these investments just as the mutual fund and reverse mortgage folks have done. Wilford Brimley, Tommy Lee Jones, and Fred Dalton Thompson all come to mind.
There are some excellent hedge funds, and there are some that are not so good. This is no different than ETFs, mutual funds and the like. However, hedge funds have three features that make them less desirable for most individual investors:
• A lack of transparency
• High fees
• Limited access to funds
As far as the ads, will these be like the drug company ads that warn you about potential side effects such as death from using the product?
Maybe I watch too much of the CNBC show "American Greed," but I’m concerned about the potential for fraudsters and scammers to prey upon the investing public using the lure of an exclusive investment like a hedge fund, or perhaps the fear-mongering angle that some overly aggressive insurance and annuity sales people use. I’m not saying that hedge fund managers are not honest or commit fraud; I'm concerned about a wider pool of potentially less sophisticated investors and the potential for an increase in fraud.
As you begin to see ads for hedge funds and related investments should you invest? The answer depends on you and your situation. In short, however, let me leave you with this: Never invest in anything that you don’t understand.
Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides financial planning and investment advice to individual clients, 401(k) plan sponsors and participants, foundations, and endowments. Roger is active on both Twitter (@rwohlner) and LinkedIn. Check out Roger's popular blog The Chicago Financial Planner where he writes about issues concerning financial planning, investments, and retirement plans.