How to Look Under a Hedge Fund's Hood

Date: Friday, October 4, 2013
Author: Julie Steinberg, The Wall Street Journal

Seven questions investors should ask before investing

Now that hedge funds are allowed to advertise their wares in the marketplace, it will be important for investors to understand this sophisticated asset.

If you meet the income or asset minimums required to invest, hedge funds can be a good way to diversify your portfolio and achieve impressive risk-adjusted rates of return.

But hedge funds may require high minimum investments and can lock up your money for months. Because of the funds' private nature, there is also increased potential of fraud.

Before giving the green light to your financial adviser or handing your money directly to a hedge-fund manager, here are seven key questions to ask:

What is the hedge fund's strategy and can it change?

Because there are so many hedge-fund strategies, research and select one that complements your portfolio, says Roger Shaffer, a managing director at Shaffer Wealth Management, an Atlanta-based firm with $300 million under management.

If the fund's performance is closely linked to other assets in your portfolio and tracks the stock market, for example, you may be better off purchasing an S&P 500 index fund, he says.

"You want a noncorrelated asset," he says. "If you're not getting that, you're not getting a lot of value."

Understand the risks associated with the fund's strategy. Know how much leverage there is—that is, how much the fund borrows to make its investments. Leverage can amplify losses as well as gains. Hedge funds also often contain both "long" and "short" investments—or bets that separate groups of securities will, respectively, rise and fall. Be sure you're not in a fund with long bets on all tech stocks and short bets on all bank stocks, for example, if you're not comfortable taking such risk.

Ask whether the fund's strategy ever changes, whether it could shift into emerging markets, for example, or invest more in gold, says Lisa Vioni, a former hedge-fund marketer and owner of a website that connects hedge funds with potential investors. Try to learn whether the fund tends to switch strategies often or suddenly.

What are the returns and track record like?

Review the performance for each year of the fund's existence, and make sure you understand the methodology the fund uses to arrive at the figures, as there isn't a uniform standard, says Barbara Roper, director of investor protection at the Consumer Federation of America, a Washington, D.C., nonprofit.

A minimum of three years will give you a good sense of the fund's performance, says Carroll Hayes, a principal at Charles Carroll Financial Partners, an investment advisory firm in Annandale, Va., with $40 million in assets under management.

Unlike mutual funds, hedge funds aren't required to report performance net of fees, so make sure to ask for the net return after fees in order to be able to make a better comparison with other funds.

Performance ultimately has to justify the risks you're taking, says Mr. Hayes. Look at the so-called Sharpe ratio, which tells you how much excess return a fund has delivered in relation to its volatility.

Anthony Zanolla, director of hedge-fund portfolio management at Northern Trust, recommends the value-at-risk measure, which looks at the level of risk a fund takes based on what it invests in and how, such as whether the bet is long or short.

Who is behind the fund?

Hedge funds typically hire prime brokers, lawyers, accountants and administrators, says Ms. Vioni. A prime broker processes a fund's trades; the administrator keeps track of financial records and handles registration issues, among other duties. Check with the institutions to ensure they are associated with the fund you are considering, says Ms. Vioni. Be sure the institutions are legitimate.

Look for an ADV form filed by the hedge-fund manager with the Securities and Exchange Commission. The forms tell about managers, fees, investing philosophy and any disciplinary actions. For more information about a manager, try Finra's BrokerCheck.

What are the fund's fees?

Hedge-fund fees typically range between 1% and 2% of assets and 20% of the profits annually. If the fund charges more than that, you may want to think twice about investing, says Mr. Hayes of Charles Carroll Financial Partners. Also inquire about the hurdle rate, which is the minimum rate of return the firm must hit before you're charged performance fees.

Who else is in the fund?

Hedge funds typically don't disclose who else invests with them, but it doesn't hurt to ask, says Nick de Peyster, chief investment officer at Genesis Wealth Advisors, a wealth-management firm based in Stoughton, Mass., that manages about $100 million in assets.

Mr. de Peyster suggests asking what percentage of the manager's net worth is tied up in the fund. "Some managers believe in eating their own cooking," he says, which ensures their interests and yours are aligned.

What access will you have to your money?

Investing in hedge funds is different from investing in mutual funds, which offer daily access to your money. Hedge funds typically "lock up" your money for months at a time. You can usually only "redeem" it, or gain access to it, on a quarterly basis, says Benjamin Pace, chief investment officer of Deutsche Bank's wealth-management unit in the Americas.

Keep in mind once you request your funds you will have to wait to receive them. According to Hedge Fund Research Inc., which tracks hedge-fund performance, about 54% of hedge funds require investors to wait at least 16 days to receive their funds once they request them.

What are the tax implications of this investment?

Ask whether you will receive a 1099 or K-1 form for tax purposes, says Mr. Shaffer of Shaffer Wealth Management. Hedge funds are generally organized as partnerships, so as a limited partner, you're most likely to receive a K-1, which can be mailed as late as September, says Lawrence Bober, a director at Chicago-based assurance, tax and consulting firm McGladrey LLP.

Mr. Bober suggests working with a tax preparer who has experience with tax returns that include hedge-fund income, since the income you receive might complicate your tax strategy. Knowing whether a fund produces mainly short-term capital gains, for instance—which could be counted as ordinary income—will help you determine whether the fund is a good fit with your overall tax strategy.

Ms. Steinberg is a reporter for The Wall Street Journal in New York. Email her at julie.steinberg@wsj.com.