1. Hedge funds are unregulated investment pools. They generally are more nimble and dynamic in their trading strategies than other investment funds.
2. Hedge funds are successful only if they make money in both up and down markets. To do this, they employ some creative and risky investment strategies—selling short, using leverage, trading put and call options, trading futures and investing in emerging markets.
3. Here is some information about hedge funds and their risks CPAs can use to evaluate the suitability of this investment for their clients.
WHY CHOOSE HEDGE FUNDS
1. The minimal connection between alternative and traditional asset classes offers the benefit of increased portfolio diversification.
2. Noncorrelation across strategies and among managers following the same strategies allows for attractive risk-adjusted returns.
3. A wide variety of hedge fund substrategies makes it easier for clients to put together a customized investment program.
4. Hedge fund managers seek absolute returns rather than trying to outperform an index. This means managers are seeking profits in all market environments rather than being satisfied with beating an index, but still earning a negative return.
5.The economics of hedge funds motivates the best-of-the-best asset managers to establish hedge funds, giving investors access to a superior talent pool only available in hedge funds.
LIQUIDITY RISKS
1. the possibility of a liquidity squeeze in moving markets has a very high risk.
2. Trading and hedging models and programs imply steadily flowing market swings But would stop functioning when price jumps and gaps occur due to market crashes or government intervention.
3. A dynamic hedge where the fund establishes an option position whose value varies with changes in the price of the underlying security—works only as long as the fund can adjust both sides of the trade at any time at fair prices. In a bear market, supply can dominate demand to such a large extent that some products have no bid prices or can be sold only at large discounts.
3. A dynamic hedge where the fund establishes an option position whose value varies with changes in the price of the underlying security—works only as long as the fund can adjust both sides of the trade at any time at fair prices. In a bear market, supply can dominate demand to such a large extent that some products have no bid prices or can be sold only at large discounts.
4. Margin call risk is another liquidity problem. It results from highly leveraged positions. When markets move in the wrong direction, the hedge fund must satisfy additional margin calls.
5. Exotic OTC derivatives, distressed securities or positions in other funds with longer redemption periods would create a cash match risk from illiquid positions where, the hedge fund’s cash reserves may not be sufficient If too many investors want to redeem quickly. Causing the hedge funds to liquidate some illiquid positions at large losses.
6. Access to invested funds can also present a liquidity problem for some clients. Many hedge funds don’t allow investors to withdraw their initial investment for at least 12 months and subsequent withdrawals may be permitted only quarterly—with advance written notice. Clients who miss the quarterly withdrawal opportunity will have to wait.
6. Access to invested funds can also present a liquidity problem for some clients. Many hedge funds don’t allow investors to withdraw their initial investment for at least 12 months and subsequent withdrawals may be permitted only quarterly—with advance written notice. Clients who miss the quarterly withdrawal opportunity will have to wait.
MARK-TO-MARKET RISKS
1. It’s not easy for a hedge fund to objectively value some illiquid positions at market prices since there is no efficient market for certain securities.
2. Many pricing models imply assumptions that are not valid for all market conditions. A net asset value (NAV) quote may therefore not reflect the “real” market price of a position.
HUMAN RISKS
1. hedge fund is only as good as its managers and traders. Investors must rely on the managers’ integrity and fairness. greed and false pride may prevent a manager from closing positions and realizing losses after a disaster.
STRATEGY RISKS
1. A benefit of hedge funds is they provide investors with an investment portfolio with lower levels of risk and can deliver returns uncorrelated with the performance of the stock market. The investor expects that strategy to remain relatively stable. Since strategy was an important reason for the client’s decision to invest.
3. A change in strategy may be enticing in times of bad performance, of changing markets (especially for quantitative programs) and after important traders depart. Typical indications of a change of strategy are sudden drops or rises of performance or increasing volatility.
4. Strategies that worked in smaller environments don’t necessarily work with large positions. The blockage and liquidity risk increases.
SIZE RISKS
1. The larger the fund, the more difficult it is to move in and out of positions and fast executions are possible only at large transaction costs.
2. The growth in assets may force the fund manager to look for new strategies and markets as opportunities in the original trading area shrink. He or she may not succeed in these new markets. In addition, the manager can no longer focus exclusively on trading but must spend time on administrative, organizational and managerial matters, delegating many trading decisions.
BASIC HEDGE FUND DUE DILIGENCE
1. Volatility - Was the fund’s annual return generated by large gains in one or two months, or was it spread evenly over the year? How bad were the fund’s worst months? Does it match an investor's risk tolerance.
2. Breadth - Did the fund manager turn a profit on all issues, or did he or she hit a home run on one or two trades that accounted for the majority of the fund’s gains?
3. Repetition - Is the fund’s investment strategy easy to repeat, or did an isolated incident cause the fund to report good performance?
4. Strategy - What is the fund’s strategy? How does it differentiate itself from others in its category? How does the fund make investment decisions?
5. Risk controls - What is the fund’s risk management philosophy? How does it gauge risk? Does the fund hedge against currency or interest rate exposure? What precautions has the fund taken in the event of electric, communication or software failures or the death or injury of its primary portfolio manager?
6. Leverage - How and why does the fund use leverage? Are there any limits on how much leverage it will use?
7. Taxes - Does the fund consider taxes in its investment decisions? Is it particularly advantageous for a tax-exempt or taxable investor?
8. Structure - What is the history of the fund’s formation? Who were the founders? Are they still with the fund?
9. Manager profile - Who manages the fund? What is his or her background and experience?
10. Fund reporting - Who, if anyone, tracks trades? Who has custody of fund assets? Who serves as the fund’s prime broker?
11. Administration - Does the fund use a third-party administrator to calculate monthly returns? Does the fund calculate net asset value, and if so, how?
12. Auditor - Does the fund use an outside auditor? What experience does the auditor have auditing hedge funds?
13. Other investors - What is the profile of the fund’s other investors in terms of net worth, individual vs. institutional and onshore vs. offshore?
THOUGHTS
1. Between audits, a hedge fund manager has a lot of freedom in valuing his or her positions. If, during his or her due diligence, an investor is uncomfortable with the pricing model a hedge fund uses to value its securities, it’s probably best the investor not invest in that fund.
2. A fund can insulate against poor management by adopting measures designed to prevent or minimize the impact of manager changes. These include a long-term incentive compensation system, systemizing trading know-how by developing proprietary trading program software and encouraging frequent oral exchange of knowledge among managers, traders and staff.
2. A fund can insulate against poor management by adopting measures designed to prevent or minimize the impact of manager changes. These include a long-term incentive compensation system, systemizing trading know-how by developing proprietary trading program software and encouraging frequent oral exchange of knowledge among managers, traders and staff.
3. CPAs should advise clients not to put any money in a hedge fund that they expect to need in the next 12 to 18 months due to withdrawal restrictions.
4. CPAs should make sure the fund follows the strategy management promotes—even in hard times.
5. fund must have an adequate structure to manage its traders, salespeople and back office and risk control staff. Since investors generally invest in the hedge fund’s ability to perform well pursuing a certain strategy, the departure of one or more head traders can affect performance.
6. Existing funds should absorb substantial new assets only if investors allocated them incrementally, to avoid the funnel effect of too much money coming in too fast.
(Source: journalofaccountancy)
