The Hedge Fund Advertising Ban Lifted: What Should Investors Know?

NerdWallet.com, a key investment website,  recently turned to Kennyhertz Perry’s partner Braden Perry  for comments surrounding the Hedge Fund Advertising Ban Lift.  The full article has been provided below:

Source: nerdwallet.com

Date: July 17, 2013

Author: SUSAN LYON

If you make at least $100,000 then you might be qualified to invest in a hedge fund – and due to a new SEC ruling this week, you may start seeing public advertisements from lesser-known hedge funds trying to get you to do just that.  Here’s what you should know first.

• See also: NerdWallet’s Hedge Fund Tracker allows investors to see what hedge funds are buying, selling, and holding so they can make more educated investments based on each fund’s 13F filings with the SEC.

The JOBS Act On Hedge Funds

Last week, the SEC voted in a 4-to-1 decision to repeal the 80-year long advertising ban on hedge funds that had been in place since the Great Depression.  This was a component of last year’s JOBS, Jumpstart Our Business Startups, Act.

What does this really mean to retail investors, and how should they prepare?

With the upcoming onslaught of advertising, investors need to educate and protect themselves from false or misleading propaganda.  Hedge funds can seem very mysterious and try to hide their strategies and positions, but fortunately regulations force them to file their long positions quarterly.  Every investor should research what a fund actually invests in before giving that fund any money, using a tool like the NerdWallet Hedge Fund Tracker.  This tool allows users to see the long positions of any fund, giving investors a sense of what they can expect the manager will do with their money.

How Much Should You Worry About Hedge Funds Ads?

Even though the mainstream media blew up about this news over the last week, the typical investor need not be worried about seeing billboards of famous hedge fund giants left and right as they drive down the 101.

Rather, what is more likely to happen is that the smaller, lesser known, and overall worse performing hedge funds will try to advertise in order fundraise.  It will be advertising to a very niche market – not in the typical way most Americans think of ads like TV ads.  As a general rule of thumb, the types of funds advertising will on average be smaller, newer, and riskier.

The lesson is simple: the best performing hedge funds speak for themselves and won’t need to advertise much, if at all; investors are already knocking at their doors.  In fact, many of these top hedge funds are already closed to new investors.

Is Investing in Hedge Funds a Good Idea?

So what if you do see an ad you like, and you want to learn more?  Until now it was illegal for any hedge fund representative to tell you about their fund or give out the fund’s prospectus, unless you were an accredited investor.  There are three ways for a person to be considered an accredited investor:

1. You have a net worth of at least $1 million
2. You’ve had an income of $200,000 or more two years running
3. You’ve had a combined income, between you and your spouse, of at least $300,000 for the past two years, and you have the expectation of similar income this year

However, investing directly in a hedge fund – even if you can afford to – is almost a surefire way to rack up far more fees than you would if you chose to invest in similar holdings as a hedge fund within your own portfolio.

Hedge funds are structured much like a mutual fund, only with a more unregulated pool of capital; they are only required to report long positions to the SEC, not shorts.  Like mutual funds, they are comprised of a group of investors who pool their money and investments are chosen by a fund manager.  The most common hedge fund fee structure is called “the 2 and 20 Rule.”  This means that 2% of total assets under management go to annual management fees for running the office, including employees’ base salaries, overhead costs, and technical equipment needed.  Then, in addition, there is a 20% performance fee charged so the hedge fund manager receives 20% of any profits.

For instance, NerdWallet’s institutional money manager tracking tool shows that Warren Buffett’sBerkshire Hathaway invests 68% of its portfolio in 4 common stocks that investors could buy directly themselves (Wells Fargo 20%, Coca-Cola 19%, IBM 17%, American Express 12%) if they felt these were a smart investment.

In most cases, investors could do just as well or better by looking at the individual holdings within a hedge fund, and the changes in ownership and industry confidence over time, than they could by trying to invest directly in a hedge fund.

A Better Way to Research Hedge Funds

Rather than relying upon biased advertising, investors should seek objective data about what hedge funds are really doing with their money.

• NerdWallet’s Hedge Fund Tracker allows investors to see what hedge funds are buying, selling, and holding so they can make more educated investments based on each fund’s 13F filings with the SEC.

The hedge fund tracker allows users to look up useful information about individual hedge funds to see exactly what each one invests in – and how much – as well as changes over time and how diversified a fund is on the whole.

Ask the Experts: What Will the Outcomes of the New Hedge Fund Rules Be?

While the world of hedge fund advertising advice is only just beginning, strategists and consultants are already weighing in with their opinions on the best marketing strategies.  NerdWallet’s opinion continues to be that the returns speak for themselves, and that no advertising is a substitute for the hard numbers.

NerdWallet asked the experts what to expect when it comes to the lifted ban on hedge fund advertising.  They responded as follows – here are the major themes we saw.

1. There Will Be No Advertising Onslaught – For Most People

“The SEC lifted the ban on ‘general solicitation’ for certain private offerings under Regulation D, which are directed only to ‘accredited investors.’ There is a long definition of accredited investor in the regulations.  If you’re not within that description, you shouldn’t be receiving a solicitation for one of these offerings.  So you have to keep in mind this is not the place for your emergency fund, or your college fund, or the money you’re depending on retiring on. This is for your Las Vegas money.”

-Robert Dow, Partner, AGG

“I believe that there will not be a rush to advertise. The larger hedge funds are established and will scoff at advertising. The smaller or new hedge funds will still face many suitability issues and accredited investor issues.  It will likely be similar to the views of legal advertising; the larger firms will play it safe and rely on their reputations, while smaller or more specialized funds will slowly leak into the marketing arena.”

-Braden Perry, Legal Counsel with Kennyhertz Perry

2. More Transparency, Competition, and Data Sharing

“I think that the recent lift will not cause drastic change to the industry or greatly effect investors, but will offer lesser known funds to compete on a larger scale and reach a larger audience of potential investors.”

-Peter Turchan, Partner at Ready to Run Designs

“The lift on the ban on general solicitation will help hedge funds in 3 ways: it may make it easier to find qualified investors using general solicitation, it will reduce compliance costs and it will enable HFs to become more transparent because the risks of inadvertent violations have been removed. The ability to disseminate information more broadly should cause a lot more information about HFs to become publicly available. This in turn should have the effect of increasing competition in the HF industry. Still unknown as yet – to what extent will this cause better disclosure of the fee structure for HFs, and will there be increased competition on the basis of fees. The mutual fund industry has seen increased competition based on offering lower fee arrangements, but the HF industry has been less competitive on this factor. Increased transparency could drive a change in that regard.”

-Robert Dow, Partner, AGG

“It is too early to predict changes to the hedge fund industry but my guess is that websites may begin to convey more information for the usually secretive industry. In addition, more investors will gain access to more deals as people become accustomed to distributing offering documents in a manner that was previously considered to be general solicitation.  Investors will have to get accustomed to providing very personal information about their financial capacity to invest and absorb losses as companies seeking investment will have a requirement to confirm eligibility for securities sold privately in a general solicitation regime. In addition, I expect to see the rise of the investor database where companies and funds seeking investment pay fees for access to a pre-screened group of investors.”

-Douglas Berman, Managing Member, Law Office of Douglas M. Berman, PLLC

3. Past Results Still Don’t Guarantee Future Returns

“Although the ads will no doubt have lengthy disclosures, the average investor won’t know (unless folks like you warn them) that performance is highly not likely to be replicated in a rising rate environment when much of the historical “carry” and leveraged returns won’t be replicable. In other words, when leveraged investors (hedge funds) bought a higher yielding security, borrowed short term at lower rates and leveraged the equity at risk, they reaped 10%+ returns. This will be difficult to repeat when borrowing rates rise – potentially at the same time investment values decline.”

-Andrew M. Aran, CFA and Partner with Regency Wealth Management

“A major concern is that hedge funds are open to “accredited investors”, but that doesn’t necessarily make them good or even smart investors.  Unfortunately there are many investors today that (accredited or not) have no idea of what they own or why they own it. Hedge funds present an additional layer of ambiguity over traditional investment products as they are often using very proprietary, illiquid, leveraged, and expensive trading methods.  For an individual that doesn’t understand or maybe just ignores the risk – these investments can be very dangerous.  As with any investment opportunity an individual would be wise to pause, take a breath and examine how it meshes with their other financial goals and plan.”

-Jason Gentile, CFP, Symmetry Partners