Investing in Hedge Funds is a Risky Business

As of April 2012, the estimated size of the global hedge fund industry was $2.13 trillion. Investing in hedge funds is not open to everyone. Only accredited investors can do so. The threshold is often raised to allow only “qualified purchasers” to invest, - these individuals are not only accredited investors, but also have at least $5 million in investments in addition to the money they are investing in the hedge fund. However, even these wealthy individuals suffer from fraudulent activities that may, and do occasionally, occur inside the hedge funds.

Just recently, on October 3rd, the Securities and Exchange Commission charged two hedge fund managers and their firms with lying to investors about how they were handling investor money. In one case, the SEC alleged that the San Francisco-based fund manager and his firm stole more than half a million dollars from a retired schoolteacher who was investing her retirement savings. According to the SEC complaint, the fund manager told the teacher that the money would be invested in the stock market using the long / short equity investment strategy, but instead used it to pay unauthorized personal and business expenses, including home mortgage, office rent and staff salaries. In addition to the SEC action, the U.S. Attorney’s Office announced criminal charges against the fund manager.

In the other case, the SEC charged the Chicago-based fund managers and their firm with fraudulently taking out at least $147,000 in excessive fees and capital withdrawals from a hedge fund they managed. Investors in the fund were not aware that the manager removed various performance hurdles when calculating the management fees. Also, the managers made unauthorized capital withdrawals from the fund.

Since the beginning of 2010, the SEC has filed more than 100 cases against hedge fund managers for lying to the investors about investment strategy or performance, hiding conflict of interests, misusing investor funds and charging excessive fees. It seems that investing into hedge funds is risky not only because of the risk of investing money in the stock market or derivatives, but also because of the possibility that fund managers may defraud the fund investors.

To protect investors and help them evaluate the risks, the SEC issued an investor bulletin on October 3, 2012. In it, the SEC advises investors to really understand the funds’ investment strategy and the use of leverage, derivatives and other investment techniques. Also, investors should identify and evaluate the managers’ conflicts of interests and conduct independent research of the managers’ backgrounds. The bulletin is a helpful and practical summary of what the investors should look for when considering a hedge fund investment. Although it will not prevent the fraudulent activities that apparently go on in some of the funds, it will at least help keep some investors away making these risky investments.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.