Hedge funds have grown increasingly popular among American investors. Some hedge funds offer significant and timely returns, but many investors mistakenly believe that hedge funds are a “safe” way to invest money for high returns with little risk. This is quite untrue, and hedge funds are actually one of the most volatile and risky investment methods available. Hedge funds are only suitable for some investors. When hedge fund managers mismanage their clients’ investments or defraud clients, investors stand to lose significant sums of money.
Hedge funds, or private investment funds, use pooled money from many investors to finance specific strategies. The goal of hedge funds is to earn active returns for investors, using leverage and derivatives with the hope of generating high returns. Many investors allocate money to hedge funds as a good portfolio diversifier, as they typically have low correlation with traditional portfolio investments, such as stocks and bonds.
How Do Hedge Funds Work?
Hedge funds take advantage of market opportunities using different investment strategies. Financial advisers often classify hedge funds according to their investment styles. Each style has its own risk attributes and return opportunities. Hedge funds are flexible, with immense diversity among styles.
This diversity can benefit investors by providing a range of choices. Most often, investors set up hedge funds as private investment limited partnerships. In this scenario, two or more partners unite to conduct business, and each partner is liable for risks only to the amount of money personally invested.
Hedge funds face minimal regulations and operate differently than most other investment methods. Investors essentially pour capital into the hedge fund, and then the hedge fund manager invests the capital however he or she chooses. Generally, the hedge fund manager receives a percentage of all the returns on these investments, which logically should incentivize hedge fund managers to make responsible investments. Unfortunately, due to a general low level of oversight on most hedge fund practices, hedge fund fraud is becoming increasingly common.
Since the goal of most hedge funds is to maximize returns on investment, they may have high risks. Hedge fund managers may make speculative investments, operating outside of Securities and Exchange Commission (SEC) regulations. Hedge funds are private investments and thus do not have to register with the SEC. They do not have to abide by SEC regulations and may pose more of a risk to investors. However, the returns can be higher than safer investments. Hedge funds therefore cater mostly to sophisticated investors.
Types of Hedge Fund Strategies
In the United States, most hedge funds require investors to earn a minimum income annually and have a net worth of at least one million. Investors must have significant investment knowledge to join a hedge fund. There are many different strategies hedge fund managers might take to maximize returns. Examples include:
- Equity market neutral. Managers attempt to identify under- and over-valued equity securities while combining short and long positions to neutralize a portfolio’s exposure to market risk. Holding short and long equity positions can balance risk with returns.
- Convertible arbitrage. Managers take advantage of mispricings in corporate convertible bonds, preferred stocks, and warrants. Managers can buy or sell these securities and hedge the associated risks. This strategy can generate returns if the price of the underlying assets increases or the issuer’s credit quality improves.
- Fixed-income arbitrage. This strategy identifies under- and over-valued fixed-income securities with the purpose of capitalizing on chances in the term structure or credit quality of issuers. Like equity market neutral funds, fixed-income portfolios combine short and long positions to neutralize against market movements.
These are just three of the dozens of different strategies hedge fund managers may use to maximize returns. If you’re considering investing in a hedge fund, you must be an accredited investor and understand how they work. Research hedge fund managers to ensure they are qualified to handle your money wisely.
Defining Hedge Fund Fraud
Much like Ponzi schemes, a fraudulent hedge fund promoter will typically offer potential investors large returns in a short time with minimal risk. When promoters and hedge fund managers make promises they cannot keep or play fast and loose with clients’ money, they stand to lose very little while their clients could face devastating financial losses.
Another issue facing hedge fund investors is that hedge funds are not legally required to register with the United States Securities and Exchange Commission. This can easily tempt some hedge fund managers to defraud their investors or take advantage of them in other ways. Many fraudulent hedge fund promoters and managers will simply try to explain questionable losses as the result of market volatility. Hedge funds typically employ multiple investment strategies that have varying degrees of risk.
While risk is always an important factor for any investor to keep in mind, there is a distinct difference between market volatility and hedge fund fraud. Most hedge funds use generally unconventional investment tactics to capitalize on high-risk/high-reward strategies. While savvy hedge fund managers stand to earn tremendous amounts of money in legitimate returns for themselves and their clients, unethical or negligent hedge fund managers cause catastrophic losses for clients. When hedge fund managers breach their fiduciary duties to their investors, they need to answer for their unethical behavior and compensate defrauded investors for their losses.
When to Find a Lawyer
Typically, hedge fund fraud takes two forms: either the hedge fund promoter promised returns and low risk they could not deliver, or the fund is an outright scam. It can be extremely difficult to prove that hedge fund fraud has occurred due to the notoriously high level of risk in hedge fund investments. To decipher whether you need an attorney that handles investment fraud, understand that there are two problems that arise with hedge funds. One is when brokerage firms recommend that their clients invest in a hedge fund, representing that the fund has a proprietary model that will yield exceptional returns at lower or controlled risk, and this turns out to be not the case. The other situation is when brokerage firms market the fund and the fund is a scam. The brokerage firm simply didn’t do their due diligence.
Fraudulent hedge fund managers may try to disguise unethical, fraudulent activity by claiming a client’s losses resulted from a market downturn or unpredictable market activity. Hedge fund promoters must accurately present their investment models to potential clients. This includes disclosing all of the potential risks of any investment strategy. When they promise extremely high returns with minimal risk, investors should tread carefully. If you believe a hedge fund promoter or advisor misled you during your dealings with the hedge fund, you should speak to a qualified and experienced hedge fund fraud attorney as soon as possible.
Most hedge funds are legitimate private businesses that appeal to wealthy investors with a high tolerance for risk, but fraudulent hedge funds hurt the economy and can financially ruin some investors. Identifying hedge fund fraud isn’t easy; it requires the help of a skilled team of attorneys. Hedge funds are notoriously riskier than other investments as well, making it difficult to prove that losses resulted from fraud and not natural market forces.
However, an experienced attorney can help wronged investors develop a strategy for accusing a firm or manager of hedge fund fraud. At Erez Law, we are committed to protecting investors from fraud. Contact our team if you think an experienced hedge fund fraud attorney can help you navigate through your investment situation. Call Erez Law today for more information.