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Here’s Why You Can’t Invest in a Hedge Fund

by Darwin on October 25, 2010

Sorry, this was too funny NOT to post

Every once in a while I read about a hedge fund that has some really unique characteristics and performance.  While many of them are over-rated and are really just collecting fees for mediocre performance, there are a few standouts.  As such, I check out their site and there’s usually some cryptic mention of “accredited investors”, “sophisticated investors” or no investor information whatsoever.  See, in this class of investors, if you don’t already know how to get in touch with the Hedge Fund Manager, you probably have no business investing in hedge funds.  That includes me, but I’m curious.  So, I’ve been shooting off emails to hedge funds and one of them actually replied.  Here’s the email I received back (bolded text is my editing) to give you an idea for why most of us can’t participate in hedge fund investing:

The xxxx Fund is a private fund that is open to accredited and qualified investors (as defined in Rule 501 under the Securities Act of 1933). I have provided below the language from our subscription documents to assist you in determining your eligibility.

Accredited Investor Criteria
1. The Investor has an individual net worth, or joint net worth with his or her spouse, in excess of $1,000,000. As used herein, “net worth” means the excess of total assets at fair market value, including home,*home furnishings and automobiles, over total liabilities; or 2. The Investor had individual income (exclusive of any income attributable to
his or her spouse) of more than $200,000 in each of the past two years, or joint income with his or her spouse of more than $300,000 in each of those years, and reasonably expects to reach the same income level in the current year.**

Qualified Eligible Person Status
A. Individuals, Individual Retirement Accounts, Keogh Plans and Other Self-Directed Defined Contribution Plans
You must be able to certify to (A)(1),(A)(2) OR (A)(3) plus (A)(4).
1. Owns securities (including pool participations) of issuers not
affiliated with the Investor and/or other investments having an
aggregate market value of at least $2,000,000; or 2. Has had on deposit with a futures commission merchant, for its own account at any time during the six-month period preceding the date hereof, at least $200,000 in exchange specified initial margin and option premiums for commodity interest transactions; or 3. Owns a portfolio comprised of a combination of securities and commodity interests in which the sum of the market value of the funds or property includable under (a), expressed as a percentage of the minimum amount required thereunder ($2,000,000), and the amount of futures margin and option premiums includable under (b), expressed as a percentage of the minimum amount required thereunder
($200,000), equals at least 100%; for example, $1,000,000 in securities or other property (50% of (a)) and $100,000 in exchange-specified initial margin and option premiums (50% of (b));Plus, the Investor is:
4. A natural person whose individual net-worth,* or joint net-worth with his/her spouse, exceeds $1,000,000 or the Investor had individual income (exclusive of any income attributable to his or her spouse) of more than $200,000 in each of the past two years, or joint income with his or her
spouse of more than $300,000 in each of those years, and reasonably expects to reach the same income level in the current year.

Our minimum investment is $1 million, but we have lowered this in some cases (not below $250,000).  Our fees are 2% management and 20% incentive. We do not share our Private Placement Memo with a potential investor until we know more about him/her.  Please let me know if you are interested and confirm that you meet accredited and qualified investor requirements.

Well, you can count me out!

Is That a Bad Thing?

I have mixed feelings on this.  I have a friend who’s pretty well-off.  He comes from a family with money and managers money for them and others.  A few years back we were shooting the breeze about investments, some of my strategies and what he invests in.  He mentioned a hedge fund he had a lot of money in that had been consistently returning about 10%-12% per year – every year.  I was a little jealous that I didn’t have the opportunity to invest in the same sort of successful fund he could.  The old adage seemed to apply “It takes money to make money” or “The rich get richer”.

Fast forward two years and boom!  He lost a ton of money in none other than Bernie Madoff’s fund.  I couldn’t believe it was the same fund and he was impacted.  Not only did he lose a lot of family money, but also his clients lost money as well.  He was pretty torn up over it.  He, along with thousands of others, were taken by someone they suspected least.  In retrospect, my inability to invest in that fund may have saved me thousands, right?  What if any retail investor could have invested in Madoff’s funds?  There’d be a heck of a lot more people impacted than the unfortunate ones that really were.

I do question whether many of the people that do quality are actually “sophisticated”.  Many of them are not.  Many are rich widows, elderly, business people who don’t necessarily understand exotic investments, etc.  These people have financial advisors who recommend hedge funds (and take a nice commission surely) and these people end up in these instruments.  While it’s very rare to have a Madoff situation, funds do collapse for other reasons aside from fraud, but just from bad investments, use of leverage, the market going the wrong way, and more.  The difference though, is while these people may not be sophisticated, given their net worth requirement, they are more likely to be able to sustain such a catastrophic loss.  See, if you’re making $500,000 per year, have a $3 Million net worth and lose $1.5 Million, you’re still going to be OK.  If you were making $40,000 a year, saved up $50,000 over 5 years and lost it all, that would be devastating.

What Do You Think?

Should We ALL Be Allowed to Invest in Hedge Funds?

{ 2 comments… read them below or add one }

Bret @ Hope to Prosper November 1, 2010 at 7:50 pm

I love the definition of an “accredited” investor. On Wall Street, that means you have a lot of money versus you know about investments.

Hedge funds scare me for many reasons, most important that they aren’t very transparent and it can be difficult to withdraw your money. I also don’t think the hedging strategies will be as lucrative in the future. As Greenspan noted years ago, the “low-hanging fruit is gone”. Hedge fund managers seem to be chasing smaller profits while taking bigger risks.

Even if I did qualify as an accredited investor (which I don’t), I would prefer to retain control and visibility of my money.

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Darwin November 1, 2010 at 9:16 pm

Yeah, it’s a bit scary. Even with the rather loose regulation that does exist for hedge funds, so much of it is based on past history and reputation. That “affinity” scam Madoff was running may be the shocker of the decade. Nobody saw that one coming, well except the people telling the SEC to investigate. But more people predicted the housing crash and financial collapse than Madoff running a ponzi scheme. Heck, he was ex head of an exchange!

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