Navigating a Labyrinth of Concealment: Researching Hedge Funds
Welcome to the June 2019 edition of our newsletter! In this issue, we’ll examine the intricacies of how hedge funds operate and provide tips on how to research these opaque vehicles more effectively.
A Peek Behind the Curtain: How Hedge Funds Operate and How to Research Them
Hedge funds typically solicit investments from large, sophisticated money managers, such as pension funds or college endowments. The reason for this on the funds’ side is simple: that’s where the most money is. For the client, they look to the hedge fund to manage the risk and drive upside in ways that retail money managers can’t. But do they always understand how a fund can attempt to do this?
The structure of most funds is designed to provide a layer of secrecy. Although a company’s offices may be in New York, Boston or another major city, often the parent company is organized in Delaware – where taxes and business law generally favor the corporation over its customer. As importantly, limited liability companies and partnerships only need to report their formation and any amendments or other changes, not to file any annual or biennial reports listing their members or officers, as is common in most other states.
Additionally, most U.S.-based hedge funds manage a portion – sometimes most – of their money offshore, in tax and secrecy havens ranging from the Cayman Islands to Switzerland. Funds are typically divided into categories based on a specific goal – volatility- or opportunity-driven investment, for instance, or a dedicated short-selling fund – which can often be organized outside of the United States.
How can a large investor – or their clients, the retirees, educators, etc., who comprise the investor’s membership – vet such entities? Fortunately, U.S. regulators offer some insight. Most hedge funds are considered commodity pool operators, who must register with the National Futures Association. The association’s BASIC service allows the public to look for any regulatory actions, arbitration awards or other actions taken against a fund, also requiring it to list basic information about its leadership and, crucially, other affiliated funds.
The U.S. Securities and Exchange Commission’ Investment Adviser Public Disclosure database, or IAPD, also often includes information about hedge funds. The Form ADV such registrants must file is a fairly detailed record of a company’s assets under management – and, generally, on whose behalf they invest – as well as their leadership and their network of funds, both in the U.S. and offshore. Taken with a look at any litigation as well as regulatory actions by state attorneys general or other agencies, these sources can help institutional investors better understand a potential investment beyond the complex illustrations used by funds to pitch their services, and better understand the people managing the funds and their approach to doing business.