In 2008, Wall Street legend Bernard L. Madoff admitted to running a decades-long, multi-billion-dollar Ponzi scheme, resulting in billions of dollars in investor losses. Some of the most heavy-hit investors were those who invested in hedge fund portfolios. Funds made up of a portfolio of hedge funds have long been seen as relatively safe choices, so following the shock of the Madoff scandal, investors rushed to withdraw their investments. According to the industry tracker Hedge Fund Research, investment withdrawals in 2008 and 2009 totaled $158 billion.
The rush of investors to withdraw their money from hedge funds only shows how investors have become too comfortable - relying on the advice of Wall Street brokers and executives without doing their research or due diligence. The exposure of Madoff's scheme has been, and should continue to be, a wake-up call to investors. Before investing in individual hedge funds or in pooled hedge funds, it is important to understand the risks associated with hedge fund investments.
Defining Hedge Funds and Funds of Hedge Funds
The most common investment vehicles involved in the Madoff scandal were funds of hedge funds. In 2004, these accounted for 54% of all hedge fund investments. Today they account for 40% of all hedge fund investments. These funds gather investors' money into a pool that typically includes 20 or more hedge funds - and each one invests through a variety of complex and risky financial instruments.
By investing in a portfolio of hedge funds, rather than just one or two funds, the investor achieves broad diversification. While hedge funds are only lightly regulated and carry high inherent risks, funds of hedge funds are thought to offer security because professional managers are picking the hedge funds that make up the pools.
If It Sounds Too Good to Be True, It Probably Is
Thousands of investors relied blindly on Bernie Madoff's representations that he was able to obtain significant positive returns year after year, despite the fluctuating economy and markets. As an investor, do not let promises of "almost a sure thing" overrule your common sense. Protect yourself - understand the risks and do your homework before investing in individual hedge funds or portfolios of hedge funds.
Understand the Risks of Hedge Funds
Even though hedge funds and fund managers have made an effort to become more transparent following the Madoff scandal, there are still numerous risks associated with even legitimate hedge funds. These include:
- Lack of regulatory scrutiny and transparency. Hedge funds have very little regulatory oversight, which means that they are not required to disclose investments or provide periodic statements. After Madoff's deception, more funds are providing monthly disclosures that include detailed information about each hedge fund in the portfolio. While there has been a demand for stricter hedge fund regulations, no formal regulations have been put in place, so it is up to the individual investor to understand where they are putting their money.
- Risky investments. Hedge funds engage in complex and risky investments, including options and derivatives. And they often use leverage or borrowing, which dramatically increases the risk of loss. Because of the enormous risks that hedge funds take, investors can lose their entire investment. While investing in a fund pooled with hedge funds can help diversify the risk, it does not eliminate it - as evidenced by thousands of investors hurt by Bernie Madoff's deception.
- Illiquidity. You may not be able to sell your investment due to restrictions placed on your ability to liquidate. Indeed, hedge funds generally have the right to prohibit you from selling at all - so do not think of them as short-term investments.
- High fees. Prior to the Madoff scandal, top hedge funds had little trouble attracting investors, so managers could charge high management and performance-based fees. As concessions to more wary investors now, many of these fees - especially performance-based ones, have been drastically reduced. But potential investors still must protect themselves from unusually high fees.
Because of these risks, you should not invest money in hedge funds that you cannot afford to lose.
Do Your Homework Before You Invest
Despite the risks and costs associated with hedge funds, the potential for enormous returns can make hedge funds an attractive component of your investment portfolio. But before you invest, you should perform some due diligence. This includes:
- Researching the backgrounds of the managers and principals. Know about the people to whom you are entrusting your money. Check out adviser and broker info on the SEC's website and on Nasdbrokercheck.com.
- Understanding your right to sell your investment. The offering materials will describe the procedure for selling your shares and whether the fund has the right to deny your sell request.
- Knowing the investment alternatives. For conservative investors, traditional mutual funds may be a better bet. Other investors are ignoring the traditional hedge fund model in favor of managed accounts, which typically include a group of 100 hedge funds, and clients have more control over where their dollars go since they sit down with a manager to pick a customized portfolio of 25 of those funds.
Are You a Victim of a Hedge Fund Scam?
If you lost money in a hedge fund investment, you should seek the advice of an investment fraud lawyer who has experience and knowledge of securities arbitration and litigation. Most attorneys will provide a free consultation to help you determine whether you have a viable claim to recover your losses.
If you are looking for an investment fraud attorney, contact DKRPA today for a FREE consultation to review your rights and options.
