So, you’ve finally decided to take a serious look at hedge funds for your clients. But you feel bad for all your ‘B’ and ‘C’ clients, because most of them aren’t accredited and don’t have access to the same types of strategies you can offer your higher-net-worth clients. Not to worry–there are several interesting vehicles that allow the average non-accredited investor access to hedging strategies for as little as US$1,000, although it varies by product and distributor.
Segregated Hedge Funds
These are hedge funds that are guaranteed by an insurance company. They are similar to segregated mutual funds. Segregated funds are investment vehicles that are “segregated” from the insurance company’s assets and provide insurance benefits. They provide a guarantee of principal upon death or on maturity of the term of the fund. In addition, they can provide creditor proofing and bypass probate fees in an estate. So, this is a hedge fund with an insurance wrapper around it.
There is a cost to this guarantee, usually in the 1% range. Some offer less than a 100% guarantee; they might offer a 75% guarantee of your principal, so they’re a little less expensive. The term for the guarantee to kick in is usually 10 years, longer than a typical note structure. Some people argue that over a 10-year period, you should be able to make your principal back and think it’s a waste of money to pay for a 10-year guarantee.
The investment minimum on the segregated funds is usually US$1,000. You can redeem them usually weekly, but there may be a fee associated with selling it before the maturity date.
Closed-End Hedge Fund Trusts
A closed-end fund is a hedge fund that trades on an exchange, just as a stock would. These vehicles are filed with securities regulators and have a full prospectus. A closed-end fund is issued in the same way as a “new issue” for a stock. There are underwriters (banks/brokerages) who can offer the fund for sale to their clients through their investment adviser distribution network. The closed-end fund is made available for sale for a limited offering period, usually two to three months, at which point it is closed off to new investors.
Liquidity is an issue with closed-end trusts. Because it trades on an exchange as a stock would, in order to sell your shares you have to find a buyer for them. Remember, it’s not as widely traded as a blue chip stock. It’s usually a smaller offering, so they don’t issue as many shares as a regular company would if it was going public. If you want to sell your trust you have to find a buyer for it.
In addition to that, the shares on the exchange may trade at a discount to their actual net asset value. If you can wait, the trust usually will have an offer to buy back the shares once a year at the net asset value, rather than the share value on the exchange.
Because this type of offering is made under a full prospectus and registered with securities regulators, you don’t have to be an accredited investor to participate. Investment minimums are usually around US$1,000.
Hedge Funds Light: Mutual Fund Hedge Funds
These are hedge funds that file a full prospectus with the various regulators but aren’t real mutual funds in the traditional sense of the word. This is like a quasi-mixed hedge fund product with mutual fund characteristics. They don’t have all the restrictions of mutual funds, nor do they have all the freedom of hedge funds.
For example, you can still short sell and use leverage and derivatives in a registered investment fund (mutual fund) in many cases but only to a limited extent. So there is a small group of “mutual fund-light funds” that offer hedge fund strategies within the context of the restrictions placed on them. It is usually large mutual fund companies that include this type of fund as part of their overall offering of funds. They are not called hedge funds because they fall under the mutual fund banner, but they will have names such as ABC Market-Neutral fund or XYZ long/short fund.
I call these hedge fund-light strategies. They have tighter restrictions on the techniques they can use and to what extent. For example, some of these registered funds are allowed to hold no more than 15% of their assets in illiquid investments, whereas a hedge fund can hold 100% of its assets in illiquid investments, if the managers think it makes sense. They are permitted to short sell provided they place funds aside to cover their short position. This ties up investment funds, however, as collateral would on a loan. Hedge funds aren’t restricted in this way.
One of the nice things about these hedge fund-light products is that they have many of the benefits of mutual funds. Aside from the low investment minimum of US$1,000 or so, they offer daily liquidity and pricing, as well as full transparency and reporting.
Registered Fund of Funds
More and more funds of funds in the United States are registering themselves with the Securities and Exchange Commission and are registering the offering of their securities for sale under the Securities Act. In other words, they are using prospectuses to offer investments to the general public. This is great news.
To invest in a registered fund of funds that registers its securities for sale under the Securities Act means you do not have to be an accredited investor to participate. By being registered in this way and issuing a prospectus, registered funds of funds can offer their securities for sale to the general public. Many of these still have their own minimums for investment, but they may be lower than unregistered funds of funds. The only caveat is you have to find the ones that are registered.
The regulators are thinking about this issue as well. In the September 2003 SEC report on Implications for Hedge Fund Growth, one of the recommendations made was: “The commission should consider issuing a concept release for wider use of hedge fund investment strategies in registered investment companies. … We believe it may be the case that retail investors interested in absolute return strategies should be able to pursue those investments through the registered investment company structure.”
The full report is available online at the SEC web site.
I think the more interest there is from average investors who don’t meet the accreditation test, the more the regulators will be forced to further examine the issues around the current regulations. Remember, the regulator’s job is to protect the investor from potential harm. Hopefully, the more educated investors become about the risks and rewards of hedge funds, the more the regulations will reflect that new education.
The investment vehicles available today for the non-accredited investor aren’t perfect. Some are better structured than others. Some have higher fees and some have lower, depending on the specifics of the product. In general, they provide a good way for investors to access an asset class that provides them with great diversification and can potentially reduce the overall risk in their portfolio.
Do the benefits of being in these types of hedge fund structures outweigh the potentially higher fees associated with these products? That is something only you can decide. In my opinion, they do. That said, you must still do your homework on these products to fully understand how they work and what fees are associated with them. Only then can you make a proper decision as to whether any of them make sense for your clients.
Renata Neufeld is the author of A Practical Guide to Hedge Funds: How to Profit in Any Market. Her web site is www.hedgefundlady.com.