As is the case with any type of investment, hedge funds and hedge fund investing can involve substantial risks. Below is a summary of certain risks involved in hedge fund investing, but by no means should this list be considered exhaustive.
Potential loss of investment
No guarantee or representation is made that the investment programs mentioned in this presentation will be successful. Past performance is not indicative of future results. Hedge funds typically represent that their returns have a low correlation to the major market indices. Investors should be aware that hedge funds may incur losses both when major market indices are rising and falling.
Limited liquidity
Investors typically have limited rights to redeem and substantially limited rights to transfer hedge fund interests. In addition, there is generally no secondary market for interests in hedge funds and none is ever expected to develop. In addition, illiquidity of a hedge fund's investments, held directly or indirectly, in the case of a fund of hedge funds, may prevent a fund's management company from satisfying investor demand for redemptions.
Use of leverage and other speculative investment practices
Funds of hedge funds may use leverage to invest in hedge funds. Hedge fund managers investing directly also may employ leverage through a number of measures which could increase any loss incurred. The more leverage employed, the more likely a substantial change will occur, either up or down, in the value of the investment. Futures trading normally requires low margin deposits to permit an extremely high degree of leverage. Hedge funds involved in futures trading may experience immediate and substantial loss or gain due to relatively small movements in the price of a futures contract. In addition, hedge funds, in general may engage in speculative investment practices, which may lead to losses.
Lack of regulatory oversight
Hedge funds are generally not registered under the Investment Company Act of 1940 (the ‘1940 Act'). Therefore, investors will not receive the protections of the 1940 Act afforded to investors in registered investment companies.
Valuations
Funds of hedge funds normally look to the underlying managers for fair valuations of a fund's investment in the underlying manager's fund. While the underlying hedge fund managers must adopt policies relative to determining such fair values, funds of hedge funds managers do not have the ability to verify the accuracy of the valuations utilized by the underlying managers. Certain hedge funds may directly invest in instruments that may not be readily marketable which could complicate the determination of fair value of such instruments. It should be noted that there have been a number of high profile instances where hedge fund managers have mispriced portfolios, either as an act of fraud or negligence.
Tax risks
Investors in hedge funds are typically subject to pass-through tax treatment of their investment. This may result in an investor incurring tax liabilities during a year in which they have not received a distribution of any cash from the fund. In addition, it is likely that the fund manager will not be able to prepare its tax returns in time for investors to file their returns without requesting an extension of time to file. Also be aware that additional tax disclosure forms or additional state tax returns may require filing and payments from time to time due to the activities of the underlying hedge fund managers in any given year or tax law changes that may arise in the future. There are also tax risk factors particular to tax-exempt investors as hedge fund investments may generate unrelated business taxable income. Investors should consult with their tax advisors before investing.
Layering of fees
A fund of hedge fund's direct fees and expenses, including the applicable management fee and expense reimbursement to the general partner or management company, coupled with the compensation of the underlying managers, results in two levels of fees and greater expense than would be associated with direct investment. A fund of hedge fund's expenses constitute a higher percentage of net assets than expenses associated with other types of investment entities, such as mutual funds.