Sulzberger Capital Advisors

Given their investment flexibility, hedge funds may vary greatly in terms of the following: investment style, use of financial instruments, concentration of holdings, use of leverage, manager talent, and whether they are directional versus non-directional.

Although hedge funds vary greatly, most can be organized into four groups:

Relative Value Strategies, which seek to take advantage of price discrepancies between closely related issuers or instruments; Global Trading/Macro, which seek to anticipate global macroeconomic events to generate returns; Event Driven Strategies, which typically trade around catalyst or corporate events; andHedged Equity or Directional Strategies, which focus on long and short equity strategies.

Traditionally hedge fund portfolios have complemented traditional assets and offered true portfolio diversification. They take different sets of risks and generate a different set of returns from traditional long only strategies. Hedge funds typically lower overall portfolio volatility. They can also protect capital in times of stressful markets.

Important lessons emerged from the 2008 economic recession with regard to hedge funds. Some of the issues involved delays in investors being able to redeem their investment. There was also an issue of some managers taking positions outside of their investment mandates. Other issues that have faced hedge funds have been issues with high minimums for entry, delayed K-1s for filing tax returns, and some states seeking state income tax returns from owners of hedge funds because a manager was based in that state even though the investor was not.

One of the ways these issues have been addressed by fund of hedge funds managers is through managed account platforms. What does this mean? Historically, many fund of hedge funds managers would invest directly with thirty or forty managers for certain investment disciplines. By doing so, the fund of hedge funds would become a limited partner in the underlying hedge funds. As a limited partner, the fund of hedge funds was subject to the rules of the hedge fund’s offering memorandum, which often gave the hedge fund broad authority to delay redemptions and alter their investment mandates.

What we learned in particular in 2008 and 2009 was that some managers were not staying within their given mandates in trying to generate returns. For example, investors would ask for their money back and the manager had to say that the money is tied up in a lending strategy and can’t be accessed, sometimes contrary to the given mandate. The transparency of what the underlying managers were doing was not as evident as it should have been.

In a managed account platform, the fund of hedge funds does not make direct investments in underlying hedge funds. Rather, the fund of hedge funds hires managers to manage a sub-account controlled by the fund of hedge funds. Through a managed account platform, the fund of hedge funds manager has more control of the fund’s underlying assets. Some of the issues that had arisen were solved by the fund of hedge funds manager opening and closing all of the sub-accounts and then giving the sub-managers access to trade in the account.

One, the fund of hedge funds manager had direct access 24/7 to the activity in the fund. Transparency increased. The overall manager could see what each sub-manager was doing. This reduces the idea of surprises occurring that are outside the sub-managers given mandates.

This is also solved the issue of taxation in the individual states. If a Florida fund of hedge funds manager opens up all of the sub-accounts in Florida (which has no state income tax) then the states that do collect state income tax, like Illinois, can’t collect income on the sub-managers activity. No more unhappy surprises from investors about now owing state income tax in a state they thought they had no connections to, just because a sub-manager had been based there.

This also solved the issue, to a degree, of late K-1 returns. With the fund of hedge funds manager opening up the accounts themselves, the records for the transactions within the larger fund are at their ready and they are not waiting for longer periods for information coming from the sub-managers before they can prepare the K-1s. An income tax return extension is still more than likely to need to occur, but there is usually a greater window for the tax preparer.

Managed account platforms are not the norm with every fund of hedge funds manager, but they are a step in the right direction and one that investors should inquire about when looking to purchase a hedge fund for their portfolios.

Liquidity within hedge funds is still something that needs to be discussed with every client. Please see a white paper written by Benjamin Hein on this website for more information on the liquidity issues behind some alternative investments.

An important consideration before looking at any hedge fund is whether the investor is qualified to own the hedge fund. There are certain regulations that require an investor to have a certain minimum net worth before they can own certain hedge funds. Please consult with an investment professional about these net worth minimums.

Lastly, it is important to understand the due diligence process that an investment firm undergoes before recommending a hedge fund and the ongoing due diligence that occurs. There has been large growth in the number of hedge funds being offered to investors. There are relatively low barriers to entry into the hedge fund market. Operational failures account for a majority of hedge fund closures. Access to information is often limited and manager skill difficult to verify. Also, past performance is not indicative of future returns. Chasing the winners in the hedge fund market rarely pays off.With these considerations, the due diligence process is vital.

The due diligence process should focus on diving deep into the investment strategy of the hedge fund manager and the risk management process. Each manager must be able to identify and defend their competitive advantages. The due diligence provider should be interviewing the portfolio managers, key analysts, risk managers and business managers. The managers need to create expectations for returns and volatility in their funds. There also must be an understanding of the investment risks and weaknesses and a consideration for the worst case scenario.

Operational issues account for 50% to 70% of hedge fund failures according to industry studies. The operational review process is vital. Key elements should include the following:

• Analyzing the legal structure of the hedge fund and the management company;
• Analyzing the rights of shareholders or investors (control of the fund, voting, and the ability to implement change);
• Identifying current and potential conflicts of interest;
• Evaluating cash controls and related risks;
• Analyzing the valuation process, determining the independence of pricing and the effectiveness of asset verification;
• Evaluating compliance (prevention of insider trading and the employee trading policy); and
• Opining on litigation, understanding the regulatory history and doing background checks.
• Post investment due diligence is also important.In order to understand the potential impact of changes these are some of the questions to be addressed on a continuing basis:
• Have their been changes to the business structure or ownership, to the staffing or members of the board of directors?;
• Has their been strategy drift by the fund (including unexpected changes in exposure, a sudden increase in AUMs, or new asset classes in the fund)?;
• Is this a hedge fund with a competitive edge or is it an asset gathering firm?; who are the competitors?;
• Is the space becoming crowded?;
• Has the alpha opportunity disappeared?;
• Have their been changes to the service providers (administrator, legal counsel, auditor)?;
• Have their been changes to the fund documentation, shareholder rights, risk disclosures, and conflicts of interest?; and
• Have their been changes to the access to senior investment staff, risk managers and business management personnel?
• Hedge funds as an investment are an interesting area and one for qualified investors to consider when looking at the overall volatility of their portfolios.

Hopefully this white paper will help give the investor a road map of some questions to ask when considering a hedge fund for their portfolio.

The genesis for this white paper comes from a panel discussion that EFG Capital Advisors hosted on November 8, 2012 in Miami, Florida. The panelists included Benjamin Hein, President and Chief Investment Officer of EFG Capital Advisors; Dan Ledbetter, Vice President with Lighthouse Partners; and Timothy Foley, Senior Research Analyst with EFG Asset Management.

Gene Sulzberger is president of Sulzberger Capital Advisors in Miami, Florida. He works with U.S. and international investment clients, helping them meet their wealth management goals. Gene is a CERTIFIED FINANCIAL PLANNER™ and a registered trusts and estate practitioner (TEP). He is also an attorney who previously practiced law in the area of trust and estate planning. He has over 20 years of experience in financial services. Gene can be reached at (305) 573-4900 or gene@sulzbergercapital.com.

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