Five Things to Ask Before Investing in a Hedge Fund

Marc Freedman, a Boston-area financial advisor, likes to compare hedge funds to cigarettes. Regulations govern how they can be marketed, and to whom; both hedge funds and smokes come with stern warnings about the risks involved; and anyone who wants to buys them anyway—if they can afford them.

By law, individuals must be worth at least $1 million to have access to a hedge fund. Institutional investors are required to have $100 million in assets.

Figured this way, Freedman says, it doesn’t much matter that the JOBS Act, signed yesterday in a Rose Garden ceremony by President Obama, lifts a decade-old ban on advertising by hedge funds and private equity firms. “Whether they advertise or not, there are suitability requirements,” says Freedman, president of Freedman Financialin Peabody, Mass. “Maybe one percent of the population would even qualify to deal with a hedge fund directly.”

Freedman isn’t alone in thinking that worries about the end of the ban are overblown. Defenders of the industry point out that hedge funds won’t likely be advertising in any traditional sense—hiring a Don Draper to put together TV commercials or buying up the naming rights to stadiums. In practice, the effect of the ban was to limit what fund managers could say in public about their products.

“Under the old rules, part of my job was to keep hedge-fund managers from talking about what they really do,” says Mitch Ackles, president of the Hedge Fund Association, a public-relations group. “You turn on CNBC and see them being interviewed, but only about their views on the economy, not their specific business.”

By allowing hedge-fund managers to talk more openly about their products, the new rules will make hedge funds more transparent, says Ackles, increasing the information available, so investors can make educated decisions. The openness will in turn foster employment in the hedge-fund industry, as new MBAs and other jobseekers come to understand the business better.

"Under the old rules, part of my job was to keep hedge-fund managers from talking about what they really do." -president, the Hedge Fund Association, Mitch Ackles

Still, no one seems to disagree that the JOBS Act puts the onus on investors to know what they are getting into. Whether the idea comes from a hedge fund directly, a notice in a newspaper or through a trusted advisor, the usual safe-investing advice still applies.

“Have the fund provide the Alternative Investment Management Association’s due-diligence questionnaire,” he says. “It’s the industry standard, and most managers usually have already filled them out. “

Hedge funds engage a broker to execute their trades. Check with the brokerage firm that the hedge fund has an account with them as they claim. “You should perform a background check on all their service providers,” says Ackles, especially the fund’s administrator—the outside vendor who handles accounting and other back office chores. “Are they with a Big Four accounting firm, or some guy in a shopping mall?” A self-administrated fund is probably not a good bet.

While you’re talking to the administrator, ask whether the fund manager has a personal stake in the fund. "If they believe in their strategy, they should have some skin in the game,” says Ackles.

Meet with the fund manager in person. Take a look at the operation and the equipment he or she is using. “If they are day trading, they should have Bloomberg terminals,” Ackels says. If the employees are using substandard equipment or working out of a private home, you can generally take it as a bad sign.

The most important question is for yourself: How much of an investment makes sense? Successful hedge funds put up their alluring numbers by making very aggressive bets in the market. Even the wealthiest investor can’t afford to live on high risk alone. “This is an investment for a sliver of your portfolio,” warns Marc Freedman, “not the entire pie.”