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Dissecting Hedge-Fund Secrets
Wealth-Managers Say SEC-Required Revelations Won't Replace Due Diligence

By ELEANOR LAISE and RACHEL EMMA SILVERMAN, Staff Reporters of Wall Street Journal

February 4, 2006

This past week, for the first time, many hedge funds started airing some of their secrets -- and wealth managers are lining up to use that information to help make investment recommendations.

But financial advisers also say the new revelations, required by the Securities and Exchange Commission, won't take the place of the due-diligence process they have long used in vetting hedge funds.

Feb. 1 was the deadline for hedge-fund firms to register with the SEC as investment advisers, under a rule adopted in late 2004. It marks the first time that hedge funds, lightly regulated investment pools for institutions and wealthy investors, are facing strict oversight. More than 900 hedge-fund advisers have registered since the beginning of 2005, according to the SEC, joining others that have been registered with the agency for years.

Firms registering with the SEC must give details on everything from their managers' education and business experience to fee arrangements, total assets and past disciplinary problems. Yet advisers aren't required to make public details of their fund's performance and holdings, or its trading secrets.

Details on registered advisers are disclosed in an SEC document known as "form ADV." Investors can find the first part of this form on the SEC's Web site (www.adviserinfo.sec.gov), while the second part, which contains more information, is typically available only to accredited investors on request from the fund's advisers.

Financial advisers caution that researching a hedge fund before investing requires much more than just reading the ADV. Many investors and wealth-advisory firms use interviews and questionnaires to vet fund managers and some hire consultants to help investigate the funds. Indeed, some financial advisers say the ADV form doesn't provide them any additional information because they already have a rigorous research process in place.

Yet many advisers have chosen not to register, taking advantage of exemptions for funds that lock up investors' money for more than two years or close their doors to new investors. Some may want to avoid what they consider unnecessary regulation, while others may simply not want to attract new investors. And only advisers with at least $30 million in assets under management or at least 15 individual investors are required to register.

Failing to register can raise red flags for some wealth managers. "You can learn by what people don't do much more than from the ADV itself," says Jeff Spears, a managing director at Presidio Financial Partners LLC in San Francisco, a financial advisory firm for high net-worth clients. "You really have to understand why they didn't file their ADV."

Many wealth managers, however, find the ADV form helpful when researching money managers. Financial advisers at J.P. Morgan Private Bank, a unit of J.P. Morgan Chase & Co., read ADV forms to see "if it's consistent with what we find about the fund," says Andrew Craighead, chief investment officer for the bank's alternative investment group.

The first part of the ADV includes information on the adviser's assets under management, compensation arrangements, disciplinary history, type of clients served and owners of the firm. A simple detail like the firm's total assets under management can be important to prospective hedge-fund investors, who want to be sure they're putting money with a firm that not only makes sound investments but can also run a stable business, says Ryan Tagal, product manager for hedge funds at research firm Morningstar Inc.

Rod Wood, head of the wealth-advisory business at Wilmington Trust Co., says he doesn't like to have his clients' assets represent more than 10% of a fund. If the fund can't attract other investors, "the viability of the business could be affected."

Traditionally, hedge funds have provided investors with little standardized data. While they give investors an "offering memorandum" similar to a mutual-fund prospectus, because hedge funds are private "they could put in their memorandums basically whatever they want," says Joseph Omansky, president of hedge-fund research firm Sky Fund LLC.

The second part of form ADV gives details on the managers' business background, a basic fee schedule and potential conflicts of interest between money managers and their investors. Investors can also find the name, education and previous five years' business experience of each member of the firm's investment group.

When he looks at newer funds, J.P. Morgan's Mr. Craighead generally seeks advisers who have at least a couple of years experience running a firm. That history shows that "not only is this guy able to trade on his own, but also build a business, build an infrastructure and hire the right people," he says. A 2003 study by Capco, a financial-services consulting firm, found that half of hedge-fund failures are caused by operational issues -- not problems with the fund's investments.

The form's second part also requires advisers to disclose their basic fee schedule, how fees are charged and whether they're negotiable. But some advisers divulge more details than others. Mellon Financial Corp. unit EACM Advisors LLC, for example, spells out the complete fee structure for its domestic hedge funds, while FX Concepts Inc. says that it receives management and "incentive fees" from its funds but doesn't give the amount of those fees, though it plans to.

Hedge funds typically charge management fees of 2% and performance-based incentive fees of as much as 20% or more. Wilmington Trust's Mr. Wood says he's wary of funds that charge an incentive fee over 20%.

Advisers must also disclose use of "soft dollars" on the second part of the ADV. This practice, which involves using brokerage commissions to cover the cost of research or other services, has drawn criticism from regulators because it can drive up transaction costs. In a recent survey by consulting firm Greenwich Associates, about two-thirds of hedge funds reported using soft dollars.

One controversial practice that's not reflected on the ADV: The existence of special arrangements known as "side letters" -- which can allow certain investors to make withdrawals from the fund more often than others. Such agreements typically aren't disclosed to all investors, says Sky Fund's Mr. Omansky.

The new oversight comes amid dramatic growth in hedge funds. Nearly $47 billion flowed into hedge funds last year, according to Chicago-based Hedge Fund Research Inc., compared with almost $74 billion in 2004. Hedge funds held $1.1 trillion in assets at the end of 2005, up more than 13% from a year earlier.

...they could put in their memorandums basically whatever they want, says Joseph Omansky, president of hedge-fund research firm Sky Fund LLC.

One controversial practice that's not reflected on the ADV: The existence of special arrangements known as "side letters" -- which can allow certain investors to make withdrawals from the fund more often than others. Such agreements typically aren't disclosed to all investors, says Sky Fund's Mr. Omansky.


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