Investor Assistance (800) 732-0330 www.investor.gov

INVESTOR BULLETIN

Hedge Funds

The SEC’s Office of Investor Education and Advocacy 

is issuing this Investor Bulletin to educate individual 

investors about hedge funds. 

What are hedge funds?

Hedge funds pool investors’ money and invest the 

money in an effort to make a positive return. Hedge 

funds typically have more flexible investment strategies 

than, for example, mutual funds. Many hedge funds 

seek to profit in all kinds of markets by using leverage 

(in other words, borrowing to increase investment 

exposure as well as risk), short-selling and other 

speculative investment practices that are not often 

used by mutual funds. 

You generally must be an accredited investor, which 

means having a minimum level of income or assets, 

to invest in hedge funds. Typical investors include 

institutional investors, such as pension funds and 

insurance companies, and wealthy individuals. Hedge 

funds are not subject to some of the regulations that are 

designed to protect investors. Depending on the amount 

of assets in the hedge funds advised by a manager, some 

hedge fund managers may not be required to register 

or to file public reports with the SEC. Hedge funds, 

however, are subject to the same prohibitions against 

fraud as are other market participants, and their managers 

owe a fiduciary duty to the funds that they manage. 

What information should I seek if I am 

considering investing in a hedge fund?

n Read a fund’s offering memorandum and 

related materials. The hedge fund’s offering 

documents and agreements contain important 

information about investing in the fund, including 

the investment strategies of the fund, whether the 

fund is based in the United States or abroad, the risks 

of the investment, fees earned by the hedge fund 

manager, expenses charged to the hedge fund and the 

hedge fund manager’s potential conflicts of interest. 

It is important that you read all the documents before 

making your decision to invest in a hedge fund. You 

should consider consulting an independent financial 

advisor before investing in a hedge fund.

n Understand the fund’s investment strategy.

There are a wide variety of hedge funds with many 

different investment strategies. Some hedge funds 

will be diversified among many strategies, managers 
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and investments, while others may take highly 

concentrated positions or may only use a single 

strategy. Make sure you understand the level of risk 

involved in the fund’s investment strategies and 

ensure that they are suitable to your personal 

investing goals, time horizons and risk tolerance. 

As with any investment, generally the higher the 

potential returns, the higher the risks you must 

assume. 

n Determine if the fund is using leverage or 

other speculative investment techniques. 

Leverage is the use of borrowed money to make an 

investment. A hedge fund using leverage will typically 

invest both the investors’ capital and the borrowed 

money to make investments in an effort to increase 

the potential returns of the fund. The use of leverage 

will magnify both the potential gain and the potential 

loss from an investment. The use of leverage can 

turn an otherwise conservative investment into an 

extremely risky investment. A hedge fund may also 

invest in derivatives (such as options and futures) and 

use short-selling (selling a security it does not own) to 

increase its potential returns, which could likewise 

increase the potential gain or loss from an investment. 

n Evaluate potential conflicts of interest 

disclosed by hedge fund managers. For 

example, if your investment adviser recommends 

that you invest in a fund that the adviser manages, 

there may be a conflict of interest because your 

adviser may earn higher fees from your investments 

in the hedge fund than the adviser might earn from 

other potential investments. 

n Understand how a fund’s assets are valued. 

Hedge funds may invest in highly illiquid securities 

that may be difficult to value. Moreover, many 

hedge funds give themselves significant discretion in 

valuing illiquid securities. You should understand 

a fund’s valuation process and know the extent to 

which a fund’s securities are valued by independent 

sources. Valuations of fund assets will affect the fees 

that the manager charges.

n Understand how a fund’s performance is 

determined. Hedge funds do not need to follow any 

standard methodology when calculating performance, 

and they may invest in securities that are relatively 

illiquid and difficult to value. By contrast, federal 

securities laws dictate how mutual funds can advertise 

their performance by requiring specific ways to 

calculate current yield, tax equivalent yield, average 

annual total return and after-tax return, as well as 

having detailed requirements for the types of disclosure 

that must accompany any performance data. If you are 

provided with performance data for the hedge fund, ask 

whether it reflects cash or assets actually received by the 

fund as opposed to the manager’s estimate of the change 

in value of fund assets and whether the data includes 

deductions for fees.

n Understand any limitations on your right to 

redeem your shares. Unlike mutual funds where 

you can elect to sell your shares on any given day, hedge

funds typically limit opportunities to redeem, or cash 

in, your shares (e.g., monthly, quarterly or annually), 

and often impose a “lock-up” period of one year or 

more, during which you cannot cash in your shares. 

In the time it takes for you to redeem your shares, 

their value could diminish and you will not have use 

of the money invested in those shares. Furthermore, 

hedge funds may charge you a redemption fee before 

you are allowed to cash in your shares. Hedge funds 

may also have authority to suspend redemptions 

under certain circumstances, including in times of 

market distress or when their investments are not 

able to be quickly or easily liquidated. 
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n Research the backgrounds of hedge fund 

managers. Before entrusting your money to anyone, 

research their background and qualifications. Make 

sure hedge fund managers are qualified to manage 

your money, and find out whether they have a 

disciplinary history within the securities industry. 

If the manager is registered with the SEC, you can 

get this information (and more) by reviewing the 

manager’s Form ADV. Form ADV is the uniform 

form used by investment advisers to register with both 

the SEC and state securities regulators. You can search 

for and view a firm’s Form ADV using the SEC’s 

Investment Adviser Public Disclosure (IAPD) website. 

You also can get copies of Form ADV for individual 

advisers and firms from the investment adviser, the 

SEC’s Public Reference Room or the state securities 

regulator where the adviser’s principal place of business 

is located. If you don’t find the investment adviser firm 

in the SEC’s IAPD database, be sure to call your state 

securities regulator or search FINRA’s BrokerCheck 

database for any information they may have.

Disciplinary history. In a recent action, 

SEC v. GEI Financial Services, Inc., the SEC 

alleged that a hedge fund manager failed to 

disclose to his advisory clients that the State 

of Illinois had barred him from acting as an 

investment adviser.

What questions should I ask the hedge 

fund manager before investing?

n Ask about fees and expenses. Fees and expenses 

affect your return on investment. Hedge funds 

typically charge an annual asset management fee 

of 1 percent to 2 percent of assets as well as a 

“performance fee” of 20 percent of a hedge fund’s 

profit. These fees are typically higher than the fees 

charged by a mutual fund. A performance fee could 

motivate a hedge fund manager to take greater risks 

in the hope of generating a larger return. 

Excessive fees. In GEI Financial Services, the 

SEC also alleged that the hedge fund manager 

withdrew excessive fees from the hedge fund 

he managed. The amounts withdrawn allegedly 

were based on fee calculations that substantially 

differed from what the manager initially told 

investors about how the fees were to be calculated.

Tip. A fund of hedge funds is an investment 

company that invests in hedge funds—rather than 

investing in individual securities. Funds of hedge 

funds typically charge a fee for managing your 

assets, and some may also include a performance 

fee based on profits. These fees are charged in 

addition to any fees paid to the underlying hedge 

funds and, therefore, you will be paying two layers 

of fees. You may wish to read FINRA’s investor 

alert, which describes some of the costs and risks 

of investing in funds of hedge funds.

n Ask about how a fund’s assets are safe 

guarded. A hedge fund’s manager generally has 

authority to access and transfer the fund’s assets. 

This authority can potentially be misused. To guard 

against this, many hedge funds undergo an annual 

financial audit by an independent auditor that 

includes verification of the existence of the fund 

assets. You should inquire about where a fund’s 

assets are held (e.g., whether they are held in custodial

accounts at a reputable bank or broker) and whether 

an independent third party confirms or otherwise 

verifies the existence of the fund’s assets.
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n

n

Manager malfeasance. In a recent action, 

In the Matter of Gerasimowicz, the SEC’s 

Enforcement Division alleged that, unbeknownst 

to investors, a hedge fund manager over the 

course of several years invested the majority of 

a fund’s assets into a private business owned by 

the manager’s affiliated company. The fund was 

marketed as being invested primarily in public 

equity securities with the aim of constructing a 

“diversified portfolio” and employing “controlled 

risk diversification.” The manager allegedly 

failed to inform investors of this substantial 

investment in a private business or the conflict of 

interest resulting from the manager’s substantial 

personal investments in the business. The 

business ultimately filed for bankruptcy, and a 

distribution to the fund to recover its investment 

in the business is uncertain and could be very 

small. Audited financial statements that were 

months late in being prepared and delivered to 

investors, if delivered at all, allegedly failed to 

timely alert investors to the investment. 

In another recent action, SEC v. Lion Capital 

Management, LLC, the SEC alleged that a 

manager used his hedge fund as a ruse to 

misappropriate over $550,000 from a retired 

schoolteacher. The schoolteacher considered 

the manager a close family friend and believed 

him to be a successful money manager. Instead 

of investing as he represented, the manager 

allegedly used the funds for personal and office 

expenses, including his residential mortgage, 

office rent and staff salaries. The manager 

allegedly provided false account statements to 

the schoolteacher reflecting nonexistent gains 

on her investment.

 

Ask about others that perform services for 

the fund. A hedge fund typically has third parties 

who provide various services to the fund, including a 

prime broker, an administrator, an outside accountant 

that audits the fund’s financial statements, and possibly

a valuation agent. You should consider contacting 

these third party service providers to check the 

accuracy of information provided to you by the 

hedge fund and its manager. 

Don’t be afraid to ask questions. You are 

entrusting your money to someone else. You should 

know where your money is going, who is managing 

it, how it is being invested, how you can get it back, 

what protections apply to your investment and what 

your rights are as an investor. 

What protections do I have if I purchase a hedge fund?

Hedge fund investors do not receive all of the federal 

and state law protections that commonly apply to 

most mutual funds. For example, hedge funds are 

not required to provide the same level of disclosure 

as you would receive from mutual funds. Without 

the disclosure that the securities laws require for most 

mutual funds, it can be more difficult to fully evaluate 

the terms of an investment in a hedge fund. It may also 

be difficult to verify representations you receive from 

a hedge fund. 

The SEC can take action against a hedge fund or a 

manager that defrauds investors, and the SEC has 

brought a number of fraud cases involving hedge funds. 

For example, a number of these cases involved hedge 

fund managers misrepresenting their experience and 

the fund’s track record. Other cases involved “Ponzi 

schemes,” where returns to existing investors were paid 

with funds contributed by new investors. In some of the 

cases the SEC has brought, the hedge funds sent phony 

account statements to investors to cover up the fact that 
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their money had been stolen. That’s why it is extremely 

important to thoroughly check out every aspect of any 

hedge fund you might consider as an investment. 

Ponzi schemes. In a recent action, SEC v.

Jawed, the SEC alleged that a hedge fund 

manager operated a long-running, $37 million 

Ponzi scheme. Instead of investing in securities 

as he represented to investors, the manager 

allegedly used most of his investors’ money to 

pay back old investors, to pay himself, to travel 

and to create an illusion of achievement by 

hiring professionals and educated personnel. 

The manager allegedly hid the Ponzi scheme 

by creating fake, illiquid investments. With 

increasing redemption requests, the manager and 

others he hired manufactured a sham buyout of 

the funds to make investors think their hedge 

fund interests would soon be redeemed. 

In another recent action, SEC v. Alleca, the 

SEC alleged that a hedge fund manager caused 

investor losses of $17 million as he engaged 

in a Ponzi scheme to cover-up losses from his 

undisclosed trading. The manager created a 

fund of hedge funds—a hedge fund that would 

be invested in other hedge funds. Instead of 

investing in other hedge funds, the manager 

allegedly engaged in active securities trading and 

incurred substantial losses. To satisfy redemption 

requests and conceal losses, the manager created 

two additional funds and allegedly siphoned 

investors’ money from these funds to satisfy 

redemptions on the first fund. 

Where can I go for help?

If you have a question or concern about an investment, 

or you think you have encountered fraud, please 

contact the SEC, FINRA or your state securities 

regulator to report the fraud and to get assistance.

U.S. Securities and Exchange Commission

Office of Investor Education and Advocacy

100 F Street, NE

Washington, D.C. 20549-0213

Telephone: (800) 732-0330

Fax: (202) 772-9295

Financial Industry Regulatory Authority (FINRA)

FINRA Complaints and Tips

9509 Key West Avenue

Rockville, Maryland 20850

Telephone: (301) 590-6500

Fax: (866) 397-3290

North American Securities Administrators 

Association (NASAA)

750 First Street, NE

Suite 1140

Washington, D.C. 20002

Telephone: (202) 737-0900

Fax: (202) 783-3571
 

Additional Information

For information about accredited investors, visit 

www.sec.gov/answers/accred.htm.

For our Investment Adviser Public Disclosure 

(IAPD) website, visit www.adviserinfo.sec.gov.

For FINRA’s BrokerCheck resource, visit www.

finra.org/Investors/ToolsCalculators/BrokerCheck/. 

To determine the contact information for your state 

securities regulator, visit www.nasaa.org/about-us/

contact-us/contact-your-regulator/.

For FINRA’s investor alert regarding hedge funds, 

visit www.finra.org/Investors/ProtectYourself/

InvestorAlerts/MutualFunds/P006028.

For the SEC’s press releases regarding the recent 

actions brought against hedge fund managers, visit 

www.sec.gov/news/press/2012/2012-192.htm, 

www.sec.gov/news/press/2012/2012-206.htm and 

www.sec.gov/litigation/litreleases/2012/lr22487.htm.

For more information about Ponzi schemes, visit 

www.sec.gov/answers/ponzi.htm. 

For our Avoiding Fraud resource, visit www.

investor.gov/investing-basics/avoiding-fraud. 

For additional investor educational information, 

see the SEC’s website for individual investors, 

www.investor.gov. 

The Office of Investor Education and Advocacy has provided this information as a service to investors. 

It is neither a legal interpretation nor a statement of SEC policy. If you have questions concerning the 

meaning or application of a particular law or rule, please consult with an attorney who specializes in 

securities law.

SEC Pub. No. 139 (2/13)