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Hedge fund ads: Game changer?

By Sheyna Steiner ·
Wednesday, July 10, 2013
Posted: 7 pm ET

Curious about hedge funds and private equity? Even if you're not, you could soon be hearing a lot more about various types of alternative investments that fall under what's known as Regulation D as a result of today's vote by the Security and Exchange Commission, or SEC.

Regulation D exempts some companies from registering their securities with the SEC.

One of the mandates in the Jobs Act, signed into law in 2012, was for the SEC to lift the advertising and solicitation restrictions on hedge funds and other Regulation D offerings. Today's vote accomplished that, but consumer advocates say it left a lot to be desired for protecting investors.

"General solicitation for hedge funds must only be to sophisticated investors. Already, that's oxymoronic, since a person who doesn't know enough to find a broker in a phone book hardly qualifies as a sophisticated investor," says Bartlett Naylor, financial policy advocate for Public Citizen, a consumer advocacy organization in Washington, D.C.

"If you're not sophisticated enough to look up a broker and say, 'I want to get in on a private equity deal,' then run away. If you haven't done this before, run far away," he says.

The alternative marketplace will still be limited to accredited investors -- those are investors with a net worth of $1 million or a yearly income of $200,000 for singles, $300,000 for couples. With advertising now permissible, more investors may realize they are qualified to buy into the exclusive investments. That could be a good thing, or it could be bad.

"From the manager's point of view, it is a good thing: Raise money, invest in capital markets, provide liquidity and allow your information to be reflected in market prices. There are good benefits that could result, like capital formation," says George Aragon, associate professor of finance at the W. P. Carey School of Business at Arizona State University.

"But you allow managers that may not be as productive to raise more capital, and that takes it away from other sources that could put it to good use," he says.

The possible good

The reason the Jobs Act included a requirement to lift the ban on hedge fund advertising was to make it easier for businesses to get money.

"Banks weren't lending, and because banks weren't lending, businesses couldn't hire," says Mick Swartz, associate professor of clinical finance and business economics at the USC Marshall School of Business and a board member of the California Hedge Fund Association.

The hope is that advertisements for hedge funds and other alternative investment vehicles will attract more investors, which will funnel money toward small and midsize businesses.

"So you'll see more distressed lending and things related to this. There will be an increase in the amount of capital invested in smaller companies," says Swartz.

"With more businesses flourishing, more jobs could be created. Plus more investors will be able to enjoy the benefits of diversifying into alternative investments and markets. The mutual fund and (exchange-traded fund) arena offers investments that attempt to replicate hedge fund strategies, but investors could be better represented if they bought the hedge fund," says Swartz.

"There's a difference between performance and exposure to asset class. In the industry we differentiate between alpha and beta: Hedge fund alternatives offer exposure to beta, not exposure to alpha," he says.

In other words, investors in funds that replicate alternative strategies get some of the protection from volatility that hedging strategies offer, but not the out-performance that hedge fund investors pay extra to get, in his view.

The possible bad

The possibility that unsophisticated investors could lose their shirts, or worse, get scammed, worries consumer advocates.

"The potential for an increase in fraud is a legitimate concern," says Swartz.

"The potential for fraud is real, and the potential for people investing money in companies that fail is very real. It's important to keep diversification," he says.

Investors rarely recognize themselves as unsophisticated. The draw of ads touting 30 percent returns may lure in people who lack the expertise to know where these types of investments fit into their portfolio.

Barbara Roper, director of investor protection at the Consumer Federation of America, criticized the vote in an email newsletter, citing the lack of investor protections in the new rule.

With this vote, the Commission has thrown open the doors to mass marketing of hedge funds and other so-called private offerings, knowing full well that it lacks the tools to provide effective market oversight and that the current rules are inadequate to ensure that only those with the financial sophistication to understand the risks and the wealth to withstand potential losses invest in such offerings.

Investor protection may be strengthened in the future; today, the SEC also voted to propose another set of investor protections at a later date that would require issuers to provide more information about the offerings.

What to expect

A full-on advertising onslaught from the hedge fund industry isn't likely to happen overnight. Instead, it may likely begin with a more substantial Internet presence. With the advertising ban in place, only accredited investors could even view the offers from hedge funds.

"When you try to find something out about a hedge fund or private equity, you can't find out anything if you're not an accredited investor," says Swartz.

"Websites will change; the hedge fund or private equity can control everything there. I think they will start there and then maybe move into radio and television," he says.

For investors who find their interest piqued by hedge fund marketing, due diligence is as important as ever.

Make sure "there are procedures in place to manage risk (and) that the investment is audited. And check their track record and do background checks on key personnel," Swartz recommends.

Do you think investors are savvy enough to understand marketing for complex, and sometimes expensive, investment products?

Follow me on Twitter: @SheynaSteiner.

Senior investing reporter Sheyna Steiner is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers.

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