By Cory Bowman

A pertinent topic for today’s financial advisors is the subject of hedge funds. One effective way to support and build your financial advisor career is to stay educated on current financial products and methods of investing. This article will outline the basics of hedge funds for financial advisors looking to take their financial advisor career further. Whether you already are an FA or if you are wondering how to become a financial advisor, learning about investing products and methods can be very helpful.

Hedge funds are loosely regulated pools of capital that invest in stocks, currencies, bonds, and/or commodities. Hedge funds are similar to mutual funds but with fewer rules, less government oversight, and much greater investment flexibility. Hedge funds are usually either limited partnerships or offshore corporations. These funds can take both long and short positions, use leverage and derivatives, and invest in many markets at the same time. Minimum initial investments typically range from $250,000 to $10 million. Frequently, these funds have a one-year lock-up for first-time investors.

The median fee structure, according to TASS (which collects data on hedge fund returns), is a 1.5% management fee plus a 20% incentive fee. From Over a period of 10 years (ending 12-31-2005), this came out to an average fee of about 3.8% annually. Hedge funds are not required to report returns, so most of the results reported to data collectors are voluntary.

The two main biases that pump up hedge fund returns are survivorship and backfill. When a hedge fund fails, the fund, along with its poor performance, is frequently removed from the index and data set. This leaves an artificially inflated index composed solely of surviving funds that have all had some level of success. And because hedge funds must report returns in order to join an index, they frequently tend to join only after a period of solid performance-what is referred to as “backfill.” When learning how to become a financial advisor, always make sure to look up terms if you do not know the meaning or definition.

Today, the SEC is looking into a number of potentially abusive hedge fund practices. One is secret agreements, known as “side letters,” that give certain investors privileged information about holdings or special redemption terms. These side letter agreements are not part of a hedge fund’s general offering memorandum; they can provide increased liquidity, lower management fees, greater portfolio transparency, and/or access to the fund’s prime brokers, lawyers, and accountants. You will likely come across other questionable investing practices in your financial advisor career; if you do you should make sure that you understand the situation and the implications involved.

Side letters give some investors preference over others without disclosing such information to all shareholders. It is estimated that roughly half of all hedge fund managers make separate deals with certain investors. The majority of side letters are with hedge funds that manage less than $1 billion.

Hedge funds are also under scrutiny for improperly valuing holdings to hide losses or trump up returns (which increases management fees). SEC examiners believe that some hedge funds are invested heavily in exotic instruments that lack marketability. There is also the question of internal controls; a failure by some hedge funds to separate their business practices.

Portfolio valuation is a major concern of hedge fund observers. Many of these funds own thinly traded securities and complex derivatives whose values can be subjective. A number of past enforcement cases against hedge funds have involved valuation methods that mask or hide losses or artificially inflated returns. Some funds, claiming certain holdings are difficult to value, put 10-15% of their portfolios in so-called “side pockets,” which are sequestered from the overall package. A few funds have up to 25% of their holdings in side pockets-a warning sign.

As you can see, there are a variety of topics to understand when it comes to having a successful financial advisor career. Learning how to become a financial advisor involves educating yourself on investing topics – like hedge funds – and continually staying on top of current events and economic news.

About the Author: Cory Bowman is Director of Ops at the Institute of Business Finance. IBF has helped thousands of members of the financial services industry attain designations. For more information about IBF,

how to become a financial advisor

, or building your

financial advisor career

visit http://www.icfs.com

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