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February 1, 2000

Technology Viewpoint: Cyberspace Hedge Funds

By Lewis Knox

Countless markets are moving to the World Wide Web, selling everything from Beanie Babies to billion-dollar bond offerings.

By allowing simultaneous communication among an unlimited number of people, the Internet promises to bring more efficiency to over-the-counter markets of all sorts.

Since October 1999 four different web sites have announced plans to offer accredited investors on-line electronic trading in hedge fund shares in the secondary market. Here's why it is important for hedge fund managers and investors to understand the relative merits of these systems and their limitations.

An investor who wants to enter a hedge fund that is closed may be willing to pay a premium to go to the secondary market to buy shares of that fund (from an investor who put money into it before it closed).

Similarly, an investor who wants to exit a hedge fund with infrequent redemption privileges or an initial "lock-up" on new investments may value the opportunity to sell those shares directly, to another investor, instead of waiting to redeem them.

Saving Time

Electronic matching systems reduce the time it takes to bring buyers and sellers together. They can provide listings of funds available to many investors simultaneously. That's much more efficient than the informal telephone market that exists today.

A good system can provide subscribers data on funds they want to trade through a link to an on-line fund database. This link gives users one-click access to a secondary market trading system.

Despite all of the advantages of secondary market trading systems, hedge funds remain long-term investment vehicles. Regardless of the online technology, they will never be suitable vehicles for market timers.

That's because daily, or tick-by-tick net asset values, are difficult to calculate for many hedge funds. Those specializing in derivatives arbitrage, or arcane mortgage securities, have positions that are hard to price on a daily basis.

Furthermore, in order to calculate NAVs in real time, hedge fund managers must give a third party access to their positions on a real-time basis. Only a limited number of funds will be willing to do this, limiting the liquidity of the trading system.

Risk Factor

Hedge fund investors should have qualms about investing in a hedge fund that is so transparent that it risks giving away its position information and thereby exposes itself, and its limited partners, to front-running.

Finally, the legal structure of hedge funds can make it difficult to trade participations in the funds without the cooperation of the hedge fund manager.

Hedge funds domiciled in the U. S. are usually structured as limited partnerships. The partnership agreement often requires that the general partner approve each and every limited partner. Individuals who trade partnership interests among themselves without the consent of the GP may not have clear title to their investment.

As a result, most hedge fund secondary market trading takes place in the shares of offshore funds, which are usually structured as corporations, although even these may have transfer restrictions similar to those of U.S. domestic partnerships. Again, limiting the pool of tradable funds to offshore entities will inhibit liquidity.

False Security

The liquidity and transparency that are the goals of some of the recently announced secondary market trading systems may give investors a false sense of security. Daily NAVs, and even daily value-at-risk measurements, will not prevent future hedge fund disasters similar to the near-collapse of Long-Term Capital Management.

What risk measurement can do is allow investors to set limits on the types of risks managers may take, monitor compliance with these limits and have informed discussions with managers if these limits are breached.

Risk measurement is a valuable tool, of course. However, understanding a manager's investment process, and shunning those managers who refuse to disclose sufficient information about that process, is the investor's best protection in the long run.

Lewis Knox is Chief Content Officer at Altvest, Inc. (, an independent web-based service which provides investors with information posted by hedge fund managers.