Let the Hedge Fund Lawsuits Begin

Looking for a good reason why hedge funds shouldn't market themselves to the broader investing public? Look no further.

An investor in West Palm Beach, Florida is suing Citigroup Alternative Investments for defrauding investors by falsely marketing one of its hedge funds as low risk. The fund, Falcon Strategies Two B LLC, lost 40 percent of its value since last year and has frozen investor redemptions. Falcon is a part of Old Lane Partners, a hedge fund group that was sold to Citigroup by now-C.E.O. Vikram Pandit for a tidy sum last year.

Citigroup markets its funds to Smith Barney customers who meet certain net worth requirements, and the minimum investment amount in this particular fund was $500,000. So you'd think they would be pretty sophisticated investors.

Think again. According to the suit, the investor claims the fund was marketed as low risk and low volatility and "as being consistent with intermediate government bonds." It promised annual returns of between 7 percent and 10 percent. It charged 2.5 percent management fee, plus an undisclosed incentive fee (20 percent of profits, in all likelihood).

The suit claims that Citi changed its strategies to high risk, high volatility investments without telling its investors. The plaintiff is seeking class action status.

It's a weak argument all around, and it seems to be argued by an investor who doesn't know the definition of "hedge fund," which is by its very nature a high-risk investment.

The plaintiff argues that Citi was motivated to take on high-risk investment strategies to generate its "exorbitant fees." "Therefore, the more money the manager earned for the Fund, the higher their compensation," the filing reads. "This created an incentive for [Citigroup] and the other defendants to take greater risk with the Fund's assets to try and generate a greater return."

Well, yes. Obviously. It's how hedge funds work.

The suit demonstrates that even marketing hedge funds to so-called "sophisticated investors" comes with its risks. But any investor who pays 2.5 percent for a promise of a 7 percent return in a fund invested like government bonds is far from sophisticated.

Who's the guilty one here? The investor? The fund manager? The broker that sold it? They probably each bear some responsibility.

Phillip Goldstein of Bulldog Investors wants to be able to market his hedge fund to the public, and he is suing the Securities and Exchange Commission for violating his right to free speech by telling him he can't.

Goldstein may want to take a look at this lawsuit. It's enough to muzzle even the most vocal hedge fund marketers.

by Megan Barnett