Hedge funds are the latest investment vehicle to be put through the ringer as the Securities and Exchange Commission mulls more stringent regulation.

William Donaldson, chairman of the SEC, delivered an address before the Senate Committee on Banking, Housing and Urban Affairs earlier this month, in which he invited representatives of the industry to a public roundtable to discuss investor protection. The two-day forum is scheduled for May 14-15.

One of the biggest concerns is that hedge funds are becoming too mainstream, and inexperienced investors may not understand the high level of risk involved. There are now an estimated 5,700 hedge funds in existence with about $600 billion in assets under management. In 1990, there was only $50 billion invested in hedge funds. The allure of these privately run investment pools has increased even more rapidly in the last three years due to a stock market swoon.

Clandestine World

Hedge funds have been able to stem the tide by borrowing large sums of money and selling shares short, two things that make them more flexible than traditional vehicles. In addition, they are not required by law to register with the SEC, therefore enabling them to operate clandestinely and avoid examination or inspection. In 2002, hedge funds generated an average return of only 0.2%, according to the Van U.S. Hedge Fund Index. That is far better than the -22.4% decline posted by the average American equity mutual fund. And over the past three years, hedge funds have had an average return of 11.2% a year while mutual funds have fallen -11.7% a year.

Regulators believe, however, that those performance numbers are misleading given the amount of risk the funds shoulder. They also omit funds that have disappeared. Another factor to be considered is that many hedge funds lock up investors' cash for a specified period of time and cannot be redeemed without prior notice. Not to mention, many hedge funds charge hefty fees for good performance. Hedge funds also do not have to meet any diversification requirements their mutual fund counterparts do, thereby increasing their potential exposure to market volatility. When managers implement a short-selling strategy, for example, there is limited upside while the losses could be enormous.

The last time the SEC took an in-depth look at hedge funds was back in 1998, when Long Term Capital Management nearly imploded. The Connecticut-based firm borrowed massive amounts of cash to use as leverage, a strategy that inevitably caused it to lose $1.8 billion after Russia devalued its currency. The knock on many of these investment pools is that they manipulate the market because they are not bound by the same rules as other investment entities.

Donaldson outlined four problem areas the Commission has been gathering information on, including conflicts of interest, "retailization," prime brokers and corporate fraud.

Potential conflicts arise when advisors to registered investment companies begin offering a hedge fund product to its clients. In some cases, it is merely an attempt to satisfy their need for an alternative product, whereas other times it is to keep top managers from jumping ship for a more lucrative job at a hedge fund. That could lead to the problem of advisors favoring their hedge fund clients over its regular clients in allocating lucrative trades, Donaldson said.

The increasing number of investors who qualify to be accredited has contributed to the retailization of hedge funds. Essentially, individual incomes have steadily risen while the minimum investment for many funds have remained the same. The most recent development on that front has been the emergence of funds of hedge funds, which are registered investment companies that invest in an underlying pool of hedge funds.

The required investment for these funds can be as little as $25,000, a far cry from the old standard of $1 million. "Funds of hedge funds raise special concerns because they permit investors to invest indirectly in the very hedge funds in which they likely may not invest directly due to the legal restrictions," Donaldson said.

Separately, U.K. investment watchdog Financial Services Authority (FSA) said in March that it would not relax the rules governing marketing of hedge funds to retail investors because it believes the current system provides the right balance of consumer protection and access.

"Generally, the feedback we received did not indicate a great desire on the part of hedge funds or investment advisors to provide or sell hedge funds as retail products," said Gay Huey Evans, director of markets and exchanges at the FSA, in a release. "Nor was there evidence of significant demand from retail investors."

But Evans did not squash the idea altogether. She said FSA would remain vigilant on the presently unregulated schemes and discuss the possibility of allowing a broader range of funds to be included as retail investment products. The FSA conceded that it currently does not have sufficient resources or manpower to adequately regulate hedge funds or set standards for them to achieve. Evans said that all investment firms based in London, including hedge fund managers, must take "reasonable care" to maintain systems and controls appropriate to their business. They also must be properly qualified and controlled when undertaking investment activities for their client fund. Any manager not abiding by such standards would be in breach of the rules, he said.

The third issue Donaldson said he would look at was the prime brokerage system, which is typically a means of providing additional services to hedge funds such as margin loans and risk management services. But prime brokers also provide "capital introduction" services, such as sponsoring investor conferences and arranging individual meetings. These services are designed to draw in potential customers and will be closely monitored as to how they are disclosed.

Potential Fraud

The most significant issue the SEC is investigating is potential fraud. "There have been complaints by some issuers that hedge funds have acquired large short positions in their stocks and have then attempted to drive the share price down through the issuance of highly critical and allegedly inaccurate reports on their finances," Donaldson said. Last year, the SEC instituted twice as many enforcement actions against hedge funds or their managers they did in the previous four years.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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