MFS Investment Management Chairman Robert C. Pozen doesn't think hedge funds require any additional regulation beyond the recent requirement to register their advisors with the Securities and Exchange Commission.

Despite swelling to $1 trillion in assets and more than 8,000 in number, hedge funds have become increasingly challenged to make money through arbitraging differences among related securities. In addition, the flattening of the yield curve has hampered their ability to make "carry trades." As a result, the average hedge fund is barely positive this year and trailed the S&P 500 in both 2003 and 2004.

In an op-ed piece in The Wall Street Journal, Pozen argues that the SEC should not impose additional regulatory safeguards to protect investors in hedge funds that underperform. "These are almost all wealthy individuals and institutions who should be able to protect themselves," Pozen wrote. "Some hedge funds will perform poorly and go out of business, while others will thrive by generating excellent returns despite their hefty fees."

Given the fact that the fees hedge funds charge their customers have risen to 2% of assets, plus an incentive fee equal to 20% of positive returns, with no penalty for negative returns, there exists a disparity between hedge fund investors and mutual fund investors, Pozen noted. However, the answer, he argues, is not to limit the incentive fees for hedge funds. He believes that wealthy investors are capable of rejecting these fee structures or negotiating modifications.

Pozen's solution to the problem?

Allow "more flexible incentive fees" for managers of mutual funds, pending board and shareholder approval. For example, have hedge funds and their shareholders approve paying a manager a below-median, performance-tied advisory fee. Depending on how well the manager performs relative to an index or peer group, they could reap additional bonus fees, Pozen says.

As for hedge fund investors, they need an accurate and consistent metric to compare performance among hedge funds with similar strategies, he reasons. While there are a number of services out there that generate performance statistics, there remains no industry standard for measuring performance or categorizing different types of hedge funds.

On top of that, the current stats on hedge funds do not account for hedge funds that can simply shut down and reopen under a different name after performing terribly. As Money Management Executive reports have noted a number of times, mutual funds and hedge funds, alike, often merge or close down out of existence - and with those closings, so goes the funds' performance history.

No More 'Blind Pools'

To rectify that practice, and reduce abuse of it, Pozen urges the SEC to take the lead on coming up with a precise definition of hedge fund performance.

For instance, Pozen believes that the SEC should focus its attention more on funds-of-hedge funds because they tend to sell to a large group of less-sophisticated investors and are essentially "blind pools of hedge funds."

Ultimately, Pozen posits, "some of the regulatory concerns about the hedge fund industry and its rapid growth should be self-correcting, especially if standardized comparisons of hedge funds and fees are widely disseminated."

The staff of Money Management Executive ("MME") has prepared these capsule summaries based on reports published by the news sources to which they are attributed. Those news sources are not associated with MME, and have not prepared, sponsored, endorsed, or approved these summaries.

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