The President's Working Group on Financial Markets will form two private-sector groups to develop best practices for the hedge fund industry, and while it comes far short of requiring hedge funds to register with the Securities and Exchange Commission, this is welcome news, both for investors and the market.

The working group, which is being run under the Treasury Department, is suggesting best practices in lieu of regulation, which it fears could preclude hedge funds from innovating new investment strategies.

One of the groups will develop best practices for hedge fund investors, helping them to assess such funds and decide whether to invest in them. The other, targeted at hedge fund managers, will concentrate on trading practices, valuation and recordkeeping.

The timing is critical, for, as sister publication Securities Industry News recently reported, in an increasingly crowded market, hedge fund managers are taking on more risk, and the chance that they could turn to illegal activities is rising. Ways that hedge funds might commit fraud include misreporting assets or returns, self dealing, insider trading and failing to disclose liabilities.

"Fund manager fraud is the No. 1 reason for serious loss, defined as greater than 50% in a hedge fund," according to Mark Sunshine, president of First Capital, which provides credit services to hedge funds. "Because this is essentially an unregulated industry, there is little timely oversight of the managers."

Increasing risk in hedge funds is the fact that many are turning to such exotic instruments as derivatives and structured products to boost returns. These can not only inflate returns on the upside, but do the same on the downside.

"Often, derivatives and structured products have a built-in leverage or gearing effect, which may make the effect of a change in an underlying or reference asset more severe than otherwise," said Anna Pinedo, a partner with Morrison & Foerster. "A thorough understanding and careful review of each product is required to be certain that the people at the hedge fund monitoring the portfolio understand the risk exposure."

Let's hope the best-practices groups take this into consideration.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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