The SEC Ponders Greater Regulation Of Hedge Funds

by Carla Johnson, Investors Offshore, London

10 May 2002

Hedge funds, once an arcane corner of the investment industry known only to the ultra-rich and their advisers - and happy to stay that way - are emerging into visibility in ways they would not choose. The hedge fund sector, which has nearly doubled in size in the last three years to more than US$500bn just in the US alone, has given the financial system one serious fright when LTCM collapsed, has seen a series of high-profile fraud cases, and now is increasingly being used as an investment medium by institutional investors - that's to say, by your and my pension funds.

All of this is causing regulators sleepless nights. Nobody much cares if Mr Filthy Rich Croesus loses an arm and a leg, but the increasing exposure of supposedly safe investment funds to largely unregulated, free-wheeling hedge funds is another matter.

According to the Wall Street Journal, the US Securities and Exchange Commission is contemplating ways of exercising greater control over hedge funds. Some SEC officials, says the paper, are discussing new rules that would force hedge funds to submit to regular examinations by the agency, like other investment firms. The SEC also is contemplating making hedge funds provide investors and regulators with much more accurate and timely information about their operations, including their performance, leverage and holdings. Paul Roye, the director of the SEC's investment management division, told a conference last month that even though hedge-fund managers "may consider themselves unregulated, they have a fiduciary responsibility to their clients."

Industry executives aren't losing much sleep over the rumours, pointing to chronic under-funding at the SEC, its preoocupation with Enron, Merrill Lynch and Arthur Andersen, and the sheer difficulty of pinning down hedge funds, which often have offshore bases and can turn on the head of a proverbial pin in terms of their investment tactics.

One straightforward change the SEC could put in place is to raise the entry barrier for hedge fund investment, currently set at $1 million in net worth or $200,000 in annual income. These limits have come to seem anachronistic as wealth increases. But it might not be so simple: funds of hedge funds already offer a way around the entry barriers, and inventive lawyers would quickly find other instruments allowing investors to put their money where they want to, as has happened in Europe. Plus the SEC can realistically pin down only US-based hedge funds, not those operating offshore, which can increasingly use the Internet to bypass local restrictions on advertising. All in all, the SEC might better spend its time educating investors rather than limiting their freedom to lose money.

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