Hedge Funds Closer to SEC Regulation

The hedge fund industry, a fast-growing but lightly policed corner of the investment business, may soon be getting more scrutiny from regulators.

The Securities and Exchange Commission’s staff recommended Monday that hedge fund managers be required to register with the agency as investment advisors, a change that would give the SEC the power to regularly inspect the funds and force managers to disclose more to their investors.

Such a move could help regulators sniff out fraud in the industry, the agency’s staff said.

The number of hedge funds has swelled to between 6,000 and 7,000, and they control an estimated $650 billion in assets from institutions and wealthy individuals, the SEC staff said.

“That’s a pretty significant pool of assets for us not to know much about,� said Cynthia Fornelli, the agency’s deputy director of investment management.

The SEC proposal would not require that hedge funds publicly disclose their portfolios, nor would it result in the identification of the funds’ investors.

But critics of the proposal noted that hedge funds already are subject to many U.S. securities laws. Moreover, they said, simply requiring the funds to register with the SEC is unlikely to deter managers who are set on bending or breaking the rules.

“This is a huge administrative burden that is (a) not necessary and (b) not sufficient,� said Robert Jaeger, author of “All About Hedge Funds� and a fund manager based in Connecticut.

Jaeger said regulators have brought a number of cases against hedge funds under existing laws covering securities fraud. He added, “The bad guys are not likely to get caught during a routine audit.�

Hedge funds, which generally are limited to investors with at least $1 million in assets, employ various speculative trading strategies including short selling, or betting on a decline in stocks. The funds often used borrowed money to pump up their bets.

Despite the near-collapse of a highly leveraged fund, Long Term Capital Management, in 1998, the industry has mushroomed as well-heeled investors have sought alternatives to stocks amid the bear market.

Also, investors of more modest means have been able to enter the hedge fund arena by buying funds of hedge funds -- mutual funds that invest in a selection of hedge funds and offer initial minimum investments of as low as $5,000.

The SEC staff recommendation requires approval from the five-member commission after a public comment period. But in a news conference Monday, SEC Chairman William H. Donaldson signaled his backing.

“The commission needs to have a means of examining hedge fund advisors and monitoring their operations,� he said.

Though it was long in the works, the SEC proposal comes as hedge funds are drawing more regulatory attention because of the role played by the Canary Capital Partners hedge fund in touching off the scandal now tarnishing the $6.9-trillion U.S. mutual fund industry.

In early September, New York Atty. Gen. Eliot Spitzer accused Canary of engaging in illegal trading of mutual fund shares. Canary and its manager, Edward Stern, agreed to pay $40 million to settle charges that it was allowed to make illegal after-the-bell trades of fund shares, as well as legal “market timing� trades that can run up costs and dilute the savings of buy-and-hold investors.

Spitzer and the SEC are investigating whether such “abuses� are more widespread in the mutual fund industry.

“Nobody can say if Canary would have been detected before the alleged fraud occurred,� Fornelli said, “but if we had seen what they were doing our staff surely would have raised red flags and investigated further.�

Supporters of registration point to the industry’s increasing effect on public markets.

“You can’t have a $650-billion gorilla running around unchecked,� said Henry Hu, a corporate and securities-law professor at the University of Texas at Austin. “Hedge funds will be that much more careful in the future if they know the SEC could come in and do a surprise audit.�

Several Southern California hedge fund managers said registration could help improve the industry’s controversial image.

“I can’t think of a good argument against it,� said Steve Persky, managing partner of L.A.-based Dalton Investments, which has voluntarily registered with the SEC since launching in 1999. “The term ‘unregulated hedge funds’ is a negative. It affects public perception.�

Elliot Blumberg, manager of Vigilant Investors fund in Santa Monica, agreed. “Anything we can do to build confidence in the market is a positive,� he said.

Others said registration might unintentionally harm investors who don’t grasp the risks of hedge funds. “There is a moral hazard: The investing public may misinterpret SEC registration as some sort of government seal of approval,� Jaeger said.

But by requiring registration, the SEC would effectively increase the minimum net worth requirement of investors in many hedge funds to $1.5 million, the staff proposal said.

The staff’s 134-page report also suggested that the commission consider requiring hedge fund managers to enact consistent procedures for valuing their holdings. The staff also recommended greater disclosure of the fees investors are charged by funds of funds.