SEC Puts Hedge Funds Into Focus

The simmering controversy over hedge funds drew an overflow crowd Wednesday to a Securities and Exchange Commission hearing where industry executives defended the lightly regulated funds from criticism that they are unsuitable for small investors and need greater government oversight.

Hedge funds, a freewheeling relative of mutual funds traditionally favored by the super-rich, have become popular among less-affluent investors as the bear market has derailed more conventional investment strategies. Their ardor has been stoked in part by the aggressive marketing of hedge fund companies that hope to tap the legions of disaffected investors.

But critics worry that individual investors, as they did with technology mutual funds in the late 1990s, may be jumping into investments that they don’t understand at precisely the wrong moment.

“Hedge funds are unsuitable investments for unsophisticated investors,” David Swensen, chief investment officer of Yale University, said at the hearing. “It would be best for the investment world to have high hurdles in place” to keep small investors out of hedge funds.

The debate has huge stakes for the financial industry, a fact clearly on display Wednesday.

Dozens of industry officials gathered outside the SEC’s headquarters early in the morning, and a line to get into the meeting snaked down the block about two hours before the hearing began at 9 a.m.

It was the first of two days of hearings the SEC is holding as it nears completion of a study to determine whether to impose new rules on the lightly regulated hedge-fund industry.

“While there are frequent reports of high returns for hedge funds,” said SEC Chairman William H. Donaldson, “there are reports just as frequently that highlight possible areas of concern, such as potential conflicts of interest, questionable marketing techniques, valuation concerns and the market impact of hedge fund strategies.”

Potential rules include forcing hedge funds to disclose more about their operations and imposing stricter limits on who can invest in the funds.

Hedge funds make aggressive bets in volatile financial markets, often trying to goose returns with heavy leverage and risky maneuvers such as selling short, or trying to gain from a drop in stocks or other assets. There are more than 7,000 hedge funds managing $650 billion in assets, according to Van Hedge Fund Advisors International.

Industry officials portrayed the funds as safe and said their swashbuckling reputation has been exaggerated by critics. Subjecting the industry to greater oversight could damp the entrepreneurial spirit that has helped the industry grow, they said.

“When you include hedge funds as part of an overall portfolio, you actually increase performance and decrease risk,” said Richard Lindsey, a top official at Bear Stearns Cos.

Hedge funds also have largely avoided the “catastrophic” losses suffered by stock mutual funds in recent years, said Robert Schulman, co-chief executive of Tremont Advisors, a fund consulting firm.

Industry experts also stressed that the funds are increasingly pitching themselves to institutional investors such as pension funds and endowments rather than small investors.

Regulators pointed out that some funds have aggressively pitched themselves to individuals while downplaying the risks.

Some of the marketing is “pretty over-the-top,” R. Clark Hooper, senior vice president at the NASD, formerly the National Assn. of Securities Dealers, said during a break.

Paul Roye, the head of the SEC’s investment management division, said during a break that one fund company is seeking permission to list its shares on a stock exchange, while others have applied to be open-end mutual funds -- both steps that would make them available to small investors.

When hedge funds were the preserve of the wealthy, the lack of oversight wasn’t a concern because regulators figured that well-to-do investors could watch out for themselves.

One reason that hedge funds are now accessible to the less-affluent is that mandatory income and net worth standards needed to invest in a hedge fund have not been boosted in years.

An investor must have at least $1 million, including real estate; or an annual salary of $200,000 ($300,000 for a couple). As home values have shot up in recent years, that has made the funds available to a wider swath of investors.

Hedge funds have a reputation for operating under a cloak of secrecy, thus making it impossible to discover problems before a fund explodes.

That has happened several times in recent years.

The most famous failure was Long-Term Capital Management, which melted in dramatic fashion in 1998 despite being run by the seemingly smartest investors on Wall Street.

Some critics say hedge funds are so risky they should be off-limits to small investors. About 14% of hedge funds closed last year, most because of poor performance, according to Tremont data.

“The whole reason hedge funds are allowed to be structured the way they are is because there’s an understanding that they’ll only be sold to the most sophisticated, wealthiest investors,” Barbara Roper of the Consumer Federation of America said in an interview.

“People should not allow their desperation at finding something that’s making a decent return in this market to send them into the arms of the hedge-fund industry.”