Hedge fund advocates tried to calm down an increasingly paranoid regulatory community Wednesday, telling an SEC-moderated conference that their products are no more risky than other investment vehicles and fail less frequently than most people seem to believe.

The statements came on the first day of a two-day gathering of 70 hedge fund managers, investor advocates, attorneys and accountants in Washington.

The industry, which consists of mostly unregulated offshore funds catering to the wealthy, is contending with a growing sense among regulators that its frenetic trading and short-selling has played a role in the market meltdown of the last three years. The testimony of advocates on Wednesday's first panel sought to counter some of this opinion, painting hedge fund investors as not substantively different than others.

"In the recent bear market, hedge funds have outperformed traditional long-only vehicles," said Charles Gradante, managing principal of the Hennessee Hedge Fund Advisory Group. "A large part of the hedge fund investor base is interested in capital preservation; so, hedge fund managers are interested in capital preservation."

Moreover, the failure rate of hedge funds is usually overstated, according to the panelists. Mutual funds are generally quoted as having a 5% failure rate, while some 8% to 14% of hedge funds close each year. But the data are misleading, they argued.

Included in the 8%-14% range are hedge funds that closed simply because it was the only way the manager could make a career move, or were subject to a time limit (some hedge funds automatically close after five or 10 years). Other funds in that calculation are just closed to new capital. In reality, the amount of actual outright failures is about 5% -- no different from that of the mutual fund industry.

The Securities and Exchange Commission launched a formal fact-finding investigation of the industry a year ago. Former SEC chief Arthur Levitt long advocated more stringent regulations on hedge funds, which now enjoy very little oversight. Current SEC Chairman William H. Donaldson has begun to evaluate the industry; this conference is supposed to provide information the SEC can use to determine if more regulation is warranted.

Bad Press

The panelists blamed the negative image many investors have of the hedge fund industry on two factors -- the media, which use phrases like "shrouded in mystery" when talking about hedge funds, and the industry's inability to market its products to the public. The strictures on advertising and marketing effectively prevent investors from gathering information on hedge funds the way they can research mutual funds or stocks, for instance.

But hedge funds are more transparent now than ever, Joel Press, a senior partner at Ernst & Young, noted. "The technology that allows improved transparency in valuation and reporting has helped a lot," Press said.

Another panel was intended to address marketing and distribution of hedge funds, but the debate focused mainly on how much investors should be trusted to make sophisticated decisions.

Hedge funds are excluded from the definition of "investment company" in the Investment Company Act of 1940, provided that they have 100 or fewer investors, or that the investors meet certain minimum standards of investable assets and annual income. For instance, to meet the standards of an "accredited investor," individuals must have at least a $5 million portfolio or have earned $200,000 in income for the past two years and with $1 million to invest.

It's the latter standard that has caused some consternation. When the language was adopted some 20 years ago, it was designed to keep all but the richest investors out of hedge funds. But with inflation and a booming market, those requirements are not so hard to reach any more.

"Whether the accredited investor definition is where it should be is a good question," said Alan Beller, the SEC director of the division of corporate finance. "But that definition reaches across the spectrum of securities law, and affects other investments."

There was little disagreement that the economic standards for hedge fund investing could become more stringent. "Maybe the test ought to be higher to get back to the economic sense indicated by the language 20 years ago," said James Hedges, founder, president and chief investment officer of LJH Global Investments. "It doesn't matter to the industry if the standards are a little higher."

What does matter, though, is the use of wealth as a stand-in for investor sophistication. "I'd rather decouple this notion of investor education deriving from net worth," said Judson Reis, a partner with the Sire Group of Partnerships. "Investors need to be educated about the category as well as the individual product. Those are monumental steps -- not something that just having $200,000 or $300,000 in income will give you."

Panelists agreed that the primary goal was to assess the suitability of investors in hedge funds, but didn't come up with a mechanism for ensuring it. Beller noted that in the U.K. there's an exemption to those countries' equivalent of the law for investors who demonstrate a history of investing experience. "That's out there as an alternate approach," Beller said.

Funds of Funds

The trend toward creating so-called "funds of hedge funds" as a way of giving little-guy investors access to the industry was a repeated theme of day one. "I don't think funds of fund are the solution to the investor's lack of sophistication," one panelist said. "The unsophisticated judge by performance, and if they do that they'll still end up in the soup." To which another panelist rejoined: "Many sophisticated investors simply judge by performance as well."

But while the hedge fund industry does seem to be developing products in the hope of reaching a wider audience, many panelists were skeptical of such a strategy, saying that jittery investors new to hedge funds would jerk their money around and generally create more problems than their business may be worth.

"In a group of unsophisticated investors, there's a very high failure rate in hedge funds -- but that's the same in mutual funds," said David Swenson, chief investment officer for Yale University. "Of the thousands of mutual funds, probably a dozen are worthy of investors' paying higher fees. The rest of investors are better off in index funds."