Hedge Funds Defend Their Turf

Updated from 3:05 p.m.

The hedge fund industry argued Thursday against charges that its investment strategies cause market upheaval and put small retail investors at a disadvantage.

During a conference held by the Securities and Exchange Commission to help determine whether hedge funds warrant more regulation, panelists argued that the risks present in the market aren't necessarily related to the strategies employed by these funds.

Much of the market volatility comes from individual investors' behavior, the panelists said. Risks, they said, can be mitigated by investor education rather than regulation. Skittish and uninformed investors are more likely to roil the markets than hedge funds are, the panel argued.

Hedge funds aren't subject to the same strictures that regulate mutual funds and other retail investments, as hedge funds are generally excluded from the definition of "investment company" in the Investment Company Act of 1940. To be excluded from that category, hedge funds must have 100 or fewer investors, or require that investors meet certain minimum standards in terms of investible assets and annual income. But those minimum standards were set some 20 years ago, and thanks to inflation and the recent bull market, far more "average" investors are able to invest in hedge funds than originally intended.

The broader investor base, as well as some spectacular hedge fund failures, prompted the SEC to launch a formal fact-finding investigation of the industry a year ago. This week's two-day conference is supposed to provide information that the SEC can use to determine if more regulation is warranted.

Risky Business

Hedge fund advocates argue that it's up to the investors to do their homework on risks. "Each style of hedge fund carries its own unique risk that can't be measured by volatility. You can't explain that to an unsophisticated investor. Most of them can't get the blinking 12 on their VCRs to stop," said Andrew Lo, professor of finance at the Massachusetts Institute of Technology.

William Heyman, chief investing officer of the St. Paul Companies, added, "Risk is like energy. It can change form but it can't be eliminated."

To further the advocates' argument, Peter Brown, executive vice president of Renaissance Technologies, compared hedge funds to stocks. "The median volatility of hedge funds is half that of stocks," he said. "The median volatility of a fund of hedge funds is one-quarter that of the S&P 500. Using an objective measure of risk, hedge funds are less risky."

Indeed, while hedge funds emerged from the dot-com bubble relatively unscathed, mutual funds took the hardest hit. "This is one of my favorite statistics. Eighty-five percent of all the money in technology mutual funds came in after January 2000," Heyman said. In other words, investors made a bad move, and they might benefit from access to the tactics employed by hedge funds, because the managers have a plethora of strategies to exploit market inefficiencies.

The panelists argued that regulation won't minimize hedge fund disasters, which are generally thought to agitate the markets. "Most blowups are operational issues and could be prevented by auditors," said Lawrence Harris, chief economist and director of the SEC's office of economic analysis. "We should be able to rely on an intermediary such as the accounting profession to provide some risk-control measures."

Flip Side

Nonetheless, even institutional investors comfortable with investing in hedge funds would like greater disclosure requirements.

"There certainly should be a basic minimum of disclosure required," said Mark Anson, chief investment officer for Calpers, the California Public Employees' Retirement System, the nation's largest public pension fund. "Right now, it's all over the board."

That's not to say that Anson advocates heavy regulation, though. Regulating hedge funds to the extent that they're forced to disclose specific positions will only hurt the performance of the fund, he said. "And that doesn't help me as an investor."

Likewise, Sandra Manzke, founder and co-chief executive of Tremont Advisers, an advisory and research firm for the hedge fund industry, also would like to see increased disclosure, without revealing each position.

"Wouldn't it be nice to have a database like Morningstar's for hedge funds?" Manzke asked the panel. Tremont has something of a similar database, but all manager contributions to it are voluntary and therefore often sporadic. "We'd like there to be a place people can check the background of the managers, the auditors of the fund, any changes in auditors, and to trail some of the people in the industry."

Mankze echoed a complaint raised several times throughout the conference: that there are virtually no standards in becoming a hedge fund manager. "I do find it odd that you need to pass exams and acquire a license to be a broker or sell insurance, but to be an investment manager all you need to do is fill out a form and 45 days later you're in business," she said. "That could help reduce fraud in some of the smaller funds, where someone raises $1 million to $5 million from smaller investors and ends up duping them."

Not surprisingly, most panelists vociferously disagreed, arguing that the free market should set disclosure requirements. "These are not public products; no one's forcing people to buy them," said one panelist. "If they can't get an answer as an investor, they should take their money elsewhere."

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