Two rating agencies, Moody's Investors Service and Morningstar ( MORN), plan to launch divisions early next year to evaluate hedge fund risk and performance. The initiatives come amid a period of relative glasnost within the secretive industry. Starting in February, the Securities and Exchange Commission will require most hedge fund advisers to register with the agency and subject themselves to random audits. "We're hoping to create a rating system by the end of the first quarter," says Morningstar analyst John Reckenthaler. He works for Ryan Tagal, who heads up a hedge fund database group launched by Morningstar last year. With hedge funds getting more popular, and with horror stories of fraud occasionally seeping into the public's consciousness, wealthy and institutional investors alike are demanding more transparency. "Investors want it," says Lisa Tibbitts, a Moody's spokeswoman. "There is a demand for it, especially in the context of very visible and high-profile failures as well as the changes with the SEC." While the launch of the Moody's and Morningstar projects happens to coincide, their approach is different. Moody's plans to focus on the operational risk of funds, looking at things like the liquidity of their investments and quality of management. Morningstar is likely to rate funds based on their performance, as it already does for mutual funds. Another key difference is the customer. In Moody's case, hedge funds will pay for the service, the way debt-issuers pay both Moody's and S&P for opinions on their bonds. At Morningstar, investors will foot the bill. "We are going to look at the downside risk: what is the likelihood that something really wrong would happen?" says Moody's Gary Witt, who has been heading the project. Witt says his group is reviewing a list of 50 hedge funds that have run into trouble due to bad valuations, poor auditing, shoddy administration and other factors.