U.S. turns up heat on hedge fund industry

Donaldson also pointed out that "funds of funds raise special concerns because they permit investors to invest indirectly in the very hedge funds in which they likely may not invest directly due to the legal restrictions."

While measures of investor net worth may seem high, they have not been updated to reflect today’s price levels. Wealthy Americans are able to buy hedge funds using nominal wealth figures that were established in 1982. "With the sustained growth in incomes and wealth in the 1990s, however, more investors meet this standard, despite recent economic downturns," Donaldson told the Senate panel. He acknowledged that changing this standard would also have an impact on small business capital formation. The same proviso applies to Internet advertising, he said. To maintain their exempt status, hedge funds in the U.S. are forbidden to advertise, lest they be regarded as making a public offering.

"Just plugging the term ‘hedge fund’ into any search engine will elicit hundreds of responses," Donaldson added. "If hedge fund sponsors fail to follow the law, every investor with access to the Internet could easily obtain materials that could constitute an offering of securities to the public, triggering registration and other requirements under securities law."

Donaldson expressed concern about an "apparent increase in reported fraud involving hedge funds."

Still, Donaldson was not negative on hedge funds in general. He expressed concern about potential conflicts of interest for a fund manager guiding both a mutual fund and a hedge fund who receives performance fees from the hedge fund. But, he said, "I stress that these types of potential conflicts are the same as those that exist for any investment advisor that manages both registered investment companies [mutual funds] and private client accounts."

Hedge fund fraud

Donaldson also said that fraud investigations by the SEC were on the rise, having doubled last year. "I emphasize that I do not intend to imply that hedge funds or their managers generally engage in nefarious or illegal activities," Donaldson told the panel. "I have no reason to believe that fraud is more prevalent in hedge funds than it is anywhere else."

Donaldson cited a number of examples of charges filed by the SEC, including false statements in offering documents, misappropriation of assets, market manipulation, false performance reporting and insider trading.

He acknowledged that the charges are not unique to hedge funds. However, "because hedge funds typically are not registered with us, we are limited in our ability to detect problems before they result in harm to investors or the securities markets."

So far, the SEC has made inquiries of 67 hedge fund managers running 650 funds with $162 billion in assets under management. In his testimony, Donaldson repeated estimates that there are as many as 5,700 hedge funds in the U.S. with $600 billion in assets under management.

As a measure of the range of hedge fund firms, Donaldson said, "The staff talked to brokerage, compliance, risk management, legal and other operational personnel of multi-billion dollar complexes with dozens of employees, as well as to their portfolio managers. At the other end of the spectrum, the staff visited hedge funds where one employee serves as marketer, portfolio manager, trader, operations officer and risk manager."

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Look for more hedge fund coverage in June when the next issue of CanHedge arrives, bundled with Advisor’s Edge. CanHedge will delve into hedge fund strategies, risk management and low-minimum hedge funds for retail investors. Click here for more information about CanHedge.

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Filed by Scot Blythe, Advisor.ca, sblythe@advisor.ca.

(04/17/03)