Commentary: Four Ways to Limit the Damage Hedge Funds Can Do

Here we go again -- another hedge-fund scandal. These investment vehicles for the wealthy engage in cutting-edge, highly leveraged trading strategies to generate superior returns. But their trading can be, well, a bit too aggressive -- so much so that it puts them into periodic conflict with regulators. That is, when the hedge funds are caught. Fund managers say the kind of trading employed by Canary Capital Partners LLC, which may have profited at the expense of mutual-fund investors, has been used by various hedge funds for years.

So what can be done to rein in hedge funds? Quite a lot -- if the Securities & Exchange Commission, which has been investigating the industry, has the will to do so. Some fund managers themselves recognize that the $700 billion industry is crying out for some selective policing to eliminate the bad apples. "What's needed is sparing and smart regulation," says Harry Strunk, a longtime fund consultant who runs Aspen Grove Capital Management LLC, a hedge fund that invests in other hedge funds.

Here are some steps to address the ills of hedge funds, both for the sake of their customers and the market:

REGISTRATION

  At a minimum, hedge fund managers should register as investment advisers, an idea being mulled by the SEC. Registered managers are required to open their books to regulators for periodic, sometimes unannounced inspections. Such spot checks may turn up red flags, such as evidence of rapid-fire trading of the kind conducted by Canary, an SEC official observes. The fund wasn't registered with the SEC or any state, but industry estimates show that some 70% of hedge fund managers are already registered with federal or state regulators.

DISCLOSURE

  Hedge funds should also confidentially disclose their trading strategies, and use of borrowed money, to regulators and their investors. Investors now get little information from fund managers -- something that proved to be disastrous at Long-Term Capital Management, whose highly leveraged trading strategies almost blew a hole in the financial system in 1998. Representative Richard H. Baker (R-La.), chairman of the House capital markets subcommittee, recently endorsed more disclosure. He should push for it.

INCOME REQUIREMENTS

  SEC Chairman William H. Donaldson has correctly decried the widespread mass-marketing of hedge funds. Just 10 years ago, says one fund manager, they were almost exclusively marketed to multimillionaires, "and if they were ripped off, who cared about that?" But now, many fund investors barely meet the regulatory requirement -- earnings of least $200,000 a year or a net worth of $1 million. The SEC should ratchet up those numbers, established back in 1982, to ensure that fund investors have the financial stamina to put their money into such potentially risky vehicles.

TRADING CURBS

  After the LTCM fiasco, a move to restrict or at least quantify the use of borrowed funds quickly fizzled. The SEC should take a fresh look at curbs on leverage and also specifically outlaw the kinds of trading that unfairly disadvantage other investors, such as the mutual funds in the Canary case.

All this would go well beyond the steps currently contemplated by the SEC. But one kind of regulation that should be avoided is any effort to coddle investors who can afford to play the hedge-fund game. Sure, fund prospectuses are a minefield of excessive fees and onerous provisions such as multiyear "lock-ups" in which investors can't get their money. Some fund practices that hurt both investors and the market should be curbed. One example: managers paying themselves performance fees based on their quarterly and not yearly performance. That encourages aggressive short-term trading that can be destabilizing.

The hedge-fund industry is right that their investors are generally sophisticated and able to look out for themselves. The SEC doesn't need to wield a hatchet -- but it should look out for the rest of us.

By Gary Weiss

With Amy Borrus in Washington

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