Editorial Board

Hedge-Fund Ads Might Spawn Frauds Unless SEC Takes Action

Congress probably didn’t mean to turn the $2.3 trillion hedge-fund industry into a breeding ground for fraud when it passed a law designed to make it easier for small companies to raise capital. That may well be the result unless the Securities and Exchange Commission steps in with new rules.

Congress passed the Jumpstart Our Business Startups (JOBS) Act with bipartisan support, and President Barack Obama signed it into law in April. Among its provisions, this misguided piece of legislation allows so-called private placements and hedge funds, lightly regulated private investment pools that serve the wealthy and institutions, to advertise their wares to the public for the first time.

Not only is this a bad idea, it is unnecessary. High-performing hedge funds aren’t having trouble raising money to invest. In September, the last month for which data is available, funds in the top 10 percent as measured by investment returns picked up an additional $10 billion to manage. The bottom 10 percent had an outflow of $6.4 billion.

It isn’t hard to see what lifting the ad ban might lead to: Underperformers will flog their funds on the airwaves, on websites and in the pages of the financial press, aiming at unsophisticated investors eager to get the same fabulous returns as the Wall Street elite.

Protect Investors

Unfortunately, the SEC seems willing to let hedge funds market themselves with no serious constraints on what they say or to whom they say it. About the only restriction that would apply is an existing prohibition on making knowingly false claims.

To protect investors, the SEC should ensure that only accredited investors -- those deemed sophisticated and wealthy enough to assess risks and absorb losses -- can invest in advertised hedge funds. Generally, these investors must meet an annual income or net worth test, currently $200,000 ($300,000 for a couple) and $1 million, respectively. But these financial thresholds haven’t been updated since 1982. Because of inflation, the potential pool of accredited investors may be 20 times larger now than it was three decades ago.

The SEC considered updating these figures in 2007, acknowledging that they are outdated, but it never followed through. To bring the benchmarks up to date, the agency should adjust the income standard to $500,000 for individuals ($750,000 for couples) and net worth to $2.5 million, and then index them to inflation.

In addition, hedge funds should be required to verify investors’ assets or income, perhaps by having a third party review and attest to their financial statements. The SEC also might consider a way of gauging investor sophistication; someone who made millions of dollars in a construction company may know little about financial markets.

The agency can apply the same advertising and marketing guidelines to hedge funds that it already applies to mutual funds, which are among the market participants urging the SEC to act. They would be at a competitive disadvantage if hedge funds could bypass the elaborate set of limitations imposed on mutual funds. For example, mutual funds disclose their fee structure, provide performance metrics based on standardized yardsticks and reveal their underlying investments.

The potential risks to hedge-fund investors are greater because of the funds’ opacity and their compensation structure, which encourages managers to bet big and grab a share of any profits. Many hedge funds hold thinly traded or illiquid investments, making it impossible for investors to withdraw their money on short notice. Rules should require hedge funds to spell this out.

Their advertising materials should also be subject to outside review, perhaps by the Financial Industry Regulatory Authority, the self-policing organization for the brokerage industry, which already has a mechanism for reviewing private placements.

Not Easy

Getting any of this done won’t be easy. The July deadline for the SEC to revise the rules that now bar hedge-fund advertising has come and gone. Complicating matters is the planned resignation on Dec. 14 of SEC Chairman Mary Schapiro, who never pressed for the appropriate oversight of hedge-fund advertising. Her departure leaves the five-person commission split between two Democrats who favor regulating the ads and two Republicans who don’t. The Obama administration can break the deadlock by naming a fifth commissioner who understands the stakes.

Markets benefit when smart oversight enhances transparency and promotes integrity. Allowing unfettered hedge-fund advertising would be a significant move in the opposite direction. Undermining trust in such a manner can make markets less appealing to investors and raise the cost of capital, the opposite of Congress’s intent when it passed the JOBS Act. The SEC has a duty to write the necessary regulations to safeguard the investing public.