Regulatory Status of Hedge Funds

Fraud, high-profile collapses, and the increasing size of the industry, may be reasons why the SEC is adopting stricter control over hedge funds. Historically, hedge funds have operated largely outside of government control. They have not been required to register with the SEC or adhere to many of the rules that apply to mutual funds. This results in decreased safeguards for investors and increased flexibility in making investments.

Investors in mutual funds enjoy certain protections that do not apply to hedge funds. For example, hedge funds are not required to provide any guarantees on liquidity or redeemability of the investment, and one condition on investing may be that you cannot withdraw your investment for over a year. There are also no guarantees on fair pricing of the fund shares. Also, because of the veneer of secrecy surrounding them, hedge funds are opaque, and are not required to disclose business practices to their investors. They are also not required to disclose their holdings, fees, or performance. This makes it difficult for investors to review the fund and determine if it is a good investment or a reckless one. Investors should take comfort, however, that the SEC’s protection against securities fraud still applies.

Hedge funds are allowed to make almost any conceivable investment, in contrast to mutual funds, which have to abide by many regulations. For example, mutual funds are limited in their use of leverage; not so with hedge funds, which can borrow up to hundreds of billions of dollars. When Long-Term Capital Management went under, the firm had 4.72 billion dollars in equity, but had leveraged an additional 125 billion dollars. Additionally, hedge funds are not restricted in how much they can invest in a single venture, nor are they restricted by concerns about conflict of interest.

In December 2004, the SEC adopted the Investment Advisors Act, requiring hedge funds operating assets of more than 25 million dollars to register by February 1, 2006. This will enable the SEC to deny registration to unqualified managers or those with a criminal record. It will also subject hedge funds to some of the same regulations governing mutual funds, such as implementation of a code of ethics and preventing the fund from misusing personal information about its clients.

The new legislation may not have a significant effect on the tactics of hedge funds, as the SEC says it does not have the staff or the inclination to actively monitor the internal practices of every hedge fund, and has given such assurances to hedge fund managers. Primarily, they will be looking into irregular trading practices that threaten investors and the financial stability of the marketplace.