Hedge Fund Registration Canard

So now the SEC wants to require hedge funds to register. Great. I suppose that now we'll enjoy the same protection against hedge fund abuses that we have against those of corporations and mutual funds. Somehow this tendency toward after-the-fact protection displayed by the SEC the last few years does not give me much comfort.

Pardon my cynicism. I'm just not sure what comfort this is supposed to offer individual investors. In fact, for some hedge funds, I think the last thing investors need is a tacit imprimatur of legitimacy bestowed by registration with the SEC. After all, there are exactly zero licensing requirements or competency tests required for people who set up hedge funds. At the Berkshire Hathaway (NYSE: BRKa  ) annual meeting in 2001, Warren Buffett told an apocryphal story of one of his friends, who had never shown any aptitude for investing, coming to him for advice in setting up a hedge fund. Buffett, understandably, was not hopeful for the outcome for the assets people entrusted with this gentleman.

SEC to the rescue
The SEC issued a report on Monday (Adobe Acrobat required), following up on its findings from hearings back in May. In this report, the commission stated that 1) hedge funds have grown rapidly in size and in market influence in the last few years, 2) the number of enforcement cases against hedge funds has risen, and 3) a lack of registration and audit controls makes it difficult for the SEC to uncover fraud or wrongdoing.

Certainly, the number of hedge funds has skyrocketed. It's estimated that between 6,000 and 7,000 are in operation -- about as many as there are common stocks on the exchanges. And hedge funds have taken on substantially higher levels of assets under management in the past few years -- again, SEC estimates put the amount at $600 billion-650 billion. That's a whole lotta clams, until you recognize that it is still about 6% of the total market capitalization of the major US indices. Mutual funds and pensions control much, much more. In fact, one of the main growth drivers for hedge-fund assets is that institutional managers have placed billions with them.

This report is a long, long way from becoming the law of the land. Still, I've got to question whether this is little more than a feel-good measure, and more importantly, whether the SEC is actually capable of providing the oversight that such registration would require. After all, during the debate on the Sarbanes-Oxley Act for better investor protection, the SEC stood on every rostrum it could and pleaded poverty, overwork and insufficient resources.

What would registration change?
Given the long list of potential changes, hedge funds are breathing easier with this SEC report. Registration is band-aid therapy. And as for the potential for audits by the SEC, let's just say that it was a state Attorney General who sniffed out the market-timing scandal at mutual funds; this isn't exactly a level of scrutiny that has the hedgies shaking in their boots.

It wasn't the SEC that dropped the bomb on Janus (NYSE: JNS  ) , or Bank of America (NYSE: BAC  ) , or J.B. Oxford (Nasdaq: JBOH  ) for their roles in the scandal. It was Eliot Spitzer. Nor did the SEC beat Spitzer to the punch in filing charges against Wall Street analysts at Merrill Lynch (NYSE: MER  ) , Goldman Sachs (GS), UBS (NYSE: UBS  ) and other investment banks.

And the SEC sure as heck didn't shut the barn door on Enron, WorldCom, Tyco (NYSE: TYC  ) , Qwest (NYSE: Q  ) , or a host of others that ginned up their financial statements until the cows were long gone. None of the regulations on the books protected investors from losses in the billions. Think hedge fund registration would solve anything?

In fact, it would seem that this move would do little more than create an additional moral hazard at the hands of our regulatory bodies. There should be no doubt that there are some bad folks who are running hedge funds in an illegal fashion. The stories at Canary, and Mark Yagalla are if nothing else, disgusting and yet another sign of decay of the moral fabric that holds the American markets together. What does a registration form accomplish?

What I fear is that it will accomplish the opposite of what the SEC wants -- it will give all hedge funds an aura of legitimacy, and the SEC once again will be inadequate in its proactive efforts to protect investors. Moreover, would increased oversight by the SEC have done anything to protect investors from the collapse at Long-Term Capital Management, Mark Yagalla, Eifuku, or the 5% of hedge funds (or perhaps higher) that collapse each year?

A look on the bright side
Of course, there are positive elements to this. Hedge funds, once the province of the accredited investors -- have gone further and further into recruiting the retail investor. We can debate whether or not "wealthier" equals "more sophisticated" until the cows come home. But there should be no doubt that many retail investors still rate mutual funds based on only one element: past performance. Additionally, registration could allow investors to see a disclosure of the investment manager's potential conflicts of interest, whereas today there is no outlet for such disclosures unless the manager voluntarily makes them.

But this is no panacea, and if the SEC's recent history of failure to prevent is taken as evidence, it isn't even much in the way of protection. The SEC already gets involved when a client of a hedge fund feels he has been ripped off. The SEC has the authority to investigate, to call hedge fund managers onto the carpet today. Legal recourse for wrongdoing already exists, and one of the channels for complaint is the SEC.

What does registration change? Until we see a general ability by the SEC to head scandals off at the pass before they harm investors, I'd suggest that the answer is "very little."

Fine pewter portraits of General Apathy and Major Boredom singing "whatever and ever, amen." Bill Mann owns shares in Berkshire Hathaway. For a complete list of his holdings, please consult his profile. The Motley Fool is "investors writing for other investors."


Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 493250, ~/Articles/ArticleHandler.aspx, 11/26/2014 8:15:56 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement