SEC Hedges on Funds

Once again, the Securities and Exchange Commission (SEC), in a hotly contested battle, chose to force more regulation on the fund industry. Normally, I'm not much for more government involvement in anything, but yesterday's 3-2 vote in favor of requiring hedge funds to register with the SEC appears to be a welcome addition to the recent decision that forced mutual funds to appoint independent boards.

The new rules, which are subject to a 60-day comment period, would require hedge funds with more than $25 million in assets to detail their holdings, reveal the names of their advisors, and provide other information about how they operate. You can expect regulators will get an earful during that time -- the majority of the hedge fund industry opposes the reforms. They have powerful allies, too, including none other than Federal Reserve Chairman Alan Greenspan. (Although, ironically, an estimated 40% of hedge funds have already registered with the Feds.)

Hedge funds operate differently from mutual funds. Most notably, they are generally reserved for high-net-worth clients, with $1 million or more in net assets. Theoretically, the limit is intended to keep the funds out of the hands of those who can't afford to lose money. And hedge funds can lose. Big.

The reason is that hedge funds make many risky bets. Instead of buying and holding rocks like McDonald's (NYSE: MCD  ) , Starbucks (Nasdaq: SBUX  ) , and Wal-Mart (NYSE: WMT  ) , hedge funds rely on highly speculative stocks, arcane instruments such as futures and derivatives, and technical tricks such as short-term trading of mutual funds to goose returns. The risks can lead to huge rewards or high-profile flameouts, such as the collapse of hedge fund Long-Term Capital Management in 1998.

So, what's so good about the proposed reforms? See the paragraph above. Hedge fund Canary Capital Partners played a key role in stealing money from mutual fund investors. SEC Chairman William Donaldson in lobbying for the proposed reforms said his agency has brought 46 fraud cases against hedge funds in the past five years. And in its recent investigation of the mutual fund industry, the SEC has determined 46 hedge funds engaged in abusive trading not unlike that which got Canary in trouble.

Of course, these reforms are by no means perfect. They may not curb future abuses. In fact, the SEC has a lousy record when it comes to catching stock market crooks. Bankruptcy ultimately claimed Enron. And it was New York attorney general Eliot Spitzer, with some help, who finally put the screws to the mutual fund industry.

Indeed, the time for hedge fund registration has come because much of the industry is already doing it. And, really, with the way hedge fund abuses have piled up over the last five years, can anyone be surprised the SEC finally decided to do something? Of course not. It's time to move on.

Not sure whether your funds are on the up and up? Not to worry. Shannon Zimmerman ofMotley Fool Champion Fundscan help. Give his newsletter a try for 30 days, risk-free.

Fool contributor Tim Beyers wishes his net worth was high enough to experience hedge fund investing. Maybe someday, right? Tim owns no interest in any of the companies mentioned, and you can view his Fool profile here.


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