Hedge Fund Heaven

To the average investor, the hedge fund industry is wrapped in the mystique and cache that accompanies membership in the highest and most reticent echelons of society. Its leaders are rich and powerful, and only a handful of wealthy individuals have access to them.

This is all about to change. The recently passed JOBS Act paves the way for hedge funds to advertise on billboards and television channels across America.

How a hedge fund becomes a law
From a regulatory perspective, hedge funds are an interesting animal -- more akin to an unbridled wildebeest than, say, a high-performing thoroughbred.

In theory, ownership interests in these risky investment vehicles should be regulated under the Investment Company Act of 1940. From the hedge fund industry's perspective, however, this act was passed to instill confidence in the then-nascent and sleepy mutual fund industry following the stock market crash of 1929. Legislators at the time certainly couldn't have foreseen how sophisticated these funds would eventually become -- or so the thinking goes.

Most hedge funds exploit one of the act's many loopholes to avoid its ostensibly oppressive restrictions on redemptions, leverage, and incentive compensation. Namely, a hedge fund can avoid regulation so long as it doesn't advertise to the public at large and limits the number and net worth of its investors.

Fund Type

Maximum Number of Investors

Investor Net Worth Requirement

Oversight

Advertising Allowed?

Mutual Fund Infinite N/A Regulated Yes
3(c)1 Hedge Fund 100 $1 million Unregulated No
3(c)7 Hedge Fund 500 $5 million Unregulated No

Sources: Investment Company Act of 1940 and SEC Regulation D. N/A = not applicable; mutual funds have no investor net worth requirement.

Here comes the fraud
The JOBS Act transforms this landscape. It removes the ban on advertising and increases the maximum number of qualified shareholders. The net result is that hedge funds are now free to both grow larger and solicit investors from a wider audience.

Although the hedge fund industry's trade association argues that the ability to advertise private offerings is "an action whose time has come," there are reasons for investors to be alarmed. In 1992, for instance, the SEC unilaterally relaxed the ban on advertising an analogous class of non-regulated securities, only to reinstate it seven years later after uncovering numerous cases of unsophisticated investors being duped by misleading advertising.

This would be less of a concern, of course, if hedge funds were prudent investment vehicles. But the reality is that they aren't. Not only are they extremely risky, they also charge monstrous fees. It's estimated that from 1998 to 2010, hedge funds collected $324 billion in fees while losing their investors $308 billion.

As we noted in our letter to the SEC:

A simple Google search turned up a website titled accreditedinvestorlists.com, which sells state-by-state lists of accredited investors by email, phone number, and physical address. In Utah, for example, this company's list already includes 21,032 physical addresses, 1,573 email addresses, and 1,606 phone numbers. Numerous other websites from investormarketinglists.com to ethnictechnologies.com helpfully break the information down into lists by ethnicity, gender, and lifestyle -- presumably to make is easier for scammers to relate to marks -- and, ominously, "seniors."

Hedge fund hell
At the end of the day, allowing inherently risky and underperforming investment vehicles to advertise is asking for trouble. It's for this reason that we've asked the SEC to tighten the definition of who can invest in a hedge fund, lay out how investor eligibility must be determined, and articulate what these funds must disclose in advertisements.

Let the SEC know how you feel about the JOBS Act by following this link. Simply tell them you're an individual investor and feel free to share your concerns or suggestions.

Click here to read how the JOBS Act walks back the Frank-Dodd Act.

Fool contributor John Maxfield owns no shares of any companies mentioned above. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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