Hedge funds have recently attracted quite a bit of publicity, most of it unfavorable, and the Securities and Exchange Commission is holding hearings and considering substantial new regulations. As an industry insider -- I've managed a hedge fund for more than four years -- I'd like to share some thoughts on what changes are -- and aren't -- necessary.

Systemic problems?
Given the recent well-publicized difficulties of a number of high-profile hedge funds, one might legitimately ask whether there is a systemic problem that needs to be addressed. I don't think so, and no less an authority than New York Attorney General Eliot Spitzer, who has severely sanctioned the investment banking industry and is now looking into hedge funds, agrees with me. He commented last month at a hedge fund forum: "By and large, the problems with investment banking were structural. Hedge funds do not demand structural change."

Spitzer did, however, raise concerns about hedge funds' use of leverage, short selling, how their portfolios are valued, and to whom they are marketed. I share his concerns and have some ideas about how to address them.

Leverage
When a hedge fund implodes, it's usually not simply due to some investments going sour -- this happens to everyone -- but rather the excessive use of leverage. For example, an article in yesterday's Wall Street Journal explained how John Koonmen, manager of the Eifuku Master Trust, a Japan-based hedge fund, lost nearly all of his investors' money in a mere seven trading days:

"Mr. Koonmen had at least $1.4 billion in just a few positions at a time when the capital in his fund was down to $155 million, according to copies of monthly statements sent to investors. Given the size of Mr. Koonmen's few positions and that they were largely financed with borrowed money, when the market moved against Eifuku in early January, it did so with a vengeance."

A highly concentrated portfolio, combined with nearly 10:1 leverage (10 borrowed dollars for every dollar of invested capital), is a recipe for disaster. But regulations limiting the amount of leverage or concentration are not the answer. Some investors may want a highly leveraged or very concentrated portfolio -- after all, Koonmen's fund reported returns north of 70% in 2002, so if one was fortunate enough to cash out at the end of the year, it was a great investment. The key is adequate disclosure: As long as sophisticated investors are fully informed, then caveat emptor (more on this below).

Short selling and market manipulation
Private investment partnerships, the technically correct term, got the name "hedge funds" because many (though certainly not all) of them short stocks to hedge against a declining market or sector. In contrast, few mutual funds ever short stocks, so when one reads about a company "under attack" by short sellers, it's usually hedge funds that are behind this. It sounds positively un-American to profit from a stock declining, doesn't it? In fact, I think short sellers -- especially those willing to go public with their analyses -- are critical to healthy markets.

Spitzer agreed when he said last month: "I am not saying anything critical of short selling. It has nearly always been an aspect of our marketplace that has been useful and beneficial. The people who first highlighted the problems at Enron were short sellers. Those under the microscope want to redirect attention away from themselves." (The last sentence is especially true, as one study showed that the stocks of companies that waged public battles with short sellers lagged the market by 2.34 percent per month for an entire year after the battles began -- clear evidence that shorts are generally raising legitimate issues.)

Yet companies that are targets of short sellers often claim that they're targets of market manipulation. Here's what a case of market manipulation would look like: One or more investors identifies a company that appears vulnerable to attack, perhaps because it has dense financial statements or is in an out-of-favor or complex industry. Then, the manipulators concoct a story, knowing that it is false or misleading, but by mixing in just enough truth, it appears credible.

At the same time, they establish a bearish position in the stock by shorting it, buying puts, etc. Then, to get the story out, the manipulators start spreading rumors, leaking stories to gullible members of the media, and so forth (under no circumstances do the manipulators reveal themselves publicly because then their scam might be exposed). Finally, if they are successful in spreading their lies and the stock drops, they quickly cover their positions for a nice profit.

Regulators should aggressively prosecute such unethical and illegal behavior. Fortunately, laws to do so are already in place, so no new regulation is necessary.

Portfolio valuation
One of the biggest advantages that hedge funds have over mutual funds is their ability to invest in any type of security, including ones that are very thinly traded. For example, let's say a hedge fund owned a January 2005 call option on IBM (NYSE:IBM) with a $50 strike price. This option does not trade frequently and last traded at a price of $31.50. However, since the last trade and number of days ago the stock has declined such that the bid-ask spread as of yesterday's close was $28.50 by $29.50. The value of the option is obviously no more than $29.50, but if it were December 31st and the hedge fund's portfolio was being valued so that the 20% profit allocation could be determined, how would the option be priced? Based on the last trade? The bid? The ask? The midpoint of the two?

There's no right answer -- and this is the most simple example I can think of. Now, imagine an entire portfolio filled with esoteric and/or illiquid securities. You can see the issues and potential for abuse, can't you?

I think the solution is to require hedge funds be audited each year -- almost all already are -- and for the auditors to independently verify the valuations that the manager assigns to the fund's positions. In the past auditors seemed willing to accept, within reason, whatever valuations the fund managers established, especially since many partnership agreements give managers this right, at least in the absence of a liquid market. But fortunately times have changed, and my experience is that auditors are more rigorous and willing to challenge managers.

Hedge funds for the masses?
As it always does, Wall Street is rushing to meet the demand from the investing public for whatever is hot by creating hedge fund "funds of funds" that pool investors' money and invest it in various hedge funds, for a hefty fee of course. I wouldn't have a problem with this, except that some of these funds are attracting small investors by setting minimums of as little as $25,000 and waiving the requirement that investors be accredited according to the same criteria that govern hedge funds (usually $1 million of net worth or $200,000 of annual income).

The "retailization" of hedge funds is a bad idea. The average hedge fund's incentive structure, lower degree of regulation, and ability to use leverage and invest in esoteric securities makes it substantially more risky than the average mutual fund -- and thus inappropriate for the average investor. If anything, I think the accredited investor test should be strengthened to, say, $1.5 million of net worth or $300,000 of annual income. This is not snobbery, the fact is that people meeting these criteria are far more likely to be able to withstand the financial loss should a fund blow up.

The fundamental problem that needs to be addressed in the hedge fund industry is lack of disclosure. Too many funds are "black boxes" -- they do not reveal to prospective or even current investors meaningful information about their holdings or activities. To address this, I think that hedge funds should be required to reveal at least once a year the following information:

  • leverage (both at the time of the audit and the maximum amount used at any point during the year);

  • number of positions; percentage of the portfolio in each of the top 10 positions and specific identification of these holdings (or, if there's a good reason not to reveal the name, a description such as "major international restaurant company");

  • and a breakdown of the portfolio by asset type, market cap, and industry allocation.

Finally, if any holdings are valued by the manager, rather than the last trade in a liquid market, this should be noted and explained.

Whitney Tilson is a long-time guest columnist for The Motley Fool. He did not own shares of the companies mentioned in this article at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback on the Fool on the Hill discussion board or at Tilson@Tilsonfunds.com. The Motley Fool is investors writing for investors.