Financial regulators yesterday rejected calls for more direct oversight of hedge funds and said that the current system for preventing market collapse and widespread investor losses is "working well" in their first policy statement on the issue in eight years.
Hedge funds are loosely regulated pools of private investment designed for wealthy individuals and institutions. Nearly 9,000 of the rapidly growing funds control more than $1 trillion in assets. On a given day, the funds may account for a third of the trading volume in major U.S. stock exchanges, according to industry estimates.
The funds' outsized returns are drawing interest from pension funds and less-well-heeled investors -- and concern from investor advocates and analysts who fear that excessive borrowing and risky trading bets by the funds could induce instability in the market.
The unanimous policy directive by the President's Working Group on Financial Markets comes weeks after pressure from allies in Europe and elsewhere to pay heightened attention to the hedge fund sector. Led by Germany, the Group of Seven nations pressed for more vigilance in policing the funds earlier this month. On Tuesday, Canadian authorities proposed forcing hedge fund managers in that country to register with regulators.
The approach in the United States has been far less direct. The Securities and Exchange Commission tried to impose a similar registration requirement in 2004, only to see it struck down by a federal appeals court as overreaching. The SEC is considering a separate proposal to raise the minimum net worth that would allow an individual to invest in a hedge fund to $2.5 million from $1 million.
The strategy set out by the working group, made up of the heads of the SEC, Treasury Department, Federal Reserve and the Commodity Futures Trading Commission, places the greatest onus not on hedge fund managers but on sophisticated investors, banks that lend vast streams of money to the funds and brokers who process their trades.
To protect themselves, wealthy investors should evaluate a fund manager's experience, disciplinary history and potential conflicts of interest, the six-page policy statement said. Managers of pension funds should perform due diligence and ensure that their portfolios are properly diversified before investing in the funds. Investors including pension funds lost more than $6 billion in last year's collapse of hedge fund Amaranth Advisors.
Since June 1999, the SEC has filed more than 100 enforcement cases against hedge funds or their advisers over securities-law violations, according to public records.
Still, Treasury Secretary Henry M. Paulson Jr., chairman of the working group, expressed reluctance to tamper with an innovative industry that has created billions of dollars in wealth and liquidity. In an interview with Bloomberg television yesterday, Paulson said that regulators do not have the ability or the desire to shield all investors from suffering losses, preferring to let the market operate without undue meddling from overseers.
In a separate interview, SEC Chairman Christopher Cox stressed that lenders and brokers, who are regularly policed by the Federal Reserve and the SEC, should monitor their tolerance for risks and losses.
The report stopped far short of creating any new rules, such as the imposition of limits on lending to hedge funds or barring their fast-moving trading strategies.
The Managed Funds Association and the Coalition of Private Investment Companies, the hedge fund industry's chief trade groups, said regulators had achieved an appropriate balance between oversight and preserving the funds' entrepreneurial benefits.
But former SEC commissioner Harvey J. Goldschmid, who had supported the agency's thwarted bid to register fund managers, expressed concern that regulators lack the authority to perform random inspections of fund operations.
In Connecticut, home to scores of hedge funds, Attorney General Richard Blumenthal criticized the recommendations as vague, insubstantial and "unenforceable."
"Opaque is the operative word for these investment pools . . . and these guidelines will do virtually nothing to make them more transparent," said Blumenthal, who created a unit last year to police the funds. "Federal inaction and inertia will invite -- indeed, fuel -- state initiatives."
House Financial Services Committee Chairman Barney Frank (D-Mass.) issued a statement calling the report "a first step" and pledged to invite the group's leaders to testify at a hearing this spring.