Hedge fund report finds improved disclosure, but there are still some concerns

Date: Tuesday, February 26, 2008
Author: Nicholas Rummell, Financial Week.com

 A long-awaited report on hedge fund risk management and transparency released today found that although the secretive investment vehicles have improved their disclosure practices in recent years, they still warrant regulatory scrutiny.

The report by the Government Accountability Office, which was requested in June 2006, found hedge funds have increased transparency, tightened credit standards and instituted greater due diligence since the collapse of Long-Term Capital Management in 1998. The GAO cited industry guidance and best practices as the catalysts for improved hedge fund disclosure.

However, financial regulators such as the Securities and Exchange Commission and the Commodity Futures Trading Commission “remain concerned” about large Wall Street firms’ reliance on counterparty credit risk management to control hedge fund risk. Furthermore, obtaining hedge fund information can be difficult because the funds often use multiple prime brokers and often decline to share information about specific positions.

Hedge fund managers often contend such data constitutes trade secrets and need to remain confidential.

The SEC does not regulate hedge funds, but under the Investment Advisers Act, it regulates many hedge fund advisers, who manage assets at the funds. The SEC oversees just shy of 2,000 hedge fund advisers, and other hedge funds fall under the agency’s purview from time to time when they purchase more than 5% of a company’s stock. In 2006, the SEC proposed rules to boost hedge fund registration, but that rule was struck down on procedural grounds in federal appellate court.

Since then, the SEC has formed an insider trading working group, which is examining hedge funds and other investment vehicles for potential violations of anti-market manipulation and prime brokerage rules.

The CFTC regulates hedge fund positions in commodities, though that failed to prevent the collapse of hedge fund Amaranth in late 2006 due to excessive natural gas trading.

Reps. Paul Kanjorski (D-Penn.), Michael Capuano (D-Mass.) and Barney Frank (D-Mass.)—the three senior Democratic members of the House Financial Services Committee who originally requested the report—want the GAO to look further into hedge fund risk disclosure. They said last year’s guidance published by the President’s Working Group on Financial Markets needs to be scrutinized, as do recent shifts in investment and risk. “We must,” Mr. Kanjorski in a statement, “remain very watchful in this field.”

An additional GAO report on pension funds’ exposure to hedge fund risks is expected in the coming months. The three lawmakers said they would wait for that report before deciding whether further legislation is needed.

Experts peg hedge fund assets at more than $2 trillion, a major increase over the $200 billion managed in 1998. But since hedge funds are so secretive, that number may be an over- or underestimation.