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U.S. brokers probed over hedge funds

Date: Thursday, August 18, 2005
Author: OTIS BILODEAU - Bloomberg News

WASHINGTON -- The U.S. regulator that polices 5,200 brokerages is concerned brokers may be seizing on the popularity of hedge funds to take advantage of non-professional customers, and is investigating the sales practices at some of Wall Street's biggest firms.

The National Association of Securities Dealers, or NASD, sent letters in June to about 10 firms, including Citigroup Inc., Merrill Lynch & Co. and UBS AG, people familiar with the probe said. The NASD asked the firms what warnings they gave investors when selling hedge fund products with minimum investments of $50,000 (U.S.) or less and whether they paid brokers sales incentives.

The NASD said in its letter that the probe "should not be construed" as a sign that investigators have concluded that the firms violated rules or securities laws. Bloomberg News obtained a copy of the June 22 letter.

The investigators are looking for evidence that the companies preyed on non-professional customers by inducing them to make unsuitably risky or expensive investments. Most hedge funds, which are private partnerships that bet on rising and falling prices and often use borrowed money to boost returns, are limited to the wealthy or institutions and require investments of at least $1-million.

"These are not very sophisticated investors and these are very complex investment pools, so you'd really want to know whether the disclosures were sufficient," said Robert C. Pozen, 59, chairman of MFS Investment Management in Boston, a mutual fund manager with about $150-billion in assets.

Shannon Bell, a spokeswoman for New York-based Citigroup, the biggest U.S. bank, declined to comment on the probe. Christine Walton, a spokeswoman at UBS, Switzerland's largest bank, declined to comment, and NASD spokeswoman Sarah Bohn also declined to comment.

"We decline to comment on any regulatory matter except to say that we co-operate with regulators when asked," said Mark Herr, a spokesman at Merrill Lynch, the world's No. 3 securities firm by market value.

Demand for hedge funds has mushroomed with the decline in stocks and the success of managers such as Paul Tudor Jones, who has posted an annualized return of about 25 per cent since opening his flagship Tudor BVI Fund in 1986. Citigroup, for example, has $29-billion under management in its alternative-investments unit, which includes hedge funds.

Worldwide, hedge fund assets climbed to $1.03-trillion in the second quarter from $490-billion in 2000, according to Chicago-based Hedge Fund Research Inc.

In contrast to hedge funds, most mutual funds bet only on rising prices and don't buy securities with borrowed funds.

The NASD is reviewing sales of hedge fund products to non-professional customers from the beginning of 2004 to May 31 of this year, according to the letter from Amy Lynch, a special investigator at the regulator.

In addition to an explanation of the "compensation structure" for brokers, branch managers and the firms themselves, the letter requests a "description of all sales contests, cash and non-cash incentives, as well as other promotions, programs and initiatives that affect the compensation of the sales force and/or management regarding hedge fund products."

The investigation covers sales practices for hedge funds, funds of hedge funds, and funds of funds of hedge funds.

A fund of hedge funds is an entity that invests in hedge funds rather than making its own bets on individual securities.

The proliferation of funds of funds, which require lower minimum investments, was cited by the U.S. Securities and Exchange Commission as a "development of significant concern" when the agency decided last year to impose new rules on the hedge fund industry.