NASD Steps Up Hedge Fund Probe, Seeks Customer Data

Date: Thursday, February 2, 2006
Author: Bloomberg.com

Feb. 2 (Bloomberg) -- The NASD is expanding a probe of the world's biggest brokerage firms for possible improper sales of hedge funds to individual investors, three people with direct knowledge of the matter said.

The industry regulator sent letters to firms including Merrill Lynch & Co., Citigroup Inc. and UBS AG seeking details on customers who bought ``retail hedge fund products'' for $50,000 or less, said the people, who declined to be identified because the probe isn't yet public. The NASD, based in Washington, is asking how the brokers who sold the funds gauged clients' ability to withstand potential losses.

``You worry about small investors getting involved through the back door in investments that aren't suitable for them because they're too risky or the fees are too high,'' said David Becker, a former chief counsel at the U.S. Securities and Exchange Commission. ``NASD requires brokers to have a reasonable basis for recommending an investment, as a counterforce to the overwhelming economic incentives for salesmen to sell.''

Hedge fund assets swelled more than sixfold to $1.1 trillion during the past decade, as the average fund rose at an annual rate of 11 percent, beating the 7.5 percent advance of the Standard & Poor's 500 Index. Until about five years ago, hedge funds were limited to investors with more than $1 million. Now, people can invest in the loosely regulated funds with as little as $25,000.

5,200 Brokerage Firms

``We don't comment on ongoing investigations,'' said Herb Perone, a spokesman for the NASD. Spokespeople for Merrill, Citigroup and UBS declined to comment. Merrill is the biggest securities firm by market value and Citigroup is the No. 1 U.S. bank. Both are based in New York. Zurich-based UBS is Europe's largest bank.

The NASD started examining hedge fund sales practices in June, asking as many as 10 firms how they promoted products to individuals. The regulator, which polices about 5,200 brokerages, broadened its probe in December after finding evidence some firms allowed less-affluent customers to invest in the funds, one person said.

Merrill, Citigroup and UBS sell so-called funds of funds, which buy stakes in multiple hedge funds rather than in individual securities. The minimum investment in funds of funds marketed by the firms can be less than $50,000, SEC filings show.

The regulator hasn't accused any firm of wrongdoing. NASD said the probe ``shouldn't be construed'' as a sign it has concluded that securities laws were broken.

Hedge Funds Doubled

The number of hedge funds has doubled to almost 8,700 since 2001 and frauds such as last year's $450 million collapse of Bayou Management LLC have prompted regulators to step up oversight. The SEC cited the proliferation of funds of funds as a ``development of significant concern'' when it decided in 2004 to force hedge funds to register with the agency. The deadline for registration was Feb. 1 and almost 800 hedge fund advisers filed with the SEC.

The NASD's investigation, which began in June, covers sales of hedge fund products from January 2004 through May 2005.

Funds of funds, which account for almost $400 billion of the hedge fund industry's assets, levy added fees.

Many charge 1 percent of assets under management and keep 10 percent of any profits on investments in addition to fees charged by the underlying hedge funds. That can increase the total fee load borne by investors to 3 percent of assets and 30 percent of profits, since many hedge funds charge 2 percent and 20 percent.

Merrill's Efforts

Merrill wants to boost sales of hedge fund products after failing to meet its targets. It gave Ben Weston, a former executive at Credit Suisse Group's securities unit, responsibility for funds of funds and an internal database that Merrill brokers use to help clients find suitable hedge funds.

Merrill is a passive, minority investor in Bloomberg LP, the parent of Bloomberg News.

Credit Suisse, the No. 2 Swiss bank, and Goldman Sachs Group Inc. and JPMorgan Chase & Co., both based in New York, also offer hedge fund products for $50,000 or less. Goldman is the world's second-largest securities firm. JPMorgan is the No. 3 U.S. bank.

To contact the reporter on this story:
Otis Bilodeau in Washington at  obilodeau@bloomberg.net