Background:  On April 8th, Securities and Exchange Commission Chairman William H. Donaldson told the Senate Banking Committee that he had asked SEC staff to “move forward” with a proposed rulemaking that would both create a form of registration for hedge funds and establish an oversight regime. The proposed oversight would be “specifically tailored to the unique dynamics” of hedge funds.

The proposal would “enhance the Commission's ability to prevent, detect and deter abusive, fraudulent conduct in the hedge fund segment of the investment management industry.” Donaldson’s testimony followed a September 2003 SEC staff report which called for requiring hedge fund advisors to register under the Advisors Act, require them to value their holdings in a manner consistent with the requirements of the Investment Company Act, and to disclose fees. The staff report also recommends ending the current prohibition on allowing hedge funds to advertise.

Status:  The proposed regulations have not yet been issued, but are being developed by SEC staff.

Discussion:  The term “hedge fund” has come to mean any private investment fund that is not regulated by the SEC. Currently, there are between 6,000 and 7,000 such funds managing about $650 billion in assets. Hedge funds avoid regulation by generally only accepting sophisticated investors (i.e. those investing large amounts) and by not advertising to the public. Although most hedge funds use sophisticated arbitrage and hedging strategies, this is not always the case. However, because hedge funds are unregulated, they are free to pursue innovative investment strategies or to quickly switch strategies to take advantage of market conditions. 

Advocates of regulation point out that pension managers and other institutional funds managers have invested in hedge funds. Hedge funds were also implicated in after hours trading by mutual funds. However, although hedge funds are exempt from SEC regulation, they are still subject to criminal laws, and the SEC has prosecuted a number of hedge fund managers for fraud, misstating fund returns, or stealing from hedge fund customers.  

Professional managers are probably best qualified to decide if the pension or mutual funds they manage should invest in hedge funds. Regulating hedge funds would likely stifle innovation that ends up benefiting the rest of the financial community. 

Action item:  The SEC should drop its effort to regulate hedge funds and instead focus on improving compliance procedures for other types of products.

This brief was prepared by Heritage Research Fellow David C. John.

The "Regulation In Brief" is produced regularly by The Heritage Foundation, providing concise summaries of key regulatory issues, along with links to key background material on each issue. If you wish to be removed from the "Regulation In Brief" mailing list, please e-mail Margaret Hamlin at Margaret.Hamlin@heritage.org.

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