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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks before the Managed Funds Association


Commissioner Roel C. Campos

U.S. Securities and Exchange Commission

London, England
July 12, 2005

Good afternoon. I'd like to thank Jack Gaines for inviting me to London to join you at this conference. The MFA's mission is (1) to enhance the image and understanding of the alternative investment industry through media relations initiatives, (2) to further constructive dialogue with the regulators in pursuit of regulatory reform, and (3) to improve the communications with and trading of the Association's members. Today, in this single forum, I believe we are accomplishing all three of these goals. As you may know, I support the hedge fund regulatory scheme we have adopted in the U.S. I believe that, at this light level of regulation, the US structure is a tool for enhancing the regulator's and investors' knowledge regarding hedge funds, a way of increasing transparency in an industry comprised of 8000 funds and over a trillion dollars, and a way to let the sun shine in without interfering with the operations of the hedge fund. However, I also strongly believe that in developing the proper inspection and examination regime within this disclosure framework, it is essential for the SEC to interact meaningfully with the industry on a regular basis. For this reason, I am pleased to be a participant in today's activities and plan to continue my active involvement in this arena as we move toward the compliance date early next year.

Before I begin, I must remind you that the views I express here are my own and do not necessarily represent those of the SEC, the staff or my fellow Commissioners.

Today I'd like to jump right into the topic of hedge funds, detailing a little recent history before posing some concerns that I hope we will address in our panels today. In making my remarks, I would like to note two preliminary points. First, the term "hedge fund" is a misnomer given the breadth of funds and investment strategies under discussion. The term hedge fund has developed into a catch-all classification for many unregistered, unregulated, privately-offered, managed pools of capital, generally excluding, in particular, funds principally involved in venture capital or similar private equity investments. In an effort to keep us all on the same page, I am going to use the term generally so as not to foreclose any interesting discussion on alternative investments.

The second preliminary note I would like to make is that many of the numbers I will use are, at best, guestimates from various sources attempting to compile statistics on hedge funds based on available information. Therein lies one of the problems with this segment of the industry: opacity. Nobody - neither regulators, industry groups, competing hedge funds, investment banks, nor investors - has a complete picture of the industry. Quite simply, the gaps in the available data regarding hedge funds as a group or even individual hedge funds provide an inadequate basis upon which an investor may evaluate the risk of an investment in such products. And that doesn't begin to address the issue of transparency of information with respect to the regulator's role, if any, in identifying and assessing the systemic and operational risks associated with hedge funds. To my mind, this lack of transparency and comparability drives the regulatory debate. Before I digress any further though, let me begin again.

Capital knows no bounds in today's world. According to statistics by the World Federation of Stock Exchanges, the global financial stock, which now totals more than $118 trillion, could increase to $200 trillion by 2010. At the current time, the role of the US relative to the world in total private debt (51 percent) and equities securities (45 percent) has increased while the US share of government debt and bank deposits has dropped (to 25 percent each). (Notably, the US financial stock is dominated by securities - private equity and debt - to a much greater extent than other markets in the world, with a relatively limited role played by US government debt securities.) Europe is the second largest capital market with 31 percent of global financial stock and its growth over the past 10 years has outpaced the rest of the world. During that same period, the US market has continued its growth, fueled by expansion in private debt securities and undeterred by the boom-and-bust of the equity market bubble.

Cross-border investments are far larger now than they were 20 years ago. From 1984 to 2003, US investment holding abroad more than tripled after controlling for inflation. Foreign investment in the US rose proportionately much more, by almost a factor of six. Because of increased market turnover, cross-border transactions have grown even faster than cross-border holdings. In 2002, the gross value of cross-border equity trades was 80 percent of worldwide equity market capitalization, whereas in 1989 cross-border trades equaled only 18 percent of a much smaller world equity market. Due to its size, liquidity, and economic health, the US continues to attract the lion's share of cross-border equity flows, and foreigners hold an increasing share of its financial stock.

With these numbers in mind, one cannot deny that globalization is a reality in the financial markets. As we all know, with this freer flow of capital comes complex new products, intricate trading strategies and inventive capital raising techniques, not to mention a freer flow of fraud. Accordingly, the task at hand for the regulator is to develop, where appropriate, high quality and consistent regulatory requirements to govern our markets and address the inherent risks. Striving for investor confidence and investor protection - two of the inextricably linked cornerstones of our capital markets - we are bound by our statutory mandate.

We have all witnessed the economic hardship that derives from a lapse in investor confidence. Such a lapse follows from a perception (reality-based or not) that investor protection is weak or lacking. A subset of investor confidence in the marketplace is investor confidence in the regulatory regime. Are investors' interests guiding the regulatory pen? In addition, regulators themselves must be confident that the regulation is properly crafted to fulfill the investor protection mandate. When taken to its logical end, strengthened global economic growth and development prospects flow from confident investors. Impose this framework on a constantly morphing, opaque, increasingly retailized, trillion dollar industry and you can see why my concerns arise. Some people call this a sixth sense; I call it my regulatory tingle.

When one thinks of risk in today's marketplace, hedge funds are not far from the discussion. Even Federal Reserve Chairman Alan Greenspan now has voiced concerns about the risks posed by the larger funds. Just last month, despite the praise he has lavished on them in the past, Greenspan stated that hedge funds are headed for a fall. That certainly makes me sit up and listen. Are the increasing numbers of hedge funds and the actions they take a real threat to our economies?

As you know, hedging is but one of the strategies employed by these funds today. Hedge funds also follow event-driven strategies, absolute-return strategies, global asset allocation, and correlation trading, to name but a few. Many hedge funds are offering new products as quickly as they can be conceived to capitalize on the hedge fund fervor. I've read that the latest generation includes a hedge fund index called the investable index. Designed to compete with the fund-of-funds, the investable index offers exposure to the hedge fund universe without paying the extra fees demanded by funds-of-funds. Because of the base index, the investor has some transparency into the fund compared with funds trading deeply distressed debt with such opacity and illiquidity that daily valuations are impossible.

Every day we read about the growing size, influence, market impact and incredible reach of these investment funds. An estimated $75 billion was invested in them last year. Hedge funds are attractive largely because of the perceived higher returns, the ability to diversify, and the investment alternatives that are not correlated with the stock markets. Hedge funds have come closer to home for the average person through pension funds, charities, foundations and endowments. Pension funds and institutional investors first began to look to hedge funds to beat benchmarks. The opportunity to diversify and the notion of high returns has increasingly attracted retail investors, especially as more individuals are meeting the regulatory wealth requirements to invest in hedge funds. But the investment floor doesn't start there either. Quadriga, an Austrian fund-management company, launched a "retail hedge fund" in its home country and, although it cannot market itself as a hedge fund in American, permits Americans to buy in for $5000.

The number of hedge funds worldwide has increased from fewer than 1000 in 1990 to more than 8000 in 2004. EuroHedge reported that total assets managed by European single-manager hedge funds now exceed $150 billion, and industry assets at the end of 2004 totaled nearly $256 billion, an increase of more than 50 percent from $168 billion at the end of 2003.

The value of hedge fund assets managed out of London more than tripled from $61 billion dollars to $190 billion between 2002 and 2004. Globally, the UK capital's share of hedge fund assets increased from about 15 percent to 20 percent as growth in hedge funds outpaced the US, the leader in terms of fund activity. The industry is continuing to spread out across Europe, with over 100 single-manager funds now trading in France. Sweden and Spain have also established themselves as major continental locations for hedge fund management. Plus, the industry has its sights on Asia for the near future.

Part of this growth stems from the expansion of hedge funds into other activities that offer profits - activities that put them in direct competition with investment banks, broker-dealers and private equity firms. For instance, some of the biggest are lending money. When Malcolm Glazer needed money to finance his takeover of Manchester United, PLC, part of the money came from banks and part of the money (approximately $500 million) came from three US hedge funds (Citadel, Perry Capital and Och-Ziff Capital Management). Cereberus Capital Management, among others, rounds out its business by providing financing for takeovers, rescues and bankruptcy-protection proceedings. In this competition, it is the hedge funds that can quickly commit capital through the use of leverage rather than traditional investment banks. Yet the hedge funds typically "loan to own," extending funds with one hand while betting against the company with the other.

In fact, they have become active players in credit default swaps, playing the counterpart to banks and prime brokers. Exploring their role in this key position, some have questioned whether the regulators of their counterparts, the banks and brokers, need regular reports from the hedge funds, to monitor the overall risk of the financial system, and the right to perform spot checks on the hedge funds, as needed to help evaluate any serious threat to the financial system.

Following on this theme of money lending, there has been an increasing involvement of hedge funds in PIPE, or private investment in public equity, offerings. Many hedge funds and short sellers participate in PIPE transactions as short-term investors, often betting on the price of the company shares to decline. For example, on May 18, 2005, the Commission settled an action against Hillary Shane for insider trading and registration violations by short selling securities of CompuDyne Corporation prior to the public announcement of a PIPE offering and prior to the effective date of the resale registration statement for the PIPE shares. Specifically, Shane purchased shares in the PIPE offering for her personal account and for one of the hedge fund accounts she managed. Despite agreeing to keep information about the PIPE offering confidential, she began short selling CompuDyne securities in both her personal account and the hedge fund's account until she had sold the same number of shares she had been allocated in the PIPE offering. In so doing, she covered all of her short sales and made substantial profits for both accounts.

Another hot area for hedge funds is reverse-mergers. Excluding deals with Pink Sheet companies, there have been 55 reverse mergers so far this year compared with 89 for all of 2004, according to one industry publication (The Reverse Merger Report). Fueling the small boom in reverse mergers is a growing pool of hedge funds and other investors keen to buy discounted stakes in the new public entities. In a conventional IPO, the company must hire an underwriting bank that examines the company's business and financial merits, acting as a gatekeeper between the company and its potential investors. In a reverse merger, there's no such gatekeeper, although the two parties generally perform "due diligence" on each other. True to form in seeking arbitrage opportunities, one hedge fund manager noted that the firms he's looking to invest in typically have rapid growth and need money quickly to finance that growth. An IPO can take up to a year to complete, and with a hot IPO shares are limited. But if aligned with the investment bankers of a reverse-merger deal, the manager said he usually can buy as many shares as he wants.

To be sure, hedge fund's involvement in the private equity arena is not limited to lending to small or struggling companies and taking over bad loans. Just last week, two separate private-equity bidders have each offered nearly $2.38 billion for Dutch bank NIB Capital NV. One of these, the already mentioned Cerberus Capital Management, has been buying companies in Germany and the Netherlands in recent months. The other is an investment fund managed by a former Goldman Sachs executive. A purchase of NIB by a private-equity buyer would make it one of the first European banks taken over by investment funds. Hedge funds and their affiliates announced deals for at least 23 companies valued at about $30 billion last year. The road goes both ways though. Private equity groups - the traditional buyout firms - are setting up hedge funds to better compete in the current market. In fact, some are asking where the line is drawn between private equity firms and hedge funds. What are the opportunities and risks associated with hedge funds' growing presence in the private equity sector? Of concern is whether the hedge fund cum private-equity owners can handle potential problems at a company like NIB, for example, which is involved in complex derivatives and capital-markets businesses across many countries.

Others have become clients of the big firms, expecting royal treatment for their large commission payments-in a questionable symbiosis of order flow for information. The securities firms offer hedge funds a dearth of services from execution to money lending, stock lending, investing in the funds, and providing research and investment ideas for trading. Do these relationships disadvantage other traders and investors? Are these conflicts disclosed or even manageable? Because hedge funds typically are high-volume traders, they create more commissions for broker-dealers than traditional investors. Consequently, hedge funds more often are targeted to attend road shows and other events planned by investment banks.

Moreover, the hedge funds are willing to pay in excess of the traditional five cents a share for trades that mutual funds are increasingly reluctant to pay. This is not surprising because their compensation is tied to out-performance, not efficiency. The Economist reports that hedge funds received $45 billion in revenues last year, of which one-third was profits. Investment banks collected $15 billion from hedge funds, producing $6 billion in profits. To put this in perspective, the article suggests this was one-quarter of Goldman Sachs's profits and only slightly less for Morgan Stanley.

Hedge funds are active not only in the capital arena but also in the corporate arena. They are the new activist investor. New York-based Atticus Capital and London-based TCI led the charge to deflate the Deutsche Bourse's bid to take over the LSE as far too expensive. Using the trappings of improved corporate governance and shareholder power to defeat the bid, the hedge funds then overthrew the management of Frankfort's top stock market. Other hedge funds are using these same tactics to force companies to more directly reward holders through buybacks or a sale. In the US, the Globe and Mail reported that Boston-based K Capital Partners LLC recently waged a battle with OfficeMax. As one of the company's largest shareholders, K Capital Partners successfully demanded changes to the board and threatened, "that a break up or sale of the retailer might be needed to maximize shareholder value." K Capital further demanded that the CEO give up certain pay and pension benefits. The CEO resigned the next day.

Just two weeks ago, on June 23rd, BKF Capital Group, a publicly traded investment firm, lost a battle with a hedge fund to replace three board members. The examples are numerous and growing. This raises the question of whether such short-term investors should be entitled to such shareholder rights in outright conflict with long-term investors. Is it right that a minority shareholder - hedge fund or not - should wield so much power, attacking beleaguered companies? The lesson may be that with massive amount of capital behind them, ignoring hedge fund managers is a bad idea. Communication may be the only chance to attempt to manage their actions by ensuring that both sides of the equation are informed to the extent possible.

That being said, some in the US have argued for a regulatory approach to hedge fund activism. They opine that hedge funds should be required to publicly disclose their large positions in a 13D filing promptly after their ownership exceeds 5 percent of any class of publicly traded equity, and should not be eligible for the delayed reporting procedures afforded to mutual funds and pension funds that are not trying to change or influence control of public companies. As I will discuss shortly, this broader concept of varying degrees of shareholder rights has appeared in European discussions too. I hope we will address this topic this afternoon in our panel discussions, including the notion of one share, one vote.

Another pressing question arising from the exponential growth of hedge funds is market saturation. Are hedge funds victims of their own success? Some feel that the industry is overpopulated and not all of the hedge funds can attain prized returns if they are all following the same strategies. Competition inevitably shrinks profit margins as there is too much liquidity chasing too few deals. Too many hedge funds? Too many employing the same strategy? A shortage of qualified managers? I wonder. In the area of managed futures and convertible arbitrage, for example, hedge funds have become the markets and therefore cannot exploit the inefficiencies of these markets by standing on the sidelines. They directly feel the ups and downs.

The Economist reports that inflows of new money may have peaked in 2002, and some in the business say out-performance is more elusive. This phenomenon likely has pushed some hedge funds into less liquid and more esoteric markets. Many have begun to use more borrowed money to enhance returns, amassing debt equal to twice capital and sometimes five times capital (though even that is less than the levels seen in the 1990's). This problem is magnified by the fact that many of the largest hedge funds are closed. Unable to get into established winners, investors are pouring money into managers with no track record but good pedigrees, or no track record and no pedigree, all of who are scrambling to find the next niche with its pot of gold.

According to Tremont Capital Management, in the first quarter of this year, $24.6 billion was invested in hedge funds, 36 percent below the level a year earlier. That is still more than went into any such fund in any full year before 2001. Reports suggest that most hedge funds last only a few years. Tremont also states that around 10% of hedge funds go out of business each year, but that is more than offset by new entrants. Yet recently, some big players joined the (at least) 270 hedge funds that shut their doors last year. On June 16, Marin Capital closed shop based on "a lack of suitable investment opportunities," returning $1.7 billion to investors. Days later, Bailey Coats Asset Management announced that it too would shut its flagship hedge fund, just two years after it began trading. And just last week, hedge fund EBF & Associates announced that it was liquidating its Lakeshore International fund, a $669 million hedge fund that is among the oldest and at one time was among the most successful funds that specialized in trading convertible bonds.

Looking at monthly reports, returns for hedge funds were positive in May, compared with a decline in April, despite the losses tied to GM. The average hedge fund is up anywhere from .22 to .35 percent for the year ending in May according to various industry sources. Yet this is not something to celebrate when one considers the stiff fees hedge fund investors pay on average. This is merely tracking the broader markets for which an investor can buy an index fund for much less money. To add insult to financial injury, according to a survey conducted by Greenwich Associates, hedge fund managers earned on average $1.2 million in 2004. The average salary was approximately $280,000 with a bonus of $900,000. Now those are nice returns.

In addition, if investors get panicky and start withdrawing large amounts of cash from a fund for any number of reasons, including low returns, the manager is often required to sell holdings to meet the redemptions. The results of such selling are worrisome. For example, the IMF found in its May report that hedge funds might account for 80 to 90 percent of all participants in the fixed income and convertible arbitrage markets. It warned that such a high concentration could strain the financial system if the funds found themselves selling all at once in response to stresses. Increased diversity within hedge funds may help mitigate the risk of a massive breakdown, but Long Term Capital still looms in the minds of many from its near collapse, and Federal Reserve organized rescue, in 1998.

And there is no accounting for the increase in hedge fund fraud. For an egregious example, just this past March the Commission obtained emergency relief against a group of hedge funds in Florida for an $81 million fraudulent offering in which the group of hedge funds lured investors by boasting of consistent above-market returns through trading in aggressive growth stocks. The hedge funds maintained the ruse by sending false statement to investors despite the fact that the funds were suffering tremendous trading losses, while the investment advisers and hedge fund managers earned their 20 percent performance fees. Last week, a Philadelphia hedge fund, Philadelphia Alternative Asset Management Company, had its remaining $75 million in assets frozen by the CFTC after being accused of misleading investors about its trading results and strategy.

Although trading under the same rules as mutual funds, hedge funds use different trading strategies and are not subject to the liquidity, diversification and senior security coverage requirements imposed on registered investment companies. They also impose restrictive investment, leverage and redemption limitations that may be responsible in part for the growth of the funds. Their fee structure - a performance fee (often as much as 20 percent) in addition to a 1-2 percent management fee - tends to raise eyebrows, particularly as returns slow and merely track the stock market. To cite popular lingo, a hedge fund is a "compensation scheme masquerading as an asset class." As an aside, one should not forget that mutual funds can follow strategies similar to hedge funds (though there are some liquidity restrictions) so long as the mutual fund sets out its strategy in its prospectus and sticks with it. In fact, several tried this in the mid-1990s but were accused of "style-drift" and suffered accordingly.

While I'm on the subject of mutual funds as compared to hedge funds, I'd like to spend a moment exploring funds of hedge funds. Funds of hedge funds account for some 45 percent of hedge-fund assets, up from 19 percent in 2000, and 60 percent of outflows. As a mutual fund, they provide the easiest and greatest access to hedge funds for the average retail investor. Investors pay handsomely for this balance of privilege and protection. Because barriers to entry are minimal, some argue that a lot of capital has gone to average or below-average money managers. In response to this structure, according to a recent Morgan Stanley poll, 71 percent of endowment funds were keen to invest directly in hedge funds instead of funds of hedge funds, avoiding the double layer of fees but losing the protection provided by the regulatory regime applicable to the mutual fund.

For the remaining unsophisticated investors, securities industry expert Robert Pozen argues for several safeguards. In a recent Wall Street Journal editorial, he suggested that every fund of hedge funds should provide investors with a standardized chart on its annual performance (with and without fees) as well as a detailed comparison of the performance and fees for each of the hedge funds held by the fund of hedge funds. Plus, investors should be informed about the professional qualifications and any material conflicts of interest of the fund of hedge funds managers as well as the investment strategies and redemption restrictions on the underlying hedge funds. Do the suggested measures reach the appropriate regulatory balance?

Despite all of these concerns, hedge funds can make our markets more efficient by using leverage and trading spreads between asset classes as well as creating competitive capital alternatives to investment banking firms and even private equity firms, as we've discussed.

The new SEC rules, slated to go into effect in February require funds larger than $25 million and with more than 15 investors to file as registered investment advisors. The rules affect funds with a lock up of under two years and require appointment of chief compliance officers.

The Commission pursued registration only after an in-depth study of the available information on hedge funds conducted through a staff study and Commission roundtable. The trends uncovered during the staff's analysis of hedge funds raise the same concerns worldwide about the risk associated with these funds, including the rapid growth of an opaque industry for which no government agency has reliable data, the potential for systemic risk to the markets due to hedge funds' influence, broader investor exposure (both retail and pension/retirement fund), their fee structure, the absence of uniform performance reporting and valuation-not to mention disclosure and transparency generally, and the growth in hedge fund fraud. If the regulator can't tell what's going on in the industry, how is the investor supposed to do so? Compounded by the lack of available data and transparency, the inability to examine hedge fund advisers makes it difficult to uncover fraud and other misconduct.

The concept of registration under the Advisers Act was selected because of its minimalist approach in both regulatory burden and in cost but extensive benefits of census information, deterrence of fraud (through inspections), barring unfit persons from the industry, adoption of compliance controls, and limits on retailization. Heeding the advice of Federal Reserve Chairman Alan Greenspan, the registration requirement neither requires an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments, in order to protect the resilience and flexibility of the markets. Moreover, the Commission carefully crafted the registration requirements to allow exemptions for, among others things, private-equity pools, grandfathering existing clients and addressing foreign components of the hedge fund industry. In other words, our regulatory approach has been to leave the success or failure of hedge funds to market forces.

Despite a mixed review, many in the industry have stated that they can and will live with the requirements. Some hedge funds have begun to prohibit their investors from withdrawing their money for two years, allowing them to fall under an exception to the rules that was included to avoid forcing private-equity firms to register. Others are using registration as a "seal of approval." Still others predict that the cost of registering will drop as much as 50 percent a year from now because the frenzy to prepare for registration will have died down, reducing pricing for advisory and other fees. I wonder whether registration will result in a self-review of the compensation structure of hedge funds or perhaps a re-pricing of assets downward once the bright light of day is shining in?

In the meantime, the MFA and the SEC have been working together to identify the components of the educational efforts that the Commission inspection staff will undertake in connection with the administration of the registration rule. As part of this collaboration and cooperation, the SEC staff has sought and will continue to seek industry speakers for its training programs and SEC staff has spoken at industry functions, including, for example, my participation today.

Other jurisdictions are actively examining the inherent risk in the hedge fund sector. Germany was one of the last big markets to authorize the use of hedge funds, in March 2004, and the BaFin has been careful in its approach to the funds. Earlier this spring, Chancellor Schroeder called for a report to analyze the industry and possible regulatory approaches. News reports suggested that the experts advised against adopting rules that restrict voting rights for shares held by certain types of investors, recommending instead that companies grant a dividend bonus to shareholders who exercise their voting rights. Also, the experts allegedly suggested lowering the threshold whereby shareholders are forced to publish the size of their holding in a company, and stressed that any regulatory intervention into the activities of hedge funds should be coordinated at an international level.

On June 13, on the basis of the report, Chancellor Schroeder noted that foreign investors are and will continue to be highly welcome in the German economy but that financial market players that put companies under pressure, such as short-term hedge funds, should be subject to greater transparency requirements. He limited his remarks on a potential regulatory approach, however, to stating that he would seek to propose the creation of international minimum standards for hedge funds at the G8 Summit, which was held last Thursday and Friday. I have heard that some of his peers appeared less keen on the proposed approach, but I must admit that I have been on vacation and unable to follow the latest reports on the Summit. I look forward to any news you may have on what may have transpired, and will get a briefing regarding the Summit upon my return to the US.

British regulators too have launched a wide-ranging review of the industry, publishing two discussion papers just weeks ago. Contrary to Germany's debate about overzealous corporate governance, the focus in the UK - as with the US - is more about transparency for hedge funds. In fact, the FSA noted in its first paper that it already has increased data collection both from prime brokers and, to a lesser extent, hedge funds. In the first paper, "Hedge funds: A discussion of Risk and Regulatory Engagement," the FSA recognizes the increasing significance of hedge funds in the provision of market liquidity. Ultimately, the paper does not propose new regulation for hedge funds but advises regulators worldwide to avoid driving hedge funds into less-regulated havens.

The paper also voices concerns over the hedge fund fee structure. The paper identifies nine key risks related to hedge funds, including fraud, market manipulation, serious market disruption, conflicts of interest, erosion of confidence, liquidity disruption and operational risks. In suggesting several risk mitigation tactics, the FSA suggests a possible "signposting" system to identify risk. Some have questioned whether the constantly changing nature of hedge funds will make monitoring the risk of each fund and labeling it a useless, as well as potentially misleading, chore. While sidestepping a conclusion of inherent, systemic risk to the financial markets and retail investors in particular, the FSA paper announces the formation of a new unit within the Agency for risk management that will focus specifically on hedge funds and the banks that help them manage trading activities. Noteworthy, the FSA also concludes that the risks to retail consumers appear to be rising.

The second paper, "Wider Range of Retail Investment Products: Consumer Protection in a Rapidly Changing World," looks at the regulatory regime that applies to sophisticated investment products. Hedge funds are encompassed within this broad category and the FSA notes that despite their significance and usefulness, hedge funds pose a risk to the UK's financial markets and it is important to fully understand them. It identified three primary risks with the proliferation of new products. First, consumers and companies may not fully understand these products. Second, consumers may be confused by different forms and distribution channels of wider range products. Third, consumers may be missing out on investment opportunities because of the current restriction on the marketing of unregulated products. The paper also mentioned the inconsistency with which these products are regulated.

In Canada, the Ontario Securities Commission and Bank of Canada are conducting a joint study of hedge fund influence in the markets. On the EU front, Commissioner McCreevey has said that it would be wrong to rush into hasty rulemaking for the 25 EU countries. This small sample demonstrates the universal concerns raised by the risks to our investors, markets and issuers associated with hedge funds. Going forward, we all must continue to review this developing and fluid industry and share our thoughts and findings.

Hedge funds have become increasingly important as a source of liquidity to the markets, to help companies raise money, and as a factor in the health of the banks with which they do business by enabling the financial institution to lay off risks. If interest rates increase, limiting the use of leverage (many hedge funds borrow at low, short-term interest rates), or if the peak has passed, what is the impact on the marketplace? Will investment banks and prime brokerages feel the pinch if hedge funds enter rough waters? Remember, hedge funds account for almost half of all trading on the NYSE and LSE. And what about concerns regarding improper valuation of the illiquid securities held in hedge funds? I think it is fair to say that we have more questions than answers regarding this industry.

True economic leverage is impossible to understand without full disclosure of all of a hedge fund's commitments. Accordingly, the best that anyone-investors, banks, regulators, Wall Street - can do in analyzing the risk pertaining to a hedge fund is to guess. Guessing does not instill confidence. And so, I can't help but end with one of the points on which I began: disclosure. The US registration requirement is rooted in disclosure because of the need to gather, analyze and compare information regarding hedge funds. Current hedge fund data reporting is sporadic, and even selective. A paper published by Burton Malkiel, a professor at Princeton, and Atanu Saha, a consultant at the Analysis Group, suggests that poor performance is rarely reported.

I was encouraged to read recently that Morningstar has announced that it will enter the world of hedge fund analysis and data provision. Currently, it has data on 1600 hedge funds worldwide, a number which it hopes to raise to 3000 by year end. Morningstar groups the funds by four investment categories: equity focus, arbitrage, corporate life cycle and macroeconomic trend. It is not going to be an easy job. Some hedge funds may be reluctant to share their data, fearing a critical report. Nonetheless, I believe that any efforts to improve transparency are steps in the right direction.

I'd like to conclude with a quote by Charles Beazley, head of global institutional and alternative investments at Gartmore, who said, "I have heard arguments against regulation but have not heard any good ones…I have also heard arguments about the cost of compliance, but if you think compliance is expensive, then think of the cost of non-compliance." Today, I would like us to leave our self-interests at the door and think of the investor as we move to the panel discussions.

Thank you.


Modified: 09/22/2005