Opening Statment by SEC Chairman
at July 14, 2004 Open Meeting
Chairman William H. Donaldson
U.S. Securities and Exchange Commission
July 14, 2004
Registration of Hedge Fund Advisers
Before the Commission this morning is a recommendation from the Division of Investment Management that we propose a new rule and rule amendments under the Investment Advisers Act to require advisers to certain private pooled investment vehicles, better known as hedge funds, to register with the Commission under the Investment Advisers Act. The new rule would implement the principal recommendation of the Division's September 2003 report "Implications of the Growth of Hedge Funds," which discussed the need to address concerns regarding hedge funds in a more proactive way than we have in the past.
Hedge funds are an increasingly influential force in our securities markets. In recent years, there has been explosive growth in the hedge fund industry. Hedge funds today represent a significant and growing segment of the money management business. Since 1993, the estimated assets in U.S. hedge funds have increased fifteen-fold. Recently, the Wall Street Journal reported that those who track the industry estimate that there are now close to 8,000 hedge funds with more than $850 billion of assets under management. Hedge fund assets have been projected to soon grow to more than $1 trillion dollars.
Because many hedge fund advisers are very active traders of securities, their significance and impact on the securities markets well exceeds the amount of assets they hold. A recent Business Week article reported that a single hedge fund trader, for instance, was responsible for approximately 5% of the average daily trading volume of the New York Stock Exchange. Another recent report in the Wall Street Journal claimed that hedge funds accounted for 95% of the trading in all convertible bonds.
Accompanying this growth have been several other trends worth noting. First, hedge fund managers have been steadily lowering minimum investment requirements. Second, hedge funds are being increasingly purchased by entities that have not been traditional hedge fund investors, including public and private pension funds, which have literally millions of beneficiaries. One study has calculated a 450% increase in this investing over the past seven years. Finally, the number of public offerings of funds of hedge funds has dramatically increased. In January 2002, the first fund of hedge funds became eligible to sell its securities to the public. Today just over 2 years later there are 40 registered funds of hedge funds that publicly offer, or plan to offer, their securities with approximately $800 million in assets.
All of this growth has also been accompanied by an almost total lack of information about the impact of hedge funds on investors, large and small, who trade in the market as counter parties, effectively exposing very large numbers of average investors to the risks of hedge funds' activities.
In addition to the increased investment in hedge funds, growth in hedge funds being established, and increased number of investors being subject to the risks of hedge funds, we have also seen a marked increase in hedge fund fraud.
In the past five years, the Commission has brought 46 enforcement cases asserting that hedge fund investors have been defrauded by their advisers in amounts we estimate to exceed $1 billion. The number of cases considered each year since 1996 has been steadily growing, and 80% of the cases involved advisers that were not registered with the Commission.
In addition to the 46 cases of hedge fund fraud, we must add another 40 hedge funds that our staff has identified as having been involved in many of the late trading and market timing cases that have come to light in just the last year. In these market timing and late trading cases, hedge fund advisers did not defraud their own investors, but instead were involved in conspiracies to defraud mutual fund investors. And interestingly, it appears that none of these hedge funds was managed by an adviser registered with the Commission.
While the frauds we've seen are not unique to hedge funds, they highlight a unique challenge. Hedge funds typically employ a compensation structure whereby they are paid based on performance. This structure provides an incentive to the unscrupulous and the world-be unscrupulous adviser to perhaps engage in fraudulent activity.
The Commission has been monitoring developments in the hedge fund industry for many years, studying and restudying the issues. I expressed concern in testimony at my confirmation hearing in February 2003 about the growing exposure of smaller investors to the risk of hedge funds and to our markets of possible manipulative aspects associated with hedge fund management practices. Interestingly, the financial services industry here and abroad has become concerned. In a recent survey of European financial industry participants, including senior executives of investment managers, banks and other financial institutions from 14 different countries, half of those surveyed identified hedge funds as the most likely source of a new wave of problems. No other financial product generated anything close to that level of concern.
For many years it has been acceptable, if not satisfactory, for this agency to take a "sit back and see what happens" approach to hedge funds. Until recently, the hedge fund population was small in both relative and absolute terms, and hedge fund investors were relatively sophisticated, with enough assets to absorb the losses that may easily accompany an investment in an opaque, unregulated, product. And in the event we were tipped off to a case of an out-and-out fraud, we had the power to bring enforcement actions against the perpetrators.
The staff is before us this morning to recommend that we depart from this historical approach. After careful consideration, the staff is recommending that the Commission propose a new rule and rule amendments that would, in effect, require hedge fund advisers to register under the Advisers Act. And I'm now going to call on Paul Roye, Director of Investment Management, to discuss the details of the Division's recommendation and the reasoning that supports it.
Check against delivery.