That under-the-radar existence is about to change -- at least a bit -- thanks to new Securities & Exchange Commission Chairman Christopher Cox's decision not to overturn a pending hedge fund adviser-registration rule championed by his predecessor, William H. Donaldson. Cox's stance is sure to anger those wary of the expansion of even minimal federal oversight of this shadowy world of financial heavy hitters. But these secretive funds have simply become too large, and their investment reach too pervasive, for regulators to ignore.
Indeed, hedge fund investing is no longer the province of just the storied rich, who have long been eager to assume the big risks hedge fund managers often take -- and the big fees they charge -- to capture outsized returns. The feds saw no need to burden these capital pools with lots of Sarbanes-Oxley-style regulation, as long as they were confined to small groups of such sophisticated investors. But, increasingly, hedge funds are pulling in cash from the merely affluent and from public pension funds and retirement plans that are supposed to provide security for the golden years of millions of Average Joes. An estimated $860 billion is invested in some 7,000 hedge funds, and assets under management grew 30% in the past year. This expanding capital trove needs to be monitored -- not only to help investors avoid fraudulent advisers but also to ensure that hedge fund actions don't roil U.S. markets.
It's not an idle worry. In 1998, the Federal Reserve had to organize a rescue for Long-Term Capital Management after the highly leveraged hedge fund got caught holding $1.2 trillion in derivative positions when bond markets moved against its bets. Maybe today's hedge fund managers won't be as foolhardy, but there are a lot more funds out there now. So the cumulative risk of another shock to the financial system remains. One need only look at the recent scandal surrounding hedge fund Bayou Management LLC to recognize that investors could use more help making sure advisers are on the up-and-up.
To be sure, the mandatory SEC registration rule won't keep hedge fund investors from making lousy or inappropriate investments. The SEC's recent stricter oversight of mutual fund managers (much tougher than the hedge fund rule would allow) has so far yielded mixed results. And even the pending minor federal role in hedge fund oversight raises the prospect of moral hazard, where some investors may rush to hedge funds because they figure the feds will bail out any future hedge fund meltdown. Nonetheless, there is a larger public interest in knowing more about the managers and practices of these huge investment pools that increasingly function as virtual operating companies. Indeed, transparency is a major reason U.S. markets draw investors from around the globe, and the SEC hedge fund rule can only increase that visibility. For recognizing that, Chairman Cox is to be applauded.