WASHINGTON (HedgeWorld.com)–The Senate Banking Committee heard from the chairman of the Securities and Exchange Commission Thursday morning, as he offered a progress report on the SEC’s ongoing examination of hedge fund policy.

Sen. Richard Shelby (R-Ala.), as chairman, opened the Banking Committee’s hearing with a brief summary of some of the issues at stake.

He began by stressing the relative secrecy in which hedge funds operate, even quoting Prime Minister Churchill’s words on Russia, “a riddle wrapped in a mystery inside an enigma.”

The Senator then noted that during recent years, which have been bearish for most U.S. equities, hedge funds have managed positive returns. Not surprisingly, this has made them attractive to qualified investors, enough so to attract a flight of capital from more traditional instruments. Furthermore, the high fees have attracted the best money managers–again at the expense of those more traditional sectors.

Sen. Shelby singled out funds of funds, which he called an “indirect retail market,” as a source of concern because retail investors might not receive sufficient disclosure about the nature of the investments they’re making. More generally, he said that the presence of mutual funds and hedge funds under the same institutional roof can create conflicts of interest and that some unscrupulous hedge funds could use “the opaqueness of the private placement to misuse or mismanage funds entrusted to them.”

Fact-Finding Issues

In his address to the committee, William H. Donaldson, the SEC chair, spoke to the same issues, while saying that the SEC is still in the fact-finding stage, having not yet reached any conclusions. On the subject of hedge fund secrecy, he observed that this trait is often crucial to a fund’s investment strategy. He used the example of a hedge fund taking a short position in a particular security–the fund clearly would not tell the world, or its own investors, of that position in real time.

As to retailization, Mr. Donaldson noted that the monetary amounts used to determine accredited investor status essentially have remained the same since 1982. With the growth in incomes and wealth, though, many more investors meet those standards, and “we could of course consider adjusting it, if appropriate.” But he added that the effects of any adjustment on small business capital formation would have to be considered before any such change is implemented.

Hedge funds of funds are another sort of retailization. Mr. Donaldson sees a benefit to their spread, though, in that the large size of their investment relative to the underlying funds makes them very influential and as a result they can compel the underlying funds to provide more information than investors might otherwise get.

Management Issues

On the issue of conflicts of interest, he said that since hedge fund managers often have large stakes in the funds and/or receive performance fees, the managers of an umbrella operation that includes mutual funds could be tempted to favor its hedge fund clients over the clients of the registered investment fund in the allocation of lucrative trades. Or a manager might determine to sell a security short for the hedge fund while maintaining a long position in the same security in the mutual fund, putting the interests of the two sets of clients directly at odds. He stressed, on the other hand, “These types of potential conflicts are the same as those that exist for any investment adviser that manages both registered investment companies and private client accounts.”

Last year the SEC instituted twice the number of enforcement actions against hedge funds or their managers than had been instituted in the four preceding years, Mr. Donaldson said, addressing the issue of potential for fraud. The nature of the charges are not unique to hedge funds (and “I have no reason to believe that fraud is more prevalent in hedge funds than it is anywhere else,”) but the policing task is greater, especially in unregistered funds, where the SEC is limited in its ability to direct problems before they result in loss of assets to investors or harm to the markets.

He said that the SEC’s simulated fraudulent hedge fund’s web site has had 70,000 hits since its creation in February. Most of the potential investors who find the site, he said, do so not through the SEC site’s own link, but by “surfing the internet looking for quick and easy returns.”

Mr. Donaldson’s address also broached issues Sen. Shelby had not mentioned. He spoke of “market-impact issues” such as the ganging-up of short selling firms upon particular target issuers. This will be among the subjects for discussion at the round table the SEC will host in May.

CFaille@HedgeWorld.com