This is the fifth article in an ongoing series that examines what’s ahead in 2004 from the viewpoints of industry experts.

NEW YORK (HedgeWorld.com)–Massive growth in hedge fund assets and a rash of fraud cases were the main reasons cited by the U.S. Securities and Exchange Commission for its initiative last year to study the industry. Observers expect both growth and regulatory pressure to continue in 2004, with firms becoming better organized and more widely accepted as a result.

“From what we’re seeing in the marketplace, there will be much broader distribution of hedge funds,” said John Kelly of Man Group, Chicago.*

Compulsory registration for most managers is one likely outcome of the regulatory probe. As many as 50% of managers already may be registered with the SEC and would therefore not be affected by any such requirement. And those not registered are subject to other regulations.

These include, as listed in a letter the Managed Funds Association sent to the SEC, fraud and insider trader prohibitions under U.S. securities laws; NASD and Commodity Futures Trading Commission rules for the large number of funds that are registered with these bodies; and anti-money laundering provisions in accordance with the USA PATRIOT Act once these are finalized.

Investors nevertheless are concerned about practices such as inflating asset values, but SEC registration might not provide protection against such misdeeds. In fact, many fraud charges involve registered investment advisers, as the MFA points out in opposing compulsory registration. In the case of Lipper and Co., for example, being registered did not prevent mispricing of convertible arbitrage assets. Manager Edward Strafaci was charged with fraud in this connection.

It would be wrong for investors to assume that because a firm is registered, regulators are keeping a close eye on it for investor protection, Mr. Kelly said. “I don’t think you can rely on regulators to do due diligence,” he said. Fund of funds managers, consultants and investors have to check for themselves.

Organization

However, registering would push firms to become better organized, as regulators want to see systems and processes. “When the SEC comes in to audit, they do a very detailed review of your record-keeping procedures,” explained Man Investments Inc. compliance officer Keith Kendrick.

“You have to document compliance processes and policies,” he added. “They look at how you maintain your books and records, what kind of documentation you have on file to show certain checks and balances are being executed.”

Another trend that boosts mainstreaming is the spread of information about hedge funds. U.S. broker-dealers and advisers are learning the benefits and risks of this type of investing and hopefully relaying the knowledge to their customers.

Man Group, which has been selling hedge fund-based products in various parts of the world for 20 years, trains advisers who in many cases have no prior experience with such instruments. Recently it has been doing this in the United States, where it started building a distribution network about two years ago .

Beyond being legally qualified, a requirement that is met by having sufficient assets, investors need to meet other suitability criteria, Mr. Kelly said. Before investing, people have to understand the risks inherent in hedge funds. Advisers should make sure a client’s portfolio, personal circumstances and even attitude toward risk are appropriate for hedge fund investing.

Man Group has built a relatively stable client base in parts of Europe, the Middle East and Latin America. Preventing unpleasant surprises down the pike by disclosing risks at the outset is essential for this so that people stay with the investment through market turbulence. “We want to make sure we have a smooth ride with investors,” Mr. Kelly said. “We’ve seen it happen in the offshore markets where we’re more established.”

In some parts of the world, hedge fund of funds-based products in particular have become common. U.S. law places more restrictions on access to hedge funds by the

mass affluent, but new regulation may make funds of funds acceptable to a larger body of investors if the underlying managers have to be registered with the SEC.

The combination of better-organized firms and better-informed investors certainly would help mainstream the industry. But will capital inflows into alternative investments keep up the pace if the equity market continues to look as good as it did in 2003? Will everybody go back to conventional investing?

One view is that having undergone the painful experience of 2000 to 2002, individuals and institutions will want to diversify their portfolios and not limit themselves to long-only assets, whatever the market. Another factor: Rallies lift portfolio values, and there is more to invest. If people decide they want to put a certain percentage of their assets into alternatives, Mr. Kelly said, “We’re likely to get more money because 10% or 20% of a growing portfolio is being put into hedge funds.”

Asset growth accompanied by infrastructure building and the spread of information may result in a more widely accepted and conventional industry. But if safeguards and understanding lag the increase in assets, calls for additional regulation are likely to continue over the long run.

*Man Group plc is a minority investor in HedgeWorld.

CKurdas@HedgeWorld.com