Mr. Chairman, thank you for holding this morning’s important hearing on hedge funds. I join in welcoming William Donaldson, the Chairman of the SEC, to the first oversight hearing at which he will testify before the Banking Committee.
In September 1998, the collapse of Long-Term Capital Management drew international attention to hedge funds. The Economist called it “one of the greatest financial failures of all time. The hedge fund's losses were spectacular: around $4 billion in five weeks . . . The fund's implosion came perilously close to causing a catastrophic failure of the global financial system.” It raised issues of systemic risk and excessive leverage.
Since then, hedge funds have grown tremendously. Industry sources reported that “Since the turn of the century, the hedge fund industry has grown by 82%, from $324 billion to $592 billion” and that in the last ten years, the number of hedge funds has grown from about 1,100 to 5,700. Fortune reported that Warren Buffett has said “Hedge funds have become the latest Holy Grail.” At the same time, according to the Financial Times, “50 percent of all new hedge funds close within about three years of starting up.” The growth in the industry has been accompanied by an increase in fraud and the number of SEC enforcement actions.
Hedge funds used to be investments for the very wealthy. Hedge fund managers sold only to “accredited investors”, those who earned more than $200,000 per year or had more than $1,000,000 in assets, in order to take advantage of an exemption in the securities laws.
However, the market for hedge funds has greatly expanded and spawned funds of funds. Fortune reported that “funds that make investments in hedge funds are peddling themselves to less accredited investors as well - dentists, school principals, and the like - for minimum stakes as low as $25,000. What’s more, a huge group of shareholders may be in hedge funds and not even know it: America’s retirees” through their retirement plans.
This raises concerns about investor protection. Chairman Donaldson at his confirmation hearing before this Committee on February 5, 2003, referred to “a distressing move towards what I would call the retailization of hedge funds, making them available to smaller and smaller investors . . . less sophisticated investors not realizing the risks inherent in these vehicles.” He said hedge funds are “pretty much unregulated.”
The SEC and other Federal regulators have been looking at these issues for some time. In 1999, the President’s Working Group on Financial Markets issued a report titled, “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management.” In that report, the Working Group recommended that: (i) hedge funds be required to “disclose additional, and more up-to-date, information to the public” through periodic reports; (ii) public companies should publicly disclose “summaries of direct material exposures to significantly leveraged financial institutions;” and (iii) financial regulators, including the SEC, should encourage improvements in the risk management systems of securities firms.
More recently, the Commission initiated a major investigation into the hedge fund industry. I appreciate the attention and interest that Chairman Donaldson is now devoting to this area.
There are many important issues to consider, particularly as they relate to retail investors. These include:
Other issues which have been consistently raised by commentators include:
Regarding the importance of hedge fund markets, Fortune dated March 31, 2003 in the article “Where the Money’s Really Made” stated “The hedge fund boom has sweeping implications not just for Wall Street traders and a few thousand well-heeled investors, but increasingly for every American businessperson, investor and retiree.”
I look forward to learning more about these potential “sweeping implications” in today’s testimony. I am particularly concerned about the Commission’s protection of retail investors.