Hedge fund fraud much higher in U.S.
The domestic industry faces many more fraud cases than in Europe. Here's why.
October 27, 2005: 12:09 PM EDT
By Amanda Cantrell, CNN/Money staff writer
NEW YORK (CNN/Money) - While becoming a successful hedge fund manager in the United States is tough, virtually anyone can give it a shot, provided they've got a handful of startup capital and a Bloomberg terminal.
That ease of entry to the industry is one of the reasons hedge fund fraud takes place in the U.S. but is virtually nonexistent in Europe, according to the Alternative Investment Management Association (AIMA), an industry group based in London.
Hedge funds are private investment pools that cater to wealthy individuals or institutions such as banks, university endowments or pension funds. Ordinary investors who have money in pensions are exposed to hedge funds if their pension plan invests.
The Financial Services Authority, England's answer to the Securities and Exchange Commission, requires managers to meet thresholds before starting a hedge fund that U.S. regulators do not require, Florence Lombard, AIMA's executive director, said in a panel discussion Wednesday.
For starters, hedge funds must register with the FSA before they can start taking clients. U.S. hedge funds do not have to register as investment advisers with the SEC now, but they will starting in February of 2006.
As it is currently written, the rule will require managers with $25 million or more to register with the SEC. Lombard said she has heard talk that the SEC may raise the minimum threshold to $50 million, which would lead to fewer funds having to register, though the SEC denies it is seeking to change the minimum.
"As we are required to, we are always discussing the appropriate threshold, but there are no discussions to actively change it," SEC spokesman John Nester told CNN/Money.
Tougher standards in Europe
Unlike the SEC, the FSA conducts background checks on would-be hedge fund managers who register. And fund managers in Britain also have to meet minimum competency requirements and prove they are qualified to run a hedge fund.
"You can't have been a librarian and then decide you want to open a hedge fund," said Christopher Fawcett, chairman of AIMA and manager of Fauchier Partners, a so-called fund of funds, or pool of capital that invests in hedge funds, based in London with roughly $4 billion in assets.
The number of fraud cases in the hedge fund industry is still considered low considering the number of funds -- there are an estimated 8,000 world wide.
But a number of recent high-profile scandals, including the $450 million fraud at Bayou and the dustup at Wood River Capital shortly thereafter, have sparked renewed debate about how to prevent hedge fund fraud.
Lombard said that in the 15 years AIMA has existed, there has only been one documented case of hedge fund fraud. Contrast that with the U.S., where the SEC has brought fraud charges in 20 hedge fund cases in the last year alone, according to Business Week magazine.
The U.S. hedge fund industry is bigger than in Europe, however -- the bulk of the hedge fund industry is concentrated in New York and Connecticut, while London is the capital for European hedge fund operations.
The domestic industry has also grown faster though Europe is catching up, particularly as hedge funds' popularity with European pension plans grows.
While AIMA supports some hedge fund regulation, one of its goals is to make sure that funds already registered in Britain don't have to register again with the SEC in order to continue servicing U.S.-based investors.
"In certain jurisdictions, managers want to minimize the amount of U.S. money they get" to curb the legal hassles they might face, said David Goldstein, partner and co-head of the investment funds practice at White & Case, a New York law firm.
If U.S. investors can't get access to overseas hedge funds, that phenomenon will be "detrimental to the industry," he added.
New strategies debuting
Another issue facing the fast-growing industry is how to extract excess returns out of an increasingly crowded market, the panelists said.
The hedge fund industry, long a Wall Street innovator, has frequently created exotic money-making strategies that have then ballooned in popularity.
But as Neil Brown, director of AIMA and managing director of New York-based Citigroup Alternative Investments, noted, when a profitable arbitrage trade is uncovered, managers then pile onto the trade, and the opportunity to make money gets "arbed away."
This summer's meltdown in convertible bond hedge funds proved a wrenching case in point. Convertible arbitrage managers buy convertible bonds, which are bonds that can be exchanged for a certain amount of a company's common stock, and short the underlying stock of the issuing company to profit from the difference in price between the two securities.
Long considered a safe haven, the strategy posted big losses this year, which forced three big convertible bond hedge funds to close: San Francisco-based Marin Capital Partners, which had $2.2 billion in assets at its peak; Alta Partners, run by San Francisco-based Creedon Keller & Partners, which had about $1.2 billion at its peak; and Minnesota-based EBF & Associates' $669 million Lakeshore International Fund.
Now, hedge funds are coming up with new, more exotic strategies as traditional strategies, such as certain kinds of arbitrage, get overcrowded.
Clarksons, one of the world's largest shipping brokerages, for example, is launching a hedge fund solely based on shipping securities and derivatives, according to a Financial Times report.
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