Hedge Fund Transparency Sets New Standard

Disclosure requirements mandated by the Dodd-Frank Act have made hedge funds more transparent than registered investment vehicles such as mutual funds and exchange-traded funds.

At least that’s the consensus within the SEC two years after it implemented Dodd-Frank provisions designed to give both regulators and investors a much clearer view of private funds and their managers, according to people familiar with the agency’s thinking. Indeed, by mandating registration for most hedge fund operators starting in 2012, and requiring them to file an expanded Form ADV and the exhaustive Form PF, the SEC now has more information about those firms than it knows what to do with.

The SEC has “a wealth of information on private funds, where [before] it was one of the biggest gaping holes,” one source said. In terms of transparency, hedge funds and other alternative-investment vehicles are now “pretty far ahead of other financial services in the asset-management area,” including mutual funds.

The regulator’s view marks an ironic turnabout for an industry that has long been castigated for being too secretive. Recent remarks by SEC officials suggest the agency is now more concerned about the transparency of mutual funds and other vehicles registered under the Investment Company Act of 1940 — unsurprising considering those vehicles manage some $17 trillion, versus about $6 trillion in hedge funds and private equity funds. At a mutual fund conference in March, Norm Champ, who heads the SEC’s Division of Investment Management, said his office wants to overhaul the disclosure requirements for mutual funds to produce better and more timely information.

Although mutual fund managers are required to file lengthy prospectuses when they launch a vehicle, as well as the semi-annual Form N-SAR detailing its holdings, the reports aren’t in easily searchable formats like Form ADV and Form PF. As a result, the SEC feels it has access to more useful data on private funds — a point that would raise eyebrows among mutual fund professionals.

“Mutual funds are the most regulated and transparent financial products in the market,” said a spokeswoman for the Investment Company Institute, a trade group representing mutual funds and other so-called ’40 Act vehicles. “We welcome efforts by the SEC to improve its ability to address systemic risk.”

What the SEC is doing with all of the new information it’s collecting on private funds is another matter. To be sure, the newly expanded Form ADV, a public filing, has given investors a better look at hedge fund-management firms. But Form PF, which isn’t public, contains reams of data on the leverage, risk and counterparty exposure of hedge fund portfolios. And the largest fund operators are required to update that filing quarterly.

Hedge fund lawyer George Mazin, a partner at Dechert, said at the very least, the SEC is using the new information to guide its on-site examinations of hedge fund firms. But regulators are still trying to get their arms around the full extent of the data available to them, he added. “I would expect that they are doing far less than they say they are,” he said. “There is probably tons of information that they are getting — data that they are not making any use of.”

In October 2012, the SEC set a goal of examining 25% of the some 1,500 newly registered fund operators within two years. So far it has performed “presence” exams on about 250 firms. Typically, SEC examinations result in deficiency notices being issued to managers in about 80% of the cases — though often the violations are quite minor.

Paul Atkins, an SEC commissioner from 2002 to 2008 who now runs his own consulting firm, Patomak Global Partners, also questioned whether the SEC has the resources to process all of the data it’s collecting on the hedge fund industry. “The real question goes back to why did they ask for all of this information,” Atkins said. “It costs a lot of money to collect and file, and I wouldn’t wish that on the mutual fund industry.”

The new disclosure requirements for private funds also are designed to guide the U.S. Treasury’s Financial Stability Oversight Council in its effort to gauge systemic risk. But four years after the council was created by Dodd-Frank, it has yet propose rules for monitoring large private-fund operators.

Industry professionals have maintained that it’s unlikely the FSOC would tag any hedge fund operations as systemically risky, unless they’re part of much larger asset-management businesses. But a report from the Federal Reserve this week could alter that view. The paper, authored by economist Reint Gropp, said hedge funds played a key role in the 2008 financial crisis.

“A surprising finding from this study is that hedge funds may be the most important transmitters of shocks during crises, more important than commercial banks or investment banks,” Gropp wrote.

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