SEC Regulator Cautions On Hedge Funds, Execution

July 17, 2001 ( - In a wide-ranging speech before a gathering of public pension fund officials, a top Securities and Exchange Commission regulator warned plan officials about the risks of investing in hedge funds and a lack of insistence on 'best execution' practices.

Paul Roye, SEC director of the division of investment management, told the Public Funds Symposium that investing in hedge funds poses significant risks.

Risky Business

He cited three kinds of risks a plan sponsor should be on the lookout for:

  • an increased chance of fraud, because of the secrecy surrounding hedge fund strategies. ‘High debt and secrecy have become parts of the hedge fund culture,’ Roye said. ‘Managers can change investment strategies and their investors would never know. Moreover, it is more difficult for hedge fund investors to vote with their feet. Many hedge funds only allow investors to cash in their holdings on a few days a year. All of this can make it easier for a hedge fund manager to engage in fraud.’
  • the possibility of a ‘bubble.’ ‘The growth in hedge fund assets has caused some market strategists to compare it to the recent technology bubble. These strategists note that hedge funds’ strategies usually decrease in effectiveness as their assets grow and that many of the best managers have closed their funds,’ Roye said. ‘As a result, over the last year new hedge funds have sprouted in the United States and Europe run by managers with little experience or track record in hedge fund strategies, raising questions about capacity to handle the billions of dollars flowing into these funds.’
  • potential conflicts of interest when consultants hired to identify hedge fund investments are also servicing those same hedge funds or when mutual fund managers and investment advisers advise and sponsor hedge funds. ‘The differing fee structures create a real risk of favoring a hedge fund over a mutual fund or other accounts when making investment decisions,’ Roye said. ‘Conflicts can also arise when hedge funds effect short sales of securities, if such securities are held long by mutual funds or private accounts managed by the same advisory firm. Such trades could adversely affect long positions held by the other accounts.’

Still, Roye admitted that ‘hedge funds have some proper role to play in helping pension funds secure the retirement fortunes of their beneficiaries.’ He urged ‘adequate due diligence’ on part of pension fund managers.

Best Execution

Roye also stressed that pension funds should pay closer attention to best execution practices. ‘Many advisers need to pay more attention to seeking the best execution for their clients’ trades,’ the regulator said in a prepared statement. ‘If an adviser is in a position to direct brokerage transactions, the adviser’s fiduciary duty includes the requirement to seek the best execution for clients’ securities transactions.’

He cited four key factors of ‘best execution’:

  • obtaining the best price
  • the speed of execution
  • the certainty of execution
  • the commission rate or spread.

He said the focus of the SEC has shifted from looking mostly at commission rates and trade prices, to also include ‘the process by which an adviser seeks to achieve best execution.’

Lax Behavior

Ahead of the release of its findings, Roye said the SEC found that:

Not all advisers consider possible alternatives. ‘Some advisers appear too comfortable with existing execution quality. Remember that advisers are required to perform a “periodic and systematic” review. One would think that this would lead to rerouting orders on occasion and not routing status quo,’ Roye said.

Advisers don’t always identify those quality factors that they are relying on in routing order flow. ‘In particular, advisers should consider the opportunity to obtain better executions for clients in light of the conflicts of interest in trade placement, including directing brokerage to broker-dealers that make client referrals to the adviser, and using commissions to pay for research or other services,’ he said.

Roye sounded a word of warning to plan sponsors. ‘It makes no sense for you to try and identify managers that will make superior investment decisions without also investigating whether the firm is likely to lose or give away the value of these decisions through sloppy placement of orders for execution,’ he said.

Finally, Roye also urged the public funds to pay increased attention to investor education as more and more public funds are adopting defined contribution-style plans, putting a heavier investment allocation burden on employees.

– John van Rosendaal                     

For the full text of the speech .