WEBMASTER NOTE: This is the unedited transcript of the hedge fund hearings held 
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             1   UNITED STATES SECURITIES AND EXCHANGE COMMISSION

             2

             3   In the Matter of:       )

             4                           )  File No. 05-007-03

             5   HEDGE FUND ROUNDTABLE   ) 

             6   PAGES:    1 through 285

             7   PLACE:    Securities and Exchange Commission

             8             450 Fifth Street, N.W.

             9             Washington, D.C.

            10   DATE:     Wednesday, May 14, 2003

            11

            12        The above-entitled matter came on for hearing, pursuant

            13   to notice, at 9:00 a.m.

            14

            15   BEFORE:

            16

            17        WILLIAM H. DONALDSON, Chairman

            18        PAUL ATKINS, Commissioner

            19        RAUL CAMPOS, Commissioner

            20        CYNTHIA GLASSMAN, Commissioner

            21        HARVEY GOLDSCHMID, Commissioner

            22

            23

            24                Diversified Reporting Services, Inc.

            25                           (202) 467-9200

             1                          C O N T E N T S

             2                                                            PAGE

             3

             4   Welcome and Overview - Chairman Donaldson                  8 

             5

             6   PANEL 1 - HEDGE FUNDS - OVERVIEW, ROLE AND STRUCTURE      12 

             7

             8   MODERATOR:

             9        PAUL F. ROYE

            10        Director, Division of Investment Management

            11

            12   PANELISTS:

            13        DAVID VAUGHAN

            14        Partner, Decker, LLP

            15

            16        RICHARD LINDSEY

            17        President, Bear Stearns Securities Corp.

            18

            19        CHARLES GRANDANTE

            20        Managing Principal, Hennessee Hedge Fund 

            21        Advisory Group

            22

            23        WILLIAM KEUNEN

            24        Director, Citco Fund Services

            25

             1        GREGORY NEWTON

             2        President, Managed Accounts Reports, LLC

             3

             4        JOEL PRESS

             5        Senior Partner, Ernst & Young

             6

             7        ROBERT SCHULMAN

             8        Chairman and CEO, Tremont Investment Management

             9

            10        MICHAEL NEUS

            11        Principal and Chief General Counsel, Andor Capital

            12        Management, LLC

            13

            14

            15   PANEL 2 - MARKETING ISSUES - HOW ARE HEDGE FUNDS

            16   MARKETED/DISTRIBUTED?                                    100 

            17

            18   MODERATOR:

            19        ELIZABETH G. OSTERMAN

            20        Assistant Chief Counsel, Division of Investment

            21        Management, Securities and Exchange Commission

            22

            23   PANELISTS:

            24        ALAN BELLER

            25        Director, Division of Corporation Fincance, SEC

             1        MICHAEL BUTOWSKY

             2        Partner, Mayer Brown Rowe & Maw

             3

             4        LEROY CODY

             5        Managing Director, American Express Alternative

             6        Investments

             7

             8        JAMES R. HEDGES

             9        Founder, President, and Chief Investment Officer, LJH

            10        Global Investments, LLC

            11

            12        CLARK HOOPER

            13        Executive Vice President of Disclosure Policy and

            14        Review, NASD

            15

            16        JUDSON P. REIS

            17        Partner, the Sire Group of Partnerships

            18

            19        CRAIG RUSSELL

            20        Managing Director and Global Head of Sales and

            21        Marketing, DB Absolute Return Strategies

            22

            23        MICHAEL TIEDEMANN

            24        Chief Operating Officer, Tiedemann Investment Group

            25

             1   PANEL 3 - ISSUES ASSOCIATED WITH HEDGE FUND DISCLOSURE,

             2   TRANSPARENCY AND PAERFORMANCE FEES                        100

             3

          1      MODERATOR:

          2           ROBERT E. PLAZE

          3           Associate Director, Division of Investment Management, 

          4           Securities and Exchange Commission

          5

          6      PANELISTS:

          7

          8           ROBERT BERNARD

          9           Chief of Administration and Finance, RiskMetrics Group

         10

         11           GEORGE HALL

         12           Founder and President, Clinton Group

         13

         14           DAVID A. HSIEH

         15           Professor of Finance, Fuqua School of Business, Duke

         16           University

         17

         18           JEAN KAROUBI

         19           President, The LongChamp Group, Inc.

         20

         21           LARRY SIMON

         22           President and CEO, Ivy Asset Management Corp.

          1           DAVID SWENSEN

          2           Chief Investment Officer, Yale University

          3

          4           MICHAEL G. TANNENBAUM

          5           Director, Hedge Fund Association

          6           Partner, Tannenbaum Helpern Syracuse & Hirschtritt, LLP

          7

          8

          9      PANEL 4 - ISSUES ASSOCIATED WITH VALUATION, ALLOCATION, USE

         10      OF COMMISSIONS AND PERSONAL TRADING                       219

         11

         12      MODERATOR:

         13           DOUGLAS SCHEIDT

         14           Associate Director and Chief Counsel, Division of

         15           Investment Management, Securities and Exchange

         16           Commission

         17

         18      PANELISTSl

         19           ANTHONY ARTABANE

         20           Partner, PricewaterhouseCoopers, LLP

         21

         22           MICHAEL DIESCHBOURG

         23           Principal, Silver Creek, LLC

         24

         25           BING LIANG

          1           Assistant Professor of Finance, Weatherhead School of

          2           Management, Case Western Reserve University

          3

          4           ANDREW W. LO

          5           Harris & Harris Group Professor of Finance, Sloan School

          6           of Management, Massachusetts Institute of Technology

          7

          8           RICHARD PHILLIPS

          9           Partner, Kirkpatrick & Lockhart, LLP

         10

         11           STEPHEN VINE

         12           Partner, Akin Gump Strauss Hauer & Feld, LLP

         13

         14

         15           ROBERT ZACK

         16           Senior Vice President and General Counsel, Oppenheimer

         17           Funds, Inc.

         18

         19      CLOSING ARGUMENTS

         20

         21           PAUL F. ROYE

         22           Director, Division of Investment Management, U.S.

         23           Securities and Exchange Commission

         24

         25

          1                          P R O C E E D I N G S

          2                CHAIRMAN DONALDSON:  Good morning, ladies and

          3      gentlemen.  I'm Bill Donaldson, Chairman of the SEC.  On

          4      behalf of my fellow Commissioners, Paul Atkins, Raul Campos,

          5      Cynthia Glassman, Harvey Goldschmid, welcome.  It's really a

          6      pleasure to have all of you here for our hedge fund

          7      roundtable.

          8                Although I'm not surprised, I'm pleased to see that

          9      we have a large turnout.  And I also welcome those of you who

         10      are watching by webcast.

         11                As you can see by the agenda, we have an impressive

         12      group of people, panelists, and a broad range of very timely

         13      and engaging issues to explore.

         14                As all of you know, this is an exciting and dynamic

         15      time for the hedge fund industry.  Over the past few years,

         16      hedge funds have become more popular and continue to grow in

         17      size.  It's estimated that there are close to 5,700 hedge

         18      funds operating in the United States today, managing

         19      approximately $600 billion in assets.

         20                By contrast, in 1990, only about $50 billion was

         21      under management in hedge funds.  And hedge funds play an

         22      important role in our markets and have a legitimate place in

         23      the array of investment options available to investors.

         24                However, while there are frequent reports of high

         25      returns for hedge funds, there are also reports just as

          1      frequently that highlight possible areas of concern, such as

          2      potential conflicts of interest, questionable marketing

          3      techniques, valuation concerns, and the market impact of

          4      hedge fund strategies.

          5                Consequently, since June of last year, SEC staff in

          6      the Division of Investment Management and our Office of

          7      Compliance, Inspections and Examinations have been engaged in

          8      a fact-finding mission aimed at reviewing the operations and

          9      practices of hedge funds.]

         10                While we still are at the fact-finding stage, and

         11      have yet to reach any conclusions, this roundtable is the

         12      next stage in the process.  With our impressive list of

         13      panelists, we hope to have a full and frank discussion of the

         14      many issues surrounding hedge funds.

         15                The last time the Commission took a good look at

         16      hedge funds was in 1998, when the Connecticut-based hedge

         17      fund, Long-Term Capital Management, nearly collapsed.

         18                After that incident, the Commission, along with the

         19      Treasury Department, the Federal Reserve, and the Commodity

         20      Futures Trading Commission, as part of the President's

         21      Working Group on Financial Markets, issued a report on the

         22      risk management and transparency issues raised by LTCM, in

         23      particular, and by "highly leveraged institutions," in

         24      general.

         25                The President's Working Group looked at such issues

          1      as firms' adherence to their own stated policy, their margin

          2      and collateral requirements, their use of leverage and

          3      whether it was excessive, and how well their risk models

          4      functioned.

          5                The President's Working Group issued a report and

          6      recommendations, and the indications are that the industry

          7      has taken these recommendations to heart.  The President's

          8      Working Group continues to function.

          9                However, as the markets and the hedge fund industry

         10      have continued to evolve, I believe the time has come for us

         11      again to advance our review of hedge funds and how they are

         12      operated, managed, and regulated.

         13                We are looking to ensure investor protection and

         14      are focusing on issues such as "retailization" of hedge

         15      funds, transparency, risk management, conflicts of interest,

         16      and fraud.

         17                As part of our fact-finding to date, SEC staff has

         18      obtained and reviewed documents and information from 67

         19      different hedge fund managers representing more than 650

         20      different hedge funds and approximately $162 billion under

         21      management.

         22                The staff concluded on-site visits to a wide range

         23      of hedge funds, large and small, and spoke to employees who

         24      are responsible for brokerage, compliance, risk management,

         25      legal and other operational issues.  The staff also met with

          1      a variety of industry experts to get their perspective on

          2      these issues.

          3                Over the next two days, you will hear from many of

          4      these experts, including a host of legal and accounting

          5      experts, academics, hedge fund investors, risk managers,

          6      prime brokers, representatives from foreign regulators, trade

          7      industry representatives, hedge fund consultants and

          8      administrators, as well as hedge fund managers and investor

          9      advocates.

         10                After these two days of discussions, let me assure

         11      you that we will continue to listen to all of the various

         12      perspectives regarding hedge funds.  I encourage you to send

         13      us your comments reflecting what you have heard today and

         14      tomorrow, because the discussion does not end when we leave

         15      here tomorrow.

         16                Before I turn the microphone over to Paul Roye, our

         17      Director of the Division of Investment Management, I want to

         18      thank Paul and the dedicated staff who worked very hard,

         19      tirelessly, on the fact-finding mission and roundtable, as

         20      well as Lori Richards and her staff in the Office of

         21      Compliance, Inspections and Examinations.

         22                I also especially want to thank all of our

         23      panelists who have been so generous with their time and ideas

         24      as we work to bring better understanding to the hedge fund

         25      industry.

          1                And, finally, I'd like to thank all of you who have

          2      taken time out of your busy schedules to be here, whether in

          3      person or over the Web, to observe and listen along with us,

          4      and I hope we exchange a few ideas as the day progresses.

          5                Paul, let me turn the podium over to you.  Thanks

          6      very much for being here.

          7                MR. ROYE:  Thank you, Chairman Donaldson, for those

          8      welcoming remarks.  You've highlighted a number of important

          9      issues that we want to explore over the next couple of days.

         10                Before I begin, I want to mention a few

         11      housekeeping items.  As you can see, we have a large audience

         12      today, and we won't be able to take questions from the

         13      audience.  The questions will come from the moderators and,

         14      of course, our Commissioners.

         15                I'd also ask you to turn off your cell phones.  Our

         16      agenda does include built-in breaks, where you can turn on

         17      your cell phones and make the calls that you have to make,

         18      but we ask that you again turn them off at the beginning of

         19      each panel.

         20                And I would note that if you leave the building,

         21      unfortunately, you have to go through our security check once

         22      again.

         23                Now let's get started with our first panel.  And,

         24      really, the purpose of our first panel is really to kind of

         25      frame the discussion for what follows, for our subsequent

          1      panels, really to provide an overview of the industry, to

          2      review how hedge funds are structured and operated, the types

          3      of services the various service providers provide to hedge

          4      funds, and really to give an overview of the current state of

          5      the hedge fund industry.

          6                We have our Commissioners present, Commissioner

          7      Glassman, Commissioner Atkins, Commissioner Campos, and, of

          8      course, Chairman Donaldson.  Commissioner Goldschmid is going

          9      to be joining us later this afternoon.

         10                But we do have a distinguished group of panelists,

         11      and I'd like to take a quick moment to introduce each of them

         12      to you.

         13                To my far right is Joel Press.  Joe is a senior

         14      partner at the accounting firm of Ernst & Young.  He's been a

         15      contributing author to a number of articles and industry

         16      publications in the hedge fund area and is a leader in the

         17      field of hedge fund accounting.

         18                Next to Joel is Robert Schulman.  Bob is the

         19      Chairman and CEO of Tremont Investment Management, and he's

         20      co-chief executive officer of Tremont Advisers, a hedge fund

         21      consulting firm that focuses on advising individuals and

         22      institutions investing in hedge funds.

         23                Next to Bob is William Keunen.  William is the

         24      Director of Citco Fund Services.  It's a firm that provides

         25      custodial and fund administration services for the

          1      international fund industry, including hedge funds, and

          2      they've been in this business for over 30 years.

          3                On my immediate right is Mike Neus.  Michael is a

          4      principal and the chief general counsel of Andor Capital

          5      Management.  They manage hedge funds.  Mike oversees all of

          6      the legal and regulatory matters and is also Andor's chief

          7      compliance officer.

          8                On my immediate left is Charles Gradante.  Charles

          9      is the managing principal of The Hennessy Group, LLC, a hedge

         10      fund consulting firm that he co-founded with Lee Hennessy in

         11      1997 after 11 years in the business division of several major

         12      financial institutions.  They're in the business of advising

         13      individuals and institutions regarding hedge fund investing.

         14                Next to Charles is David Vaughan.  David's a

         15      partner in the financial services group of the law firm of

         16      Deckert, LLP, in Washington, where his law practice focuses

         17      principally on advising hedge funds.

         18                Next to David is Dr. Richard Lindsey.  Richards is

         19      president of Bear Stearns Securities Corporation.  They

         20      provide prime brokerage, broker-dealer, and registered

         21      investment adviser clearing services.  And prior to joining

         22      Bear Stearns, he served at the SEC as the director of the

         23      Division of Market Regulation, and also as the SEC's chief

         24      economist.

         25                And then next to Richard is Greg Newton.  Greg is

          1      the president of Managed Accounts Reports, LLC, known in the

          2      industry as MAR, a New York-based publisher of several

          3      newsletters covering the alternative investment marketplace.

          4                It seems appropriate that to begin our discussion,

          5      we ought to really try to understand, when you use the term 

          6      "hedge fund," what we're really talking about.  

          7                David, could you maybe define "hedge fund" for us,

          8      or what people typically view as a hedge fund, and maybe how

          9      a hedge fund is distinguished from other types of private

         10      investment vehicles.

         11                MR. VAUGHAN:  Sure, I'd be happy to.  I heard some

         12      people in the audience kind of laughing to themselves as they

         13      heard that I was going to try to define hedge funds, because

         14      I think most people in the audience and everyone on the panel

         15      knows there is no precise definition of "hedge fund."

         16                It's a term used in the industry, people seem to

         17      know one when they see one, but there is no legal definition. 

         18                Usually we're referring to an unregistered fund,

         19      not registered with the Commission, typically relying on

         20      Sections 3(c)(1) or 3(c)(7) for that exception from

         21      investment company regulation.

         22                They're usually characterized by the ability to do

         23      short selling or leverage or other types of more or less

         24      exotic strategies, nontraditional strategies.  They often

         25      have performance-based compensation.  And the thing that

          1      makes it a little difficult to know where to draw the line

          2      is, there are lots of other funds that may have some of these

          3      characteristics, or even all of them, that do not consider

          4      themselves hedge funds for one reason or another or not

          5      considered by the industry hedge funds.

          6                Some of the more obvious examples are private

          7      equity and venture capital funds, which are really

          8      distinguished more by the level of liquidity of the fund, and

          9      that they don't mark their assets to market typically,

         10      although, again, that's not a bright line.  They are hedge

         11      funds that have some crossover aspects to them.

         12                And so that's about the best we can do in

         13      describing what a hedge fund is from a legal or even a

         14      business perspective.  I'd be interested in anyone else's

         15      views as far as other views as what are essential

         16      characteristics of hedge funds.

         17                MR. LINDSEY:  I think from a business perspective,

         18      it can be described somewhat -- a little differently, and

         19      that is, that hedge funds are actually nothing very much

         20      different than the proprietary trading activities that exist,

         21      and have existed for a very long time within street firms.

         22                So if you take a proprietary trading desk from one

         23      of the major houses of a street and you privatize that

         24      operation, that's really what a hedge fund is.  And many

         25      times, of course, that's where hedge funds even come from,

          1      are those traders that step out of the proprietary -- or step

          2      out of the houses and form their proprietary interest.

          3                Of course, the way that they have to do business

          4      is, they have to have capital, they have to have a way to do

          5      that.  So, typically, they go about with a Reg D offering,

          6      they raise capital, and then they invest that capital in the

          7      fairly typical proprietary trade strategies.

          8                CHAIRMAN DONALDSON:  I'd like to comment on that. 

          9      There's been a reduction in proprietary trading on Wall

         10      Street in the last decade.  As investment banking firms have

         11      gone public, seeking earnings that are stable and more

         12      predictable, they've cut back on proprietary trading.

         13                It's not a figure I can quote, but it's a feeling

         14      that I get from talking to fellow compatriots on the street. 

         15      And those people leaving proprietary trading desks have gone

         16      into the hedge fund industry.  Quite simply, the compensation

         17      factors are quite similar to what they were receiving on Wall

         18      Street to what they would be receiving as a hedge fund.

         19                MR. SCHULMAN:  And just to amplify for one second,

         20      if I could.  What we're hearing from managers as they come

         21      out of proprietary training desks, of course, is, they're

         22      embedded in brokerage firms that have gone through a

         23      relatively difficult earning cycle, which means that their

         24      earnings are down.

         25                So we're at a time now where there's significant

          1      inducement for a lot of these people to come out of the

          2      marketplace -- come off the trading desks and out on their

          3      own.  There's little to lose, because their pay scale is down

          4      simply because the firm has not done well.

          5                But it's not fair to categorize everything as --

          6      every hedge fund as something that would otherwise exist on a

          7      trading desk in a brokerage firm.  A lot of them are

          8      research-driven and not execution-driven.  And I think you

          9      really have to look at the market in those two ways.  

         10                Some of them are brilliance of execution and

         11      brilliance of trading.  Probably more of them are driven by

         12      some kind of internal information edge, research edge, or

         13      asset allocation edge, not just trading skills.

         14                MR. PRESS:  I think also you have to look at hedge

         15      funds as entrepreneurs.  It really is a business of people

         16      wanting to create their own culture, their own environment,

         17      instead of working either in a large organization, but

         18      creating their way of earning dollars in a way that's unique

         19      to them, in their own strategy, their own people, their own

         20      compensation environment, and allowing them to exist in

         21      today's technology wherever they choose to set up their

         22      organization and just work and trade and do their research.

         23                It's a very unique entrepreneur.  No different than

         24      any other business in America, but it really is a group of

         25      very successful entrepreneurs.

          1                MR. ROYE:  When you talk about hedge funds, I know

          2      there are, you know, just a variety of different types of

          3      hedge fund strategies.  I guess either Charles or Bob, could

          4      you kind of maybe outline the types of various strategies out

          5      there in the hedge fund world and how you sort of categorize

          6      them generally?

          7                CHAIRMAN DONALDSON:  Well, we have categorized --

          8      or located 23 different strategies.  Lee Hennessy, our

          9      founder, saw the need in order to benchmark our consulting

         10      practice, the managers we were investing in on behalf of our

         11      clients, to put managers into categories, and fundamentally

         12      we started using the categories we found in the traditional

         13      world, growth, value, and other categories like that.  There

         14      are 23.

         15                And in arbitrage, there are convertible arbitrage

         16      and merger arbitrage, and I can -- I don't think we need to

         17      list the 23 strategies.  

         18                But I think what's important is that the need to

         19      categorize hedge funds in order to benchmark their

         20      performance against their peer group is something that

         21      consultants find the need to do.

         22                MR. NEUS:  I think that one way to look at it is,

         23      if you group those various strategies, and because it's an

         24      entrepreneurial industry, there are a tremendous number of

         25      variations within each strategy and crossover strategy.

          1                I think one useful way is to bucket them in three

          2      basic groups:  market neutral strategies, event-driven

          3      strategies, and directional strategies.  And that's linking

          4      it from the least risky or volatile to the most risky.

          5                And it's useful to do that, because then you can do

          6      the comparisons between private investment funds, on the one

          7      hand, mutual funds, private equity, or other alternative

          8      investment asset classes on the other side.

          9                MR. SCHULMAN:  Another way to look at it is,

         10      understanding there are a few strategies that dominate from

         11      Charles's list, or even from the list that we just talked

         12      about.

         13                Long short equity is 35 to 40 percent of all of the

         14      money, so it is by far the largest strategy.  The other big

         15      strategies are the global macro strategies.  Recently

         16      convertible arbitrage and distressed have become big

         17      strategies.

         18                Although there may be lots of sub-strategies,

         19      contained in that first list of seven or so you're going to

         20      find the vast majority of the money.

         21                MR. PRESS:  But, again, hedge fund people, when you

         22      talk to them, the reason there's 5,000 and maybe growing is

         23      because each of them feel they bring a uniqueness to what

         24      they do, and each has a slightly different way to approach

         25      the market, and each will tell you that in general for their

          1      strategy, there is a limit to the amount of capital they

          2      would want to trade and will work with.

          3                And most will find that there is a level that

          4      they're comfortable with, and it may take years to grow into

          5      in building up a staff and credibility to take on more

          6      capital, and it's a very organized, coordinated process in

          7      growing their business.

          8                MR. KEUNEN:  Now, one of the trends that we've seen

          9      in terms of capital flows is that capital has flowed out of

         10      long short equity funds over the last couple of years into

         11      some of the other strategies that were mentioned, in

         12      particular, macro arbitrage and fixed income strategies.

         13                CHAIRMAN DONALDSON:  Paul, I wonder if I could ask

         14      a question.  And I understand that the Commissioners are

         15      allowed to ask questions --

         16                MR. ROYE:  Of course.

         17                CHAIRMAN DONALDSON:  -- without anything being

         18      attributed to -- behind that.

         19                But what's been the experience of the panel on

         20      people who have set out a strategy in some sort of an

         21      offering circular and then change it?  What happens when that

         22      happens?

         23                MR. SCHULMAN:  As the funds get larger, it is much

         24      more difficult for them to do that without it becoming --

         25      without bells going off. 

          1                In cases of small funds, especially in long short

          2      equity, we've seen some of that, not as much as you would

          3      think.  Typically, these are very small organizations run by

          4      a few entrepreneurs that have a particular area of expertise. 

          5                It becomes pretty good news and it spreads pretty

          6      rapidly through the industry if somebody really abandons

          7      their knitting. 

          8                I don't know about anybody else on this panel, but

          9      we don't want to pay 1 in 20 for anybody to learn anything. 

         10      We're paying 1 in 20 or 2 in 20 for people who are already

         11      experts in it.  So --

         12                MR. PRESS:  If I might -- and hedge funds really

         13      adhere to their offering document which defines their

         14      strategy and the partnership agreement that also sets in

         15      stone effectively their strategy.  And most stay within that

         16      strategy in my 35 years working in that industry.

         17                Where they change or may go differently is, they'll

         18      form a new product that allows them to work in a new area,

         19      and they have a new offering document, a new partnership

         20      agreement that defines the scope, services, leverage issues,

         21      and how that strategy operates relative to that performance.

         22                But they're very careful.  There's always those

         23      exceptions, but in my experience it's really very rare, and

         24      they don't have what we call "style drift."

         25                CHAIRMAN DONALDSON:  Just as a follow-on, would

          1      your experience indicate that they would communicate with

          2      their investors if they've changed the strategy or --

          3                MR. PRESS:  In my experience, any time they would

          4      go for a style change, they would need to go, per the

          5      offering document and the partnership agreement and get

          6      permission to go outside.

          7                For example, if someone said they could not go

          8      short in their offering document, and then decided to go

          9      short, they'd have to ask for permission from their

         10      investors, and then would about going through a partnership

         11      amendment offering document change.

         12                So where there are changes, they do go back to

         13      their investors and get permission to make those changes.

         14                MR. SCHULMAN:  And most funds have become pretty

         15      good now.  And I would say, again, there are exceptions that

         16      can demonstrate every concern that this panel might have. 

         17                But the vast majority of funds do write quarterly

         18      letters, and they are quite forthcoming, more forthcoming

         19      than the mutual fund industry might be about what their

         20      strategy is, what's working, and what their approach is. 

         21      Perhaps not down to the security level, but certainly down to

         22      the type of security, the sector in the industry, and the

         23      exposures to the market.

         24                There's very good information in those quarterly

         25      letters.  They have conference calls, they have web sites in

          1      many cases, and they're pretty good at communicating that,

          2      much better than they were a few years ago.

          3                MR. ROYE:  Regarding the comments from Joel and

          4      Bob, I've seen very little style drift, and managers tend to

          5      stick to what their offering documents say, and if they

          6      don't, they're advised by legal, by counsel, to notify the

          7      limited partners of any movement or any style drift that they

          8      feel necessary to fulfill the objectives of the partnership. 

          9                MR. VAUGHAN:  I think one thing in recent years,

         10      too, is many of the documents have become more detailed in

         11      what exactly the strategy is, and more detailed in what the

         12      investment guidelines are; and, as those guidelines need to

         13      be adjusted as a style evolves, people do go back to their

         14      investors and get permission and give them notice of what the

         15      changes are going to be, even if it's a relative -- what

         16      would be viewed as a relatively minor change, because the

         17      investors are looking for somewhat more detail on these

         18      documents, so that it can be triggered if there is style

         19      drift.  

         20                MR. NEUS:  I think lastly is -- there's been an

         21      increasing tendency for investors to be more activist and

         22      investors know a lot more and are much more willing to

         23      actively engage the managers.  And so I think that the time

         24      period is compressed by which changes in the past may not

         25      have been communicated as quickly.  

          1                MR. ROYE:  I just want to push back a little bit on

          2      this point because in the course of our review, you know, we

          3      saw a number of private placement memoranda that did indeed

          4      set out a strategy that was going to be employed by the hedge

          5      fund manager.  But we saw tremendous flexibility to deviate

          6      from those strategies in the document, a lot of flexibility,

          7      and a lot more flexibility than we typically see in mutual

          8      fund registrations.  

          9                So, I guess, my question is is it a matter of

         10      practice that they don't deviate, even though I think in a

         11      lot of the documents that at least we saw, there was a lot of

         12      flexibility for the manager to really move into another style

         13      if circumstances dictated.  

         14                MR. GRADANTE:  I think there is a lot of

         15      flexibility in the offering docs when you compare them to,

         16      you know, a mutual fund placement; but I think that is the

         17      nature of the hedge fund industry.  We're entrepreneurial and

         18      so it's not, you know, not to give the impression that hedge

         19      funds are a bunch of cowboys out there winging it, they do

         20      have a defined offering doc, but is very broad to give them

         21      and allow entrepreneurial, you know, spirit in investing.  

         22                MR. SCHULMAN:  Just to amplify for another second. 

         23      These are absolute return vehicles.  They come with very

         24      broad mandates.  They typically have a clientele, a

         25      traditional clientele, which is a very high net worth, U.S.

          1      and European clientele, that is premised on the idea of not

          2      losing money in most cases.  They are not mutual funds.  They

          3      don't have mutual fund kind of narrow mandates.  

          4                And, as a practical matter, if we looked at what's

          5      happened in the mutual fund industry in the last three years,

          6      if you have a narrow mandate and you have to be fully

          7      invested, you don't actually get to avoid the catastrophic

          8      impacts of the market.  

          9                The hedge fund industry has avoided, in large

         10      measure, the catastrophic impacts of the market by having

         11      enough flexibility in the document and using it to react to

         12      what you would call different market conditions.  It's hard

         13      for a technology mutual fund that says it's going to be 100

         14      percent invested to not have a very bad run when technology

         15      has a very bad run.  

         16                MR. PRESS:  It's also critical -- it's not style

         17      drift.  When they raise the capital through the offering

         18      document and the partnership agreement, they're very careful

         19      to define the scope of what they're allowed to trade and how

         20      they'll use those instruments.  

         21                And the investors know very well that -- in some

         22      cases you might say they're opportunistic reacting to the

         23      market, either on a daily, trade-by-trade, or on a

         24      philosophical strategy basis on a much longer term, but they

         25      stay within that category.  

          1                MR. ROYE:  You see articles about hedge funds being

          2      risky, more risky than mutual funds.  Any comment on that in

          3      terms of various strategies and whether or not there's any

          4      truth or merit to that?

          5                MR. SCHULMAN:  I think you only have to go back

          6      to -- well, you can go back as far as you'd like or as short

          7      as you'd like.  You can go back to any period of real

          8      dislocation and look at how hedge funds have performed, or

          9      especially fund-to-funds have performed, which is a

         10      diversified approach to hedge funds relative to mutual funds. 

         11                The typical mutual fund in the last really, really,

         12      really bad month, which I guess would be August or September

         13      of '98, with the Russian crisis -- the typical mutual fund

         14      was down in the mid-20's.  The average hedge fund was down

         15      less than 5.  The average fund-to-fund was down less than 3. 

         16                When you look at the volatility studies of the

         17      hedge fund industry, whether it be individual hedge funds, or

         18      whether it be fund-to-funds, virtually any metric that you

         19      would take to measure how they've done -- if performance is a

         20      fair measure of volatility -- suggests that diversified hedge

         21      fund investing is much less volatile than diversified stock

         22      market investing.  And probably approaches the volatility of

         23      domestic mid-maturity bond investing in terms of the actual

         24      risks.  And long term, the risks of the hedge fund industry

         25      in aggregate, and now I'm just using our own index, is

          1      less -- slightly less than half of that of the S&P.  

          2                MR. PRESS:  Again, here's where the strategies make

          3      a big difference.  If you look -- you can't look at absolute

          4      return.  You have to really look at what that hedge fund

          5      manager says they're trading, how they're trading it, what

          6      they will do within market parameters -- because if you look

          7      at the S&P or the Dow, most hedge funds do not look at those

          8      as relative to their own styles.  

          9                So when you're making that investment, they define

         10      their risk, they define what they'll call a draw down -- what

         11      they think the maximum loss is in a month or in a quarter. 

         12      And by and large, hedge funds pretty well stick to those

         13      numbers; and if the market may be up 40 percent, a hedge

         14      fund, for its style, may be up only 18 percent.  

         15                And people are investing knowing those strategies

         16      and knowing those risk parameters, because the managers are

         17      very careful to disclose them.  

         18                MR. GRADANTE:  I'd like to make several points. 

         19      You know, many feel that assuming risk creates a risky

         20      investment.  We believe that hedge funds expose themselves to

         21      risk in an intelligent way.  Is shorting necessarily a

         22      risking strategy?  We believe intelligent use of shorting and

         23      derivatives by hedge funds can reduce risk.  

         24                Leverage doesn't always mean you're taking on more

         25      risk.  In fact, banks -- of which I was a CEO of one -- and,

          1      as Mr. Lindsey mentioned earlier, proprietary trading desk at

          2      investment banks are also using leverage.  

          3                Hedge fund managers add risk with respect to the

          4      portfolio as a whole and the prudence of the strategy. 

          5      Making an investment, which in and of itself assumes greater

          6      risk, does not necessarily increase the risk of the overall

          7      pool.  

          8                You know, risk often is measured in terms of

          9      volatility risk, leverage risk, and portfolio risk.  With

         10      respect to volatility risk, which is often measured by

         11      standard deviation, as Joel and Bob reported, I think Bob

         12      mentioned that the S&P 500 is about double the hedge fund

         13      universe.  And we see the same thing.  And we have indices

         14      that go back to '87.  

         15                Since 1987, the S&P 500 has averaged 18 percent in

         16      standard deviation -- I'll drop the decimal points -- and the

         17      Hennessey Hedge Fund Index has an average standard deviation

         18      of 11 percent.  

         19                Leverage used by hedge funds is often exaggerated. 

         20      Our surveys show that 84 percent of hedge funds never use

         21      more than Reg T.  For the majority of the industry,

         22      long/short equity, the average gross exposure will range from

         23      a high of 159 percent in 1999 -- that's a average -- to a low

         24      of 117 percent in 2001.  

         25                Only 2 percent of hedge funds we've surveyed -- and

          1      our survey was 193 management companies, 763 hedge funds,

          2      and, I believe, $137 billion, or about 23 percent of the

          3      industry -- only 2 percent used leverage over 500 percent.  

          4                So -- and in our survey, we exclude CTAs.  Since

          5      they're registered, we don't include them in the world of

          6      hedge funds.  But CTA leverage is a whole different matter. 

          7                Portfolio risk management has greatly improved in

          8      the industry as the industry is involved.  You know, we're

          9      seeing a lot greater use of value-at-risk position limits and

         10      stop losses.  

         11                And, as we mentioned earlier, the performance in

         12      this bear market has been another measure of risk.  Hedge

         13      funds, during this bear market, have out performed

         14      traditionally managed, long only, vehicles -- which is a

         15      positive, not a negative.  And approximately 8 to 9 out of 10

         16      hedge fund managers, whether they be arbitrage or long/short

         17      equity, have out performed the S&P 500, which represents a

         18      diversified portfolio of securities.  

         19                MR. LINDSEY:  I'd like to add a couple of things to

         20      what Charles just said.  

         21                I think that if you look at the averages, hedge

         22      funds are somewhere on the order of 4 to 1 maximum leverage. 

         23      If you look at banks, they're probably in the range of 6 to 8

         24      to 1.  If you look at broker dealers, they're probably in the

         25      range of about 15 to 20 to 1.  

          1                So in terms of just that pure business, it hearkens

          2      back a little bit to what Robert was saying -- is that a

          3      large part of the investor base for hedge funds are

          4      interested in capital preservation; therefore, the hedge fund

          5      managers are interested in capital preservation.  

          6                And hedge fund managers also have some additional

          7      incentives that are built in -- both in terms of the way

          8      they're compensated, and the way they're not compensated if

          9      they don't meet certain hurdle rates.  So if they haven't

         10      exceeded a hurdle rate, indeed, their compensation may be

         11      dramatically different.  

         12                So they have an incentive to preserve the

         13      performance and preserve the capital.

         14                The second point that I'd like to make is if you

         15      take a look at sharp ratios associated with hedge funds,

         16      you'll find that they actually have very good sharp ratios

         17      compared to most standard indices -- meaning, of course, that

         18      the return-per-unit risk is actually very good.  

         19                And finally, I think it's important not to under

         20      estimate the value of a portfolio.  I don't think anybody in

         21      this room would ever advise that you put all of your money

         22      into any one investment period.  And that's the reason for

         23      diversification; and that's the reason for the portfolio

         24      effect.  

         25                When you look at hedge funds as a asset class, if

          1      you want to think about it that way -- and there's plenty of

          2      academic quirk that can demonstrate that hedge funds look

          3      very different than mutual funds, look very different than

          4      stock returns, look very different than anything else -- it

          5      looks like a very different asset class, both in terms of the

          6      mean return, standard deviations, skewness, kurtosis --

          7      whatever metrics you want to apply.  

          8                And when you look at that, they're fairly

          9      uncorrelated with the market, or relatively less correlated

         10      with the market.  So when you include hedge funds as part of

         11      an overall portfolio, you actually increase return and

         12      decrease risk.  So it's more a matter of what's that

         13      diversification effect worth, rather than the idea that any

         14      individual investment is or is not risky.

         15                COMMISSIONER GLASSMAN:  Can I ask a question, Paul? 

         16      To any of you.  What's the failure rate of hedge funds and

         17      how does that compare to any relevant benchmark?

         18                MR. SCHULMAN:  We have some numbers on that which

         19      we have published.  Last year it was an all-time high.  It

         20      was at about 14 percent.  There was about -- we estimate

         21      about 700 funds closed.  And I'd like to distinguish closed

         22      from failed.  

         23                Seven hundred ninety-six of the funds that closed

         24      closed up, sent the investors their money back, and said I'm

         25      going to the beach, thank you.  Most of those closed because

          1      they had performed poorly for two years, and were in danger

          2      of losing the bulk of their investors, and it did not make

          3      economic sense for them to continue.  

          4                Nobody lost money they shouldn't have lost.  Nobody

          5      dealt with a failed situation.  These companies didn't go

          6      bankrupt; they went through an orderly close down, which

          7      happens in the mutual fund business and in the asset

          8      management business all the time.  

          9                While 700 funds were closing last year -- I know

         10      Greg may have different numbers than this -- we think about

         11      1300 new funds started.  And we have found closing rates to

         12      vary between 8 and 15 percent, depending upon market

         13      conditions.  

         14                A lot of very small long/short equity managers

         15      closed because they were reaching their second year of bad

         16      performance, their clients or their limited partners were

         17      withdrawing, they effectively did not have a business.  So

         18      they, on an orderly basis, just closed the business.  

         19                And Joel's finishing up the audits on those as we

         20      speak.  So he can probably speak to what a typical close down

         21      might look like.  

         22                MR. PRESS:  I also think we missed the point here. 

         23      A hedge fund is very different than mutual funds -- again, in

         24      the risk area.  All really have their own capital invested. 

         25      And in setting up the hedge funds, especially start-up hedge

          1      funds, the key for raising capital is the fact that they're

          2      putting in most of their liquid net worth and they keep that

          3      money there.  

          4                So when it comes to risk and managing risk, that's

          5      a real part of the capital.  And in some cases, it can be as

          6      much as 20 percent of the capital; and, in the larger hedge

          7      funds, the staff, the employees, have their money and they

          8      effectively are eating their own lunch.  

          9                Very different than other investments where there

         10      is a proprietary trading desk -- unless you own stock in the

         11      company -- but it's not a direct relationship and in the

         12      mutual fund industry.  

         13                And here's where there's a huge difference in

         14      capital and how people approach risk because it's really

         15      their own money also.  And it does have an impact.  

         16                MR. NEUS:  I'd like to ask you one more thing and

         17      that's to pick up with something that Chairman Donaldson

         18      asked before.  When speaking about hedge funds, if the

         19      average hedge fund is less risky or more risky, I think that

         20      misses the point.  It's not a monolithic institution.  Hedge

         21      funds, by and large, are incredibly entrepreneurial; are

         22      constantly innovating and mutating.  

         23                So if you look at the 7,000 hedge funds, there's a

         24      continuum for much less risky, on a volatility basis, to a

         25      mutual fund, say, in the arbitrage area, to going through the

          1      continuum to manage futures or macro-funds, which have

          2      largely exhibited a greater volatility.  

          3                And if you look at a portfolio basis of -- as an

          4      investor -- an investor may want to hire risk-reward ratio;

          5      and so that's why it's important to make sure that they're

          6      selecting the right hedge fund to the right strategy for

          7      them.  I don't think it's necessarily a fair comparison to

          8      say, "Is a mutual fund more or less risky than a hedge

          9      fund?," because it varies widely.  

         10                MR. NEWTON:  I could just make one quick point that

         11      hasn't been mentioned so far.  There is a pretty substantial

         12      pile these days of academic research on hedge funds, managed

         13      futures, and various other bits and pieces, and I'm not aware

         14      of any of it which indicates that adding hedge funds to a

         15      portfolio, hedge funds as a class -- if they are such a

         16      thing -- are inherently riskier, more volatile, than

         17      traditional investments.  

         18                In fact, you know, the over-whelming evidence that

         19      I'm aware of is that adding these things to a portfolio

         20      almost always reduces their volatility and enhances their

         21      performance.  And I think that academic research is out there

         22      at the moment and it's very important.  

         23                MR. SCHULMAN:  And I would suggest that there are

         24      people around the stable who would be happy to supply the

         25      Commission with whatever -- if the Commission is not

          1      convinced that diversified hedge fund investing reduces the

          2      risk of equity investing by the addition, I think there are

          3      people around this table who would be happy to do the

          4      research in as an exhaustive fashion as they would like, or

          5      supply them with the research that's been done.  

          6                That is not something that I think is in dispute

          7      any more.  

          8                MR. VAUGHAN:  I'd just like to comment that sort of

          9      ties the two questions together.  We're saying hedge funds

         10      are not inherently risky, but the press and the offering

         11      documents tend to talk about risk and speculation.  I think

         12      the reason behind that is sort of two-fold.  

         13                One is because these hedge funds tend to be

         14      entrepreneurial.  There's a risk that the entrepreneurial

         15      enterprise simply won't make it, that the fund will go out of

         16      business in a couple of years not having achieved what they

         17      really thought they could; and, therefore, there's that risk. 

         18                And one of the reasons, coming from the legal

         19      side -- that the offering documents may seem to be pretty

         20      vigorous in their description of risk -- is that often these

         21      risks are risks with which at least some investors are just

         22      not familiar.  Most investors, all investors, ought to be

         23      familiar with general market risks.  

         24                But some of the risks that they're incurring in

         25      hedge funds, even if they're not inherently more risky than

          1      other investments, are simply novel to the investors; and one

          2      wants to be sure that they understand that these risks are

          3      different and not be lulled into thinking, because the fund

          4      is less volatile, that it is therefore not at all risky.  

          5                MR. PRESS:  Also, hedge funds, because they're

          6      entrepreneurial, embrace new strategies, embrace different

          7      ways to approach risk -- and on the cutting edge of those

          8      strategies.  And because of that, they approach risk from a

          9      very technical, academic, modeling point of view.  Especially

         10      as credit derivatives develop, they'll be the first to look

         11      at them and try and figure out how they operate, whether it's

         12      within their style, and how it will make their strategy safer

         13      within the volatility of their strategy.

         14                MR. GRADANTE:  And in this bear market, Morningstar

         15      has reported -- and I believe I'm quoting correctly -- that

         16      mutual funds have failed at a rate of about 5 percent per

         17      year.  There was mention earlier about an 8 to 15 percent

         18      failure rate among hedge funds.  I'd like to expand that a

         19      little bit because it could be misinterpreted.

         20                We see four kinds of closures that can be lumped

         21      together and interpreted incorrectly.  One is the out-right

         22      failure -- liquidation through the fund not being able to

         23      perform.  

         24                The second is a voluntary liquidation due to the

         25      fact that that's the only way a hedge fund manager can exit a

          1      career.  He decides to retire and he liquidates his fund.  

          2                Thirdly, funds that are functioning but are closed

          3      to new capital is a large portion of the closures that fall

          4      off databases and get counted as terminations.  

          5                And then the fourth one is -- although it's a small

          6      part of it, but it is a part of it -- there are time hedge

          7      funds.  There are hedge funds out there that have a time

          8      limit to them.  They will close down after five years, or

          9      after ten years.  

         10                All in all, we see the failure rate -- actual out-

         11      right failure rate -- at 5 percent; and then the remaining 10

         12      percent is voluntary closures.  

         13                I might just add -- and speaking here and to the

         14      Webcast out there -- that we would love to see any of that

         15      academic research that's out there.  We would welcome that

         16      being sent into the Commission.  

         17                MR. ROYE:  Let me just follow up on Commissioner

         18      Glassman's question about the closures.  And to what extent

         19      do you see hedge fund managers, where they have not

         20      performed, shut down the fund, resurfaced elsewhere?  Either

         21      affiliating with somebody else, starting another hedge fund. 

         22      Does that go on?  And what happens to their track record and

         23      are any potential new investors in a new fund aware of that

         24      typically?

         25                MR. PRESS:  My experience has been when a hedge

          1      fund manager shuts down, again, there's all these reasons

          2      that we just talked about -- when they decide to retire and

          3      come back into the business, they will come back in, it will

          4      be disclosed in their offering document that they took a

          5      period of time off.  And in fact, if the strategy is the

          6      same, they will tell what their strategy was for that period

          7      of time and so forth.  

          8                Many that come back that have maybe lost money. 

          9      Very often, in my experience, they will continue to offer to

         10      their old investors the concept of what's called the high

         11      water mark.  Hedge fund managers do not get compensated until

         12      they make money, so if you put a dollar in and it went up to

         13      a dollar fifty, the hedge fund manager would be compensated. 

         14      But if it lost money, the hedge fund manager doesn't get an

         15      incentive fee; they would get a management fee.  

         16                Until they go back to the dollar fifty, they cannot

         17      make more money on the incentive side.  And very, very often

         18      the managers, because of integrity issues, will put back the

         19      high water mark for their old investors.  

         20                So in terms of the integrity of the process -- now

         21      there are others that have surfaced.  If they joined another

         22      hedge fund, and they're not part of management and so

         23      forth -- they're just part of the participants -- there's no

         24      issue.  It is disclosed, usually in the letters to partners

         25      and -- limited partners, about changes in management and

          1      additional traders and so forth.  

          2                MR. SCHULMAN:  The typical advisory firms are now

          3      doing background checks and full reviews of what the

          4      background has been.  Although people have come back into the

          5      business, it's relatively unusual.  

          6                Lots of people their funds -- in some cases -- and

          7      I agree with Charles about a third of those cases are from

          8      people who decided they just didn't want to do it any more. 

          9      "I wanted to take some time off."  Those people have come

         10      back; they've gone back to their old clients; they typically

         11      have gotten the money back from the old clients, if they've

         12      done well.  

         13                It's relatively unusual to have somebody burn up in

         14      the atmosphere.  A real flame-out in terms of a closed down,

         15      really did very poorly; and successfully come back into the

         16      business alone as a stand alone entity.  It doesn't happen. 

         17                Memories are quite long.  People like me, and

         18      Charles, and Joel, are around to remind people.  

         19                COMMISSIONER ATKINS:  Yes, I'll show you.  That's

         20      one thing I wanted to ask about.  It's a relatively small

         21      society, this; and so I was going to ask you if someone could

         22      speak to the reputational aspect of this and how those

         23      memories are?

         24                MR. NEWTON:  Those memories are great because I

         25      know that we, as a newsletter in this business -- when we

          1      hear that someone who has perhaps closed a fund or something,

          2      we're all over that like a rash.  You know, when someone's

          3      coming back into business after perhaps shutting down because

          4      he was so far under his high water mark that he, you know --

          5      the bubbles weren't getting to the surface -- that happens. 

          6      But it's covered very widely and fully.

          7                And I guess, you know, you're not around a hedge

          8      fund any time for very long before the subject of long-term

          9      capital management comes up.  And the fact of the matter is

         10      that people who have been associated with substantial

         11      failures still have sufficient credibility in the marketplace

         12      to be able to reappear in the business.  It happens.  

         13                But it's no secret.  Their past is no secret.

         14                COMMISSIONER GLASSMAN:  Presumably, the funds of

         15      funds then obviously have the same information and you would

         16      avoid those funds as well?  Is that a logical conclusion?

         17                MR NEUS:  But speaking as somebody who is on the

         18      other end of filling out those due diligence

         19      questionnaires -- field that one -- I think what happened in

         20      the last -- I've been in hedge funds -- in-house counsel for

         21      10 years, and before that, outside counsel -- and I think

         22      what's happened is that the investors have become much more

         23      activist, much more interested.  The use of consultants has

         24      expanded.  

         25                The investor base has changed from a largely high

          1      net worth, both on shore and off shore, to a more

          2      institutional investor base.  And the institutions, whether

          3      they're fund-to-funds, or pensions, or insurance companies --

          4      the institutions tend to have a much more rigorous process. 

          5      Whether they do it internally of whether they hire a

          6      consultant, they do more than kick the tires.  They audit. 

          7      Sometimes they audit results, they do background checks, they

          8      do a huge amount of legal work internally, as well as

          9      externally -- talking to other investors.  

         10                And so that the entire process of investing into

         11      hedge funds has changed dramatically from a time when it was

         12      a cocktail party chatter -- "Which of your investments have

         13      done better?"  I think the industry as a whole has changed

         14      dramatically.  

         15                The fund-to-funds business, in particular --

         16      because the fund-to-funds has to be generally a registered

         17      investment advisor, the fund-to-funds, when they're choosing

         18      the hedge funds in which they're going to invest, have a

         19      higher due diligence level in disclosure information.  And

         20      that is, I think, raising the bar across the board on the way

         21      hedge funds are operated and the level of disclosure that's

         22      out there.  

         23                MR. PRESS:  One of the reasons fund-to-funds have

         24      become so important is the complexity of these strategies for

         25      people to understand.  Fund-to-funds have a tremendous

          1      infrastructure dealing with risk strategy and have a great

          2      understanding of what those hedge funds are.  

          3                So in going through the people they want to invest

          4      with, it's an incredible process.  Takes months, sometime

          5      years, for them to make a decision to make that investment. 

          6      And then they have a whole monitoring, due diligence process

          7      to make sure that it's on track, doing what they say they're

          8      doing.  And very difficult to get through a fund-to-funds to

          9      be able to make a bad investment in terms of style or people

         10      that don't belong in the industry.  

         11                MR. KEUNEN:  And the due diligence exercises that

         12      fund-to-funds perform aren't just of the investment advisors. 

         13      They're far more.  They're for all the accounts -- including

         14      administrators.  So we experience due diligence exercises

         15      just like the investment advisors.  

         16                MR. SCHULMAN:  I would suggest we have times -- as

         17      many people doing that today as we did two years ago, as a

         18      big fund-to-funds operator; and the chances of us hiring

         19      somebody that has something in their background that we don't

         20      know about, at a senior level in the organization, I think is

         21      quite small.  

         22                We have the full financial story of somebody going

         23      back to when they came into the business.  

         24                MR. GRADANTE:  I think we're all using third party

         25      investigative companies; and, insofar as they can determine

          1      prior regulatory infractions and impairments, you know, we're

          2      aware of it.  

          3                But the old Wall Street culture, and I go back to

          4      the Wall Street in the '80s, when you had a rogue trader and

          5      the whole street knew about it.  That has carried into the

          6      hedge fund industry.  

          7                So even though it appears to be a small industry, I

          8      think that culture will maintain itself as it did on Wall

          9      Street, as Wall Street grew; and that people talk, and we

         10      know who are the people who've gotten into problems in the

         11      past.  

         12                So you either get it from a third party

         13      investigative company, or you hear about it from the Street. 

         14      The Street's a small place -- whether it's hedge-fund world,

         15      or whether it's the real Wall Street.  

         16                MR. SCHULMAN:  And to Charles' point, everybody

         17      around this table understands that it's not in anyone's

         18      interest to ever hire someone who's going to do something

         19      untoward, so even competitors are pretty good at

         20      communicating where they think there's a real problem.  

         21                So I don't think it happens very much.  The rogues,

         22      if you look at them, the people who have really been

         23      dysfunctional or dishonest, are people who basically raised

         24      the money in their country club, typically out of one of

         25      the -- not in New York City, or San Francisco, or Chicago --

          1      from a bunch of people who knew absolutely nothing, and had

          2      no protection, and never got any of the vetting that we're

          3      talking about around this table.  

          4                MR. LINDSEY:  I think it also should be noted that

          5      this upsurge in due diligence isn't necessarily a function of

          6      some of the headlines we've seen in the last few years.  I

          7      think it's also a function of the kind of financial

          8      institutions, the state pension funds, and that sort of

          9      thing, that because of their returns in the traditional

         10      sectors, they['re suddenly realizing that they need to be

         11      looking at alternative investment vehicles.  

         12                And, of course, those institutions with their ERISA

         13      restrains, and various other things, are inclined to -- and

         14      also obvious, you know, at some -- to some level, political

         15      exposure -- are also inclined to look much more closely at

         16      where they're putting their money in these things because,

         17      you know, because of the perceptions that might be out there. 

         18                COMMISSIONER CAMPOS:  Well, what -- if I take

         19      everything this panel is saying just at face value, then it

         20      appears that hedge funds are safer, they're diversified, they

         21      have -- they use prudent leverage, they use prudent

         22      strategies, they're involved in maintaining principal, you

         23      know, absolute returns.  So why shouldn't all of this -- all

         24      of these good things be made available to the public, instead

         25      of just, you know, privileged people who are qualified

          1      investors?  

          2                MR. GRADANTE:  I'd like to comment on that.  Now

          3      since retail investors already have access to shorting Reg T;

          4      options; futures; distressed debt; illiquid stocks:

          5      unregistered limited partnerships; oil, gas, real estate, you

          6      name it, the core of the issue you're addressing is not the

          7      regulatory differences between mutual funds and hedge funds,

          8      but how can we protect the retail investor without inhibiting

          9      the free determination of hedge fund investment objectives

         10      and their uses of investment strategies.  

         11                We need diversified market choices and capital

         12      formation, not homogenized choices.  

         13                COMMISSIONER CAMPOS:  I don't follow what you're

         14      saying.  

         15                MR. GRADANTE:  I think what you're saying is why

         16      shouldn't -- why should we offer hedge funds to the retail

         17      public.  And those hedge funds that want to go retail, fine;

         18      but then there are hedge funds that want to maintain the

         19      entrepreneurial spirit and not be registered as a mutual

         20      fund -- and they should be allowed the entrepreneurial

         21      freedom to do that.  

         22                COMMISSIONER CAMPOS;  I didn't know the two

         23      different issues.  

         24                MR. SCHULMAN:  Let me try to answer it.  I'm not

         25      sure if my answer will be any better than Charles'.  I don't

          1      see -- if the Commission is willing to recognize and

          2      distinguish between the idea of having more risk from

          3      understanding the risk, then there is no reason why you

          4      shouldn't want to go as retail with these products if you

          5      can.  

          6                Being involved in retail distribution of hedge fund

          7      products, I will tell you it is very difficult to communicate

          8      and the less financially sophisticated that an investor is,

          9      the more pains you must go to to properly communicate what

         10      these complex and very different kinds of risks -- not more

         11      risk, but very different kinds of risks -- are.  

         12                We think this is a wonderful asset class.  Everyone

         13      sitting here around this room is in this business, makes a

         14      living at it, has been successful, and done pretty well, and

         15      watched investors do pretty well.  So we conceptually think

         16      that it is a business that other people would profit from. 

         17      The question is, is it articulatable and is it worth putting

         18      up with the inconveniences that come with it?  

         19                And that's really a decision for the Commission. 

         20      We're talking about complex tax filings; we're talking about

         21      K-1's; we're talking about, in many cases, delayed or filed-

         22      at-the-last-minute tax returns; we're talking about a set of

         23      risks that are not necessarily explainable in easy terms to

         24      an unsophisticated investor.  Which is why there's a

         25      sophisticated investor rule associated with these products to

          1      start with.  

          2                If you're asking is the actual outcome worth having

          3      available for retail, the answer is yes.  Is there a way to

          4      easily surmount some of the issues that have been raised

          5      associated with it, as in "Can we give enough disclosure?" 

          6      That's an answer that the Commission has to -- it's a trade

          7      off that the Commission has to accept because -- and, by the

          8      way, no one is trying, no one has a product out there that is

          9      trying to bring this to retail.  

         10                Everyone is a qualified investor, even when they

         11      buy registered products.  So we're not talking about

         12      unsophisticated investors.  If your question is "Should this

         13      go further down the line to unsophisticated investors?," that

         14      is "How willing are you to have them make a leap of faith?" 

         15      If they really need to understand the strategies, that's

         16      going to be hard in the size commitments you're talking

         17      about.  

         18                COMMISSIONER CAMPOS:  Do you really believe that

         19      your investors, because they necessarily have a higher net

         20      worth, understand what you're talking about?

         21                That, to me, the communication issue is the same

         22      regardless.  If it's something that's complicated, it's

         23      complicated.  You know, if you're rich, it doesn't mean you

         24      understand it any better.  So essentially they've taken a

         25      leap of faith, you know, in the particular style, the

          1      particular situation that's going on.  

          2                So if communication is the problem, isn't that

          3      something that solvable?  I mean, you know, we've got all the

          4      great communicators in the world in the industry.  Moreover,

          5      if you balance the risk that the general public is taking by

          6      going long, without any protection, in a bad market, I mean,

          7      is that their fate that they're supposed to be able to just,

          8      you know -- because it's too complicated for you, sorry, you

          9      know, there's nothing available.  

         10                MR. SCHULMAN:  The communication issue is the same. 

         11      You have to communicate what hedge funds are about, whether

         12      it's a retail investor or not; but the experience base is

         13      different.  A sophisticated investor typically has obtained

         14      their wealth and experience in manners that make it easier

         15      for them to understand what hedge funds are about.  

         16                COMMISSIONER CAMPOS:  I don't necessarily agree

         17      with that, but that's -- 

         18                MR. NEUS:  Let me take a different tact.  When we

         19      talk about the average returns and average volatility for

         20      hedge funds, you're doing it over a period of time.  And the

         21      traditional hedge fund has a lock-up period, a period of time

         22      where investors cannot remove their money.  

         23                It's not an open-end fund like a mutual fund, and

         24      the liquidity requirements of the ordinary investor are well

         25      suited for mutual funds -- less well suited for a hedge fund

          1      that needs the staying power of making sure that they have a

          2      stable capital base when some of them are illiquid

          3      investments, or areas where they can't necessarily liquidate

          4      and realize investments to cover redemptions on a daily

          5      basis.  

          6                Where the retail investor has been involved, and

          7      has had a tremendously increased exposure to hedge funds, is

          8      through the indirect way of insurance companies, pension

          9      funds, charitable endowments.  Those organizations where they

         10      are professionally managed can take the risk, and can blend

         11      the benefits, of a hedge fund as hedging the risk of mutual

         12      funds, and other asset classes, on an aggregated basis for

         13      the benefit of retail investors.  

         14                MR. ROYE:  We're going to have to move on.  There's

         15      been references to the size of the industry, that the

         16      Chairman in his remarks talked about a $600 billion dollar

         17      industry.  Is that about right, you guys who observe and

         18      track the industry, and others?  This notion that there's

         19      been a lot of growth in the industry?  Has there been growth,

         20      and if there has been growth, where's it coming from? 

         21                Michael, you alluded to the fact that you have more

         22      institutional investors, endowments, that are looking at

         23      hedge fund investments.  What's driving this growth, if there

         24      is growth?  Because, you know, they're not registered with

         25      us.  We're not -- we read the press.  We've got the $600

          1      billion number from simply reading articles.  

          2                MR. SCHULMAN:  Well, I think people like Charles

          3      and I gave it to the press, so -- 

          4                MR. GRADANTE:  We have the institutional investors

          5      at 30 percent of the industry.  The growth is from $53

          6      billion in 1998 -- this is all based upon surveys.  We're

          7      surveying about 25 percent or more of the capital industry. 

          8      $53 billion in 1998 to $175 billion in 2002.  So that's a 230

          9      percent increase, or 30 percent.  And by institutions, we're

         10      including, you know, ERISA, and corporations, endowments,

         11      foundations, in that category.  

         12                MR. SCHULMAN:  You know, we think -- Charles and I

         13      think the $600 billion is about correct.  We think the 6,000

         14      hedge funds is approximately correct.  That's our polling

         15      from the TAS database that we operate.  We think those are

         16      reasonable numbers, but I think it's important to realize

         17      that this explosive growth that has been talked about, we

         18      estimate as $32 billion in 2001, and $16-odd billion in 2002;

         19      with the fourth quarter of 2002 being negative.  

         20                And the first quarter numbers are in, by the way. 

         21      We think assets grew -- and, again, this is not appreciation;

         22      this is just the grown of new assets -- by about $6 billion

         23      in the first quarter.  

         24                So you have a business arguably over the last two

         25      years that is growing at $25 billion or so a year.  That is a

          1      rapidly growing, but not an explosively growing business on a

          2      $600 billion base.  

          3                MR. GRADANTE:  And just of the growth that has

          4      happened since January 2000, or roughly when the bear market

          5      began, where the hedge fund industry was around $300 billion

          6      in size.  So it's at $600 billion.  

          7                So prior to that point in time, when the S&P was

          8      doing 20 - 25 percent, you know, people said, "Why should I

          9      invest in a hedge fund and pay one and twenty when I can

         10      invest in an S&P 500 fund and get 25 percent?"  So a lot of

         11      this phenomenon we're seeing lately is the bear market and

         12      the performance of hedge funds relative to traditional

         13      managed funds.  

         14                MR. PRESS:  I think also this is a global,

         15      international market.  When you go to England, Australia,

         16      Hong King, Singapore, there's a vibrant hedge fund market. 

         17      That's all part of this industry.  So it's not just an

         18      American market by far, but truly is an international market.

         19                MR. KEUNEN:  That's an interesting point because of

         20      that $600 billion, a very substantial portion of it is out of

         21      Europe.  And a very substantial proportion of that --

         22      although Europe's hedge fund management sector is growing,

         23      you know, much more rapidly than it is here, in fact, because

         24      it's starting from such a small base -- a very large

         25      proportion of those European assets are invested with U.S.

          1      domicile managers, if not necessarily U.S. domicile money.

          2                MR. GRADANTE:  We show 55 percent of the money is

          3      off shore and 45 percent on shore.  

          4                MR. NEUS:  Of the off shore, Charles, does that

          5      include U.S. non-taxable?

          6                MR. GRADANTE:  Yes, it would include ERISA money

          7      and other U.S. non-taxable.  

          8                MR. ROYE:  That's kind of a nice segue.  Bob, did

          9      you have a comment?  

         10                MR. SCHULMAN:  Yes.  I just want to comment one

         11      more point here.  The vast majority of this growth -- and

         12      this would be echoed by these small fund-to-fund operators

         13      and the people we've talked to -- the vast majority of this

         14      growth is coming institutionally.  

         15                So although there's been a lot of talk about the

         16      retailization of the business, and all of these retail

         17      products, the reality is it is large commitments from big

         18      public plans and part leaders, like CALPERS and Texas

         19      Teachers, that is leading the way towards the growth in this

         20      asset.  It is not a massive flow of money from retail or high

         21      net worth investors using registered products.  That's not

         22      what's fueled the growth here to date.  It may come to be

         23      that, but that's not what it's been today.  

         24                COMMISSIONER CAMPOS:  But isn't that diverting

         25      institutional monies from the product they normally would be

          1      if they're going into hedge funds?  Isn't there some -- 

          2                MR. SCHULMAN:  Yes.  

          3                MR. GRADANTE:  I mean, diverting it from what?

          4                COMMISSIONER CAMPOS:  From operative investments.  

          5                MR. GRADANTE:  No, could be diverting it from

          6      venture capital, from private equity.  

          7                MR. SCHULMAN:  Or from -- banks.  

          8                COMMISSIONER CAMPOS:  Yes, I understand.  

          9                MR. GRADANTE:  Okay.  Let's move a little bit to

         10      structure.  You know, we talked about the off shore funds.  I

         11      guess, we observed that a number of hedge fund managers have

         12      both domestic and off shore funds.  Can we go into -- maybe,

         13      David -- the reason for that, and maybe outline sort of the

         14      typical hedge fund structure and how the funds are managed?  

         15                MR. VAUGHAN:  Sure, be happy to.  The classic hedge

         16      fund structure here in the United States was a limited

         17      partnership, with the manager, and potentially management

         18      affiliates, providing the management of the partnership, and

         19      the investors being the limited partners.  The idea being

         20      it's the most tax-efficient vehicle domestically in an

         21      unregistered form.  

         22                In recent years, limited liability companies have

         23      become popular because they provide the same tax benefits and

         24      slightly more liability shield for the manager.  

         25                The other type of vehicle you typically see is an

          1      off-shore corporation, which looks very much like the U.S.

          2      corporation.  Has a board of directors, typically; has an

          3      investment advisor that has a contract with the corporation;

          4      and shareholders are the investors.  

          5                Now this is all simplifying it quite a bit.  There

          6      are a number of structures I'm sure the staff has seen as we

          7      go through -- of different structures, different combinations

          8      of this, off shore partnerships, things like that, that can

          9      be used in different structures, depending on the tax

         10      aspects, the types of investors you have, and where the

         11      manager is located.  

         12                We talked about the itnernationalization.  There

         13      are certain tax aspects for a manager based in the United

         14      States which are different if you're based in the U.K.; and

         15      you may want, depending on your investor base -- you've got a

         16      taxable U.S. investor base -- they'll typically go into a

         17      partnership vehicle.  

         18                Non-taxable U.S. investors often want to have a

         19      corporate vehicle; and the non-U.S. investors typically will

         20      prefer the corporate vehicle.  And so you often have a

         21      combination of these vehicles really designed to appeal to

         22      the investors and provide a way, with other benefits that

         23      they see to being in off shore funds, for the investors to be

         24      comfortable and make it attractive to them.  

         25                MR. PRESS:  Hedge funds also have a very complex

          1      compensation structure.  They're different than mutual funds

          2      where it's one sum of money for all investors at one moment

          3      in time.  Hedge funds actually track the investment returns

          4      by investor domestically; and off shore, which makes it even

          5      more complicated because the off shore fund, as David has

          6      said, is a corporation -- we actually have separate share

          7      classes by kinds of investors so that you can track each

          8      investor's return separately.  

          9                And it becomes very complex.  The administrators do

         10      an incredible job of doing that accounting for the off shore

         11      fund.  

         12                But it is very different than mutual funds because

         13      it's an investor-by-investor performance.  

         14                MR. GRADANTE:  David, you alluded to the fact that

         15      off shore, it's a corporation.  It would be a board of

         16      directors.  I guess, typically an administrator.  Is that

         17      driven by the regulatory framework of the jurisdiction where

         18      the hedge fund is organized?  

         19                MR. VAUGHAN:  It's typically, primarily driven by

         20      the tax aspects of the fund, plus the off shore investors are

         21      often more comfortable in a fund that's administered off

         22      shore.  And part of the off-shore administration business

         23      grew up before a tax law change, which is no longer very

         24      recent; but basically required the off shore funds to be

         25      administered off shore if they were going to be managed in

          1      the Unites States.  

          2                It was really a tax benefit to encourage investment

          3      in the United States, I think, going back to the 1960s.  And

          4      that was liberalized to allow some of those administrative

          5      services to come on shore; but partly out of investor comfort

          6      and partly out of just where the infrastructure is, a lot of

          7      the administration has remained off shore.  

          8                MR. KEUNEN:  Yes, I'd just like to add to that. 

          9      Many of the off shore domiciles actually require

         10      administration to be performed off shore.  But as you were

         11      saying, David, the -- when the ten commandments were

         12      repealed, we expected many of the functions to move back on

         13      shore.  And mainly because of investor-driven initiatives,

         14      most of those services did not move on shore because the

         15      investors remained comfortable with the process the way it

         16      was, the way there was an independent administrator, the way

         17      that certain functions were performed independently.

         18                COMMISSIONER CAMPOS:  Well, since everybody's got

         19      statistics here, what percent of hedge fund managers are

         20      registered investment advisors and what's the difference in

         21      performance for their funds, if any?  If there's any

         22      statistics kept?  

         23                MR. GRADANTE:  I have numbers on that.  From our

         24      last survey, we asked managers if they were registered

         25      investment advisors, CPOs, or broker dealers.  And, once

          1      again, that's 173 management companies; 793 hedge funds, or

          2      14 percent of what we think is the industry; and 20 percent

          3      of the capital in the industry.  And 75 percent of those

          4      surveyed were either an IRA, and/or CPO, and or broker

          5      dealer.  

          6                So they're registered with one of the agencies, one

          7      or more of the agencies, on that sample.  So to the extent

          8      that sample is representative, it is increasing.  And that

          9      IRA number, by the way, the 75 percent, of that 54 percent

         10      were registered investment advisors, up from 38 percent in a

         11      prior survey.  So there is a movement.  

         12                MR. SCHULMAN:  We have almost identical numbers, by

         13      the way.  

         14                COMMISSIONER CAMPOS:  Do you have stats as to

         15      who -- which of those managers also managed mutual funds?

         16                MR. GRADANTE:  No, I don't at this time.  But the

         17      other question is, well, you know, why this increase?  And I

         18      think the market is segmenting, or the hedge funds are

         19      segmenting themselves into those that need registration to

         20      address a client base that requires it, like ERISA money.  

         21                And then the hedge funds that are not registered

         22      are basically saying we don't want to address that

         23      marketplace.  We will stay with high net worth individuals,

         24      and other entities that don't require it.  So there are three

         25      C-7's being segmented and -- so as money -- as Bob mentioned

          1      earlier -- money is moving in from the institutional world,

          2      much of which require registrations in order to place the

          3      investment, hedge fund managers have been stepping up to that

          4      to receive that capital formation.  

          5                COMMISSIONER CAMPOS:  Is there any difference in

          6      performance?  Registered in some fashion versus not?

          7                MR. GRADANTE:  I don't have that answer.  

          8                MR. NEWTON:  I was going to say I was pretty sure

          9      that if there was a difference in performance if getting

         10      registered was going to increase your performance by 5

         11      percent.  

         12                COMMISSIONER CAMPOS:  I was thinking -- maybe tell

         13      me -- 

         14                MR. NEWTON:  No, they would all be rich -- 

         15                MR. GRADANTE:  I mean, there is -- I think we all

         16      have seen a reversion to the mean sometimes.  Not for

         17      everyone, but some managers, if they get too big, they can

         18      revert to some sort of mean; but that's a generalization,

         19      that's not true of everybody.  

         20                MR. VAUGHAN:  We don't have statistics on it, but I

         21      think anecdotally we do see more registered hedge fund

         22      managers, mostly because institutions have gotten into the

         23      hedge fund management business and, therefore, have other

         24      businesses which drive them to be registered investment

         25      advisors.  

          1                Traditionally, going back 10 years, it was mostly

          2      CFTC registration in the industry.  Now they're registered

          3      advisors, as the institutions have gotten into it, for two

          4      reasons:  

          5                One, to keep talent in the mutual fund organization

          6      by offering the ability to do other types of products that

          7      the manager finds interesting and challenging; and also

          8      because of the interest of investors in hedge funds, being

          9      able to offer a full menu of investment products to their end

         10      investors by having their own in-house, or proprietary, hedge

         11      funds.  

         12                MR. PRESS:  And the Commission has looked at least

         13      at almost every organization that I'm aware of where they

         14      have mutual funds, hedge funds, or other kinds of investment

         15      product, and had extensive examinations on trading,

         16      allocations, commissions, and so forth.  And, to my

         17      knowledge, it's shown to be an incredibly clean examination

         18      with great compliance, great procedures being put in place,

         19      and some of the conflicts that the press has reported have

         20      not come up on those kinds of examinations.  

         21                MR. SCHULMAN:  We have about 100 funds in our

         22      database where the manager is also involved, either directly

         23      or indirectly, in a mutual fund company.  

         24                We have also -- a survey -- we also have a study in

         25      the TAS database that says a little more than half the

          1      managers are RAA's, and I think there's a subsetting:  People

          2      who are out there building businesses and raising money are

          3      registering because it's one of the things you need to do. 

          4      It's one of the ways that you can raise money.  It would

          5      involve being registered, whether it's retailization or

          6      institutionalization.  

          7                A lot of the bigger funds that have been around for

          8      a long period of time and have operated very successfully, or

          9      who are closed to new investors, but have not yet thrown out

         10      the existing investors, are not registering because they have

         11      no purpose associated with doing it.  

         12                MR. KEUNEN:  Many of the funds that we service also

         13      have stock exchange listings.  So there obviously there are

         14      requirements associated with that.  

         15                MR. VAUGHAN:  One thing to keep in mind, too, the

         16      managers that are not based in the United States are often

         17      registered in their home jurisdiction.  So while the

         18      institutionalization -- there may be a few clients who want

         19      them to be registered with the Commission if they're trying

         20      to give them a mandate, many are comfortable if they're

         21      registered with the U.K. regulatory authorities, that that,

         22      if they're based in London, is substantial equivalent from

         23      their due diligence standpoint.  

         24                MR. GRADANTE:  Did want to move on to just the

         25      roles that various service providers play in the hedge fund

          1      industry.  

          2                And since we talked about the domestic off shore

          3      fund distinction, William, maybe you could go into an outline

          4      of really what off-shore administrators do, the types of

          5      services they provide to hedge funds.

          6                MR. KEUNEN:  Yes, sure.  I mean, the first thing to

          7      say is that the services that we perform are defined in an

          8      administration agreement that is between the fund and the

          9      administrator.  So that's the first thing; and, obviously,

         10      that varies fund by fund.  

         11                Also, hopefully, the disclosure in the offering

         12      documentation properly outlines what the functions and

         13      responsibilities of the administrator are.  But we tend to

         14      split our services between cost services and added-value

         15      services.  

         16                The cost services include accounting, which

         17      basically comprises maintaining the books and records of the

         18      fund, typically, independently; taking the activities of the

         19      fund on a day-to-day basis from the accounts -- to the fund,

         20      the prime brokers; reconciling positions and cash balances --

         21      typically, daily; and then, you know, producing a portfolio

         22      in cash balances; pricing the portfolio, again, subject to

         23      the rules of the fund; calculating fees and accruals; and

         24      then, you know, preparing -- calculating the net asset value;

         25      and producing financial statements.  

          1                Typically, the cycles for that are at the very

          2      least, you know, at intervals whenever investors can either

          3      come or go out of the fund.  But they can also be daily,

          4      weekly, or monthly.  

          5                Other services are investor-related services.  We

          6      typically verify investors in accordance with applicable

          7      anti-money laundering rules.  We process capital flows.  We

          8      process subscriptions, redemptions, and other transactions

          9      such as dividends, and distributions, and transfers; we

         10      communicate with investors on a periodic basis -- typically,

         11      monthly, with standard information about the fund and the

         12      investor's holdings in the fund.  

         13                So those are sort of cost services.  

         14                Added-value services include corporate and legal

         15      services; possibly tax reporting, typically in the U.S.;

         16      compliance with investment restrictions; compliance

         17      monitoring with investment restrictions; and other

         18      administrative services.  

         19                So those are the primary services. 

         20                And again, over the last few years, we've seen a

         21      trend towards out sourcing more of the operational work that

         22      hedge funds would have historically and typically

         23      traditionally done.  And that, you know, that could include

         24      operational support such as trade rate reporting, cash

         25      exposure reporting, currency exposure reporting, on a daily

          1      basis.  

          2                But again, the parameters are covered fund-by-fund,

          3      with the funds that we service, by virtue of the agreement

          4      that we have.  

          5                MR. GRADANTE:  Now William, you've outlined some

          6      very key functions in terms of accounting, valuation,

          7      pricing -- typically occurring by you as the independent

          8      third party for what we refer to as off shore funds.  

          9                Who does that in a domestic fund context and

         10      where's the independence?  Or is there any independence in

         11      terms of those functions in the domestic hedge fund arena?

         12                MR. KEUNEN:  I think, again, for domestic funds, it

         13      tends to vary and it depends on the fund and the nature of

         14      the fund.  But, you know, I guess there are a number of

         15      different parties who perform this.  For some funds, it's

         16      done in house by the investment advisor.  For other funds,

         17      it's done by the administration.  

         18                We see a trend towards more independent

         19      administration for domestic funds.  And for other funds, it's

         20      done by sometimes the accountant.  

         21                MR. NEUS:  I think also the prime brokerage plays

         22      an increasing function on both the off-shore and domestic,

         23      but specifically with regard to reconciliation, valuations,

         24      and the other issues.  

         25                MR. PRESS:  There are numerous checks and balances

          1      within the hedge fund organization; but again, it also

          2      depends -- as an entrepreneurial organization, some hedge

          3      funds can just be the manager.  That doesn't require lots of

          4      technology, if he's trading long/short.  Call your broker to

          5      execute the trade.  It goes right through on a bookkeeping

          6      service, or you can do it yourself.  Not a lot of checks and

          7      balances to very large organizations that have no different

          8      than a mutual fund complex, or broker dealer complex -- a

          9      very elaborate compliance, accounting, risk, technology,

         10      analytics, and so forth and so on.  

         11                And each organization really has to structure it,

         12      but the administrators have the -- driving force, and the

         13      bookkeeping, and accounting part.  To my knowledge, no big

         14      four accounting firm does bookkeeping for -- as a part of its

         15      business.  It's just not something that we do.  It's also a

         16      conflict in our minds; so bookkeeping is not done by the

         17      accounting -- large accounting firms.  

         18                There may be some medium-sized firms that do it

         19      within the context of the AICPA rules and regulations; and

         20      it's perfectly acceptable under certain specific guidelines. 

         21      But the administrators have really picked it up.  

         22                There is a shortage of CFOs in this industry.  It's

         23      hard to learn and train.  It takes years of knowledge. 

         24      Legal, compliance, hard-to-get operations people.  The prime

         25      brokers are a large source of operations people that work in

          1      the hedge fund industry and there's not enough of those.  

          2                COMMISSIONER CAMPOS:  What are the statistics, if

          3      you have any, about the valuation of assets and how regular

          4      reports are produced for investors and hedge funds?

          5                MR. PRESS:  In general, hedge funds value their

          6      securities on a daily basis.  No different than any

          7      proprietary trading.  And they go through elaborate steps. 

          8                On reporting to investors, it depends on what the

          9      offering document or partnership agreement has said.  Most

         10      report on a minimum of a quarterly basis and the investors

         11      have accepted that.  Or monthly.  Some will report more

         12      often; others have elaborate Web sites, with secure

         13      identification procedures to get in, to give daily

         14      information.  

         15                It really depends on the hedge fund, investor needs

         16      or desires; but at a minimum, quarterly.  Some with a one-

         17      page letter:  "Here's how we've done."  Others with --

         18      there's one particular hedge fund that produces a 20-page

         19      thesis on the market and their philosophies; and it's quite

         20      elaborate.  And it's really very different by hedge fund.  

         21                COMMISSIONER CAMPOS:  Well, you're saying that --

         22      do you have statistics for how many actually have a net asset

         23      value per day -- daily?  You're saying most of them do?

         24                MR. PRESS:  Most value the positions.  They don't

         25      necessarily go to an NAV-type of calculation.  Some do, some

          1      don't.  They don't need to report "I've done a daily NAV."

          2                Remember, in the hedge fund industry in general,

          3      you cannot get out on a daily basis.  

          4                COMMISSIONER CAMPOS:  I understand.  I'm just

          5      wondering what the practice is.  Secondly, is GAAP being

          6      used, or other standards being used for evaluation?

          7                MR. PRESS:  For the audit that we perform on the

          8      clients we service, all the opinions are within GAAP unless

          9      there's some form of qualification required, but in general,

         10      the offering documents require GAAP or valuations in

         11      accordance with GAAP, and GAAP is dominant in the industry on

         12      a very small percentage.

         13                I don't have statistics for you on international

         14      GAAP.  U.S. GAAP dominates the hedge fund industry nb is

         15      followed rigorously.

         16                CHAIRMAN DONALDSON:  What goes on within the hedge

         17      fund is very much like getting back to Mr. Lindsey's point,

         18      proprietary trading.

         19                If you have a hedge fund manager that is long on

         20      short equities that he can mark his portfolio off the screen,

         21      typically that's the way it's done, and they have realtime,

         22      on-line P&L systems.

         23                As you deviate from that and get into more

         24      illiquid, less tradeable, on the proprietary desk of an

         25      investment bank, you would call an independent company to

          1      value that asset.  We see that being done more often.  You

          2      know, some do it monthly, where they call in an independent

          3      firm to value assets that they cannot value off the screen

          4      properly.

          5                MR. PRESS:  Hedge funds also have another

          6      uniqueness, depending on their documents, where they, what we

          7      call a side pocket, where literally they take illiquid

          8      investments and say there are no valuations -- I'm going to

          9      leave out the financial statement for the moment.  There are

         10      no valuations.

         11                Once you invest and you know you're investing, 10

         12      percent of your capital may go into this pocket, and you

         13      can't get out.

         14                Even if you take your liquid money out, that stays

         15      forever until there's a disposition on those assets, and they

         16      track those assets very rigorously by investor, and it

         17      usually is a year-by-year, in some cases it's a quarterly by

         18      quarterly investment, so they're tracking to that, because

         19      they know the difficulty in trying to value those illiquid

         20      assets in terms of someone getting in and out, and their own

         21      performance.

         22                So that's another part of the industry that's,

         23      again, a little bit different than in the mutual fund

         24      industry.

         25                From the GAAP perspective, we're required to go

          1      through, and the clients are required to go through a

          2      valuation/fair value, and they go through rigorous steps

          3      trying to get to those valuations, and we review those steps.

          4                MR. ROYE:  Am I better off, as an investor in a

          5      hedge fund, from an investor protection standpoint, being in

          6      the offshore fund versus the domestic fund because of the

          7      presence of the offshore administrator providing a lot of

          8      these independent checks, accounting, valuation, where you

          9      don't necessarily have that, and I guess our understanding is

         10      largely you don't have that, the third party administrator in

         11      the domestic fund context?

         12                MR. PRESS:  I would say that investing onshore or

         13      offshore, any investment manager would be the same.  Checks

         14      and balances exist between the prime broker and the trading

         15      desk, the internal people, offshore administrators and

         16      onshore administrators.

         17                MR. ROYE:  But the onshore administrators, I mean,

         18      that is not typical -- 

         19                MR. PRESS:  It's no different than any major

         20      brokerage house, has its own internal people determining its

         21      earnings per share and publishing it.

         22                The requirements and the recordkeeping are as

         23      strong as they are in any hedge fund organization, as they

         24      are in other organizations, and people comply with proper

         25      bookkeeping and accounting procedures wherever possible.  If

          1      it's a very small entrepreneurial, then that's a different

          2      issue.

          3                MR. ROYE:  I guess the only thing that I'm -- the

          4      point I'm making is that, you know, there's an independent

          5      party in the offshore context providing a lot of these

          6      functions.  Within a domestic context, the party is not

          7      necessarily independent, and we know from experience that

          8      from time to time people stray, and there are incentives to

          9      stray.

         10                But I guess what I'm saying is that, I mean, maybe

         11      the answer is that Rich Lindsey and the prime brokers are

         12      doing part of this, and they're part of the independent

         13      check, but I mean, it is a fact that in the offshore fund

         14      arena, you have an independent third party providing a lot of

         15      these critical functions, and you don't have that

         16      independence in a domestic context.

         17                MR. PRESS:  You do in many, in large organizations

         18      that have their own internal controls.

         19                MR. ROYE:  But those are inside folks doing it.

         20                MR. PRESS:  No different than a mutual fund complex

         21      in the same capacity.  It has not changed, and any other -- 

         22                MR. ROYE:  You have different directors in a mutual

         23      fund context.  You sometimes have third party administrators

         24      in a mutual fund context.

         25                MR. PRESS:  And you sometimes have third party

          1      administrators in domestic hedge funds, also, and in business

          2      today -- 

          3                MR. ROYE:  What percentage of domestic funds have a

          4      third party administrator?

          5                MR. PRESS:  Today more than ever on startups I

          6      would tell you that at least 75 to 90 percent go with a third

          7      party administrator for onshore and offshore startups,

          8      because there are not enough internal people, and the

          9      technology costs for the accounting systems that are out

         10      there are significant, and you have to be a larger hedge fund

         11      to be able to support it, so the small hedge funds have

         12      onshore and offshore administrators doing the ascertaining

         13      values, also.

         14                MR. KEUNAN:  I would say there's definitely a trend

         15      there.  I mean, I think that administrators now have a U.S.

         16      presence.

         17                They've demonstrated that they have the expertise

         18      with specific U.S. requirements such as tax reporting and

         19      partnership allocations in the accounting for that, so the

         20      trend is there, definitely, as Joel says, towards using

         21      administrators on domestic funds.

         22                MR. NEWTON:  A lot of the players in this business

         23      are tuning into the same people who are processing mutual

         24      fund transactions. 

         25                They're all standing on the sidelines, you know --

          1      well, not standing on the sidelines anymore. 

          2                They're in there, you know, some very big names in

          3      the securities processing business, and they are fulfilling

          4      these, and they are competing for these functions onshore

          5      since the repeal of Tinker-Monmouth.

          6                MR. NEUS:  Paul, I think the other aspect to this

          7      is disclosure documents of hedge funds and increasingly, the

          8      due diligence by the gatekeepers and the significant

          9      institutional investors are going into great depth of the

         10      reconciliation process, when you get independent valuations,

         11      when they're reported, and that has increasingly been for

         12      firms that do it in-house.  There is a vetting process that

         13      has emerged within the market.

         14                MR. LINDSEY:  Since you raised it, I should be very

         15      clear though, that a prime broker actually does not have the

         16      capability to value a hedge fund.

         17                They could not compete an NAV on any basis, because

         18      they neither see the cash accounts, bank accounts that might

         19      be held by a hedge fund when they do not see any of the off-

         20      balance-sheet activity that a hedge fund may be engaged in.

         21                That's even if you're the sole prime broker, and of

         22      course, typically, hedge funds, at least if we're talking

         23      about hedge funds of any size, you know, if you're in the,

         24      say, 50 to 150 or $200 million range, they probably have on

         25      average one-and-a-half prime brokers, and as you start to get

          1      larger, the number of prime brokers increases.

          2                MR. ROYE:  How about, can you just outline for us

          3      the roles that a prime broker would play in the hedge fund?

          4                MR. LINDSEY:  Well, the prime broker plays a

          5      relatively simple role, which, you know, I think a lot of

          6      people have had confusion about what a prime broker does over

          7      the years, and that is, you know, traditionally, of course,

          8      if you wanted to trade with six different houses on the

          9      street, and you were a proprietary trading desk, a hedge fund

         10      type of operation, you would have to open up six brokerage

         11      accounts around the street to do that, and you'd have to have

         12      assets held at each one of those accounts.

         13                What a prime broker does is essentially allow the

         14      hedge fund to give up the name of a prime broker that may

         15      hold a substantial portion or at least some sizable portion

         16      of their assets, and let them trade anywhere on the street.

         17                So the prime broker becomes responsible for the

         18      clearance and settlement of the trading activity.

         19                The prime broker may or may not trade on any given

         20      trade or even at all with the hedge fund, so they may or may

         21      not be a counter-party to the hedge fund in some cases, but

         22      basically, it provides basic clearance and settlement

         23      services.

         24                There are some additional services that prime

         25      brokers provide to try to facilitate a client relationship

          1      with the hedge fund, and those, you know, range from simple

          2      things like perhaps the facilitation of them obtaining office

          3      space in certain locations to helping them sometimes find a

          4      CFO if we know that people are looking to, unfortunately,

          5      sometimes, taking personnel from the prime broker to help

          6      augment their back office, but it's a wide variety of what

          7      I'll call services that are only meant to maintain

          8      relationships.

          9                MR. ROYE:  And the compensation flows essentially

         10      from the trading activity that -- 

         11                MR. LINDSEY:  Well, compensation for a prime broker

         12      can come from essentially three -- four areas.

         13                One could be execution, commission type of flow,

         14      if, indeed, the prime broker is associated with the

         15      executions.

         16                And the other would be essentially -- I've

         17      classified them as three separate ones, but that's

         18      essentially income derived from margin balances, short

         19      balances, and credit balances -- so debits, credits, and

         20      shorts.

         21                There may, in many cases, also be a processing or

         22      transaction fee associated with processing a trade,

         23      particularly if that trade is done someplace else.

         24                MR. ROYE:  How about in promoting the hedge funds,

         25      roles prime brokers -- 

          1                MR. LINDSEY:  I don't know of any prime broker that

          2      promoted hedge funds.

          3                MR. ROYE:  Okay.  Capital introduction services?

          4                MR. LINDSEY:  Capital introduction services are

          5      services that amount to essentially, you have a clientele

          6      that may be interested in meeting institutions.  All of our

          7      capital introduction is involved with institutional.

          8                And you have institutions that are qualified

          9      investors that indicate that they are interested in hedge

         10      funds, and what we do is, we provide a venue where they may

         11      meet, so those venues typically consist of what I'll call

         12      conferences, so -- where you have a number of hedge fund

         13      managers that may talk, a number of investors that have come

         14      into the room, and do that type of thing.

         15                As Robert, I think, said earlier, the investing

         16      process today is a very long process, particularly with more

         17      institutionalization of the marketplace.

         18                Those investors may look at hedge fund managers for

         19      anywhere between, you know, nine months to a year-and-a-half

         20      to two years.  They'll see them at a number of different

         21      prime brokers' capital introductions meetings.  They'll see

         22      them at a number of outside conferences.  They'll see them

         23      perhaps one-on-one in their offices. 

         24                But they go through a very long and detailed and

         25      rather slow  process of deciding whether or not they're going

          1      to invest.

          2                I think that I would say that the capital

          3      introduction process is a little bit akin to the fact that,

          4      you know, your next-door neighbor's son is looking for a job

          5      and asks you whether or not you know of any jobs that are out

          6      there, so you take, you know, his resume and you pass it to a

          7      few places that may have some jobs that you know of, and say,

          8      "I don't know the person particularly well, but indeed, you

          9      know, if you have a position that meets it, please interview

         10      them and see if there's something there."

         11                MR. ROYE:  So you're not really functioning in the

         12      role of placement agent/broker for the client investing in

         13      the hedge fund?

         14                MR. LINDSEY:  No.  No.  And that's, I think, our

         15      practice, and I believe the practice of at least all of the

         16      major prime brokers, is to disclaim that, disclose that in

         17      every interaction with the investors and with the hedge fund

         18      managers.  We try to make that abundantly clear.

         19                MR. NEUS:  I would just add on that, is that we

         20      make sure that, if we're participating in such conferences,

         21      we ensure that the prime broker tells us that all the

         22      investors that are there are qualified to whatever degree is

         23      required within our funds.

         24                CHAIRMAN DONALDSON:  Can you comment on how the

         25      prime broker relation unit within the firm is organized in

          1      terms of other units within the firm -- the trading desk, the

          2      research department, salespeople, et cetera, et cetera?

          3                MR. LINDSEY:  Well, I think it varies a little bit

          4      from firm to firm.

          5                In our firm, it's actually a separate broker-

          6      dealer.  All of our clearance business is in a separate

          7      broker-dealer, completely isolated from the trading

          8      activities, analysts, from any -- from basically the rest of

          9      the company.

         10                So either all of the prime brokerage personnel are

         11      separated, also all of the people that process and handle

         12      trades, see positions, et cetera.

         13                Part of that is to provide comfort to our clients

         14      that, indeed, other parts of the firm cannot access it.

         15                Other firms are organized somewhat differently. 

         16      Sometimes prime brokerage falls within the institutional

         17      equities division of the firm.  It's really a matter of

         18      individual firm structure.

         19                MR. ROYE:  Joel, how about the role of auditors in

         20      the hedge fund context?  You've alluded, I think a couple of

         21      times, to some of the services.

         22                But how would an audit of a hedge fund, say, differ

         23      from a mutual fund, if at all?

         24                MR. PRESS:  Trying not to put everybody to sleep,

         25      I'll make this very quick.

          1                A mutual fund audit is really a controls-based

          2      audit, and it dictates off of internal controls.  Most of the

          3      administrators have a SAS-70, and you can do a controls-based

          4      audit.

          5                Hedge funds are a substantive approach, so it's

          6      testing, and hedge funds really have three major investments. 

          7      It's capital, broker balances, and of course, valuations.

          8                Mutual funds require 100 percent valuations at

          9      December 31st, or at their year end. 

         10                Hedge funds, you are allowed to do testing when you

         11      think appropriate, and use that for your audit opinion.  Most

         12      auditors in the hedge fund world do most substantive testing

         13      and valuation procedures at year end, but it is not required

         14      to do 100 percent.

         15                Financial reporting, there's a 100 percent

         16      requirement disclosure.  There is a proposal for mutual funds

         17      for positions greater than 1 percent.

         18                Hedge funds have SOP-95.2, which requires a

         19      disclosure greater than 5 percent.

         20                Filing requirements must be within 60 days.  Hedge

         21      funds, if it's CFTC, is 90 days.  Otherwise, there are no

         22      filing requirements.

         23                One of the key things for hedge funds on auditing

         24      is getting out the K-1s.  People want to file their return,

         25      as much as possible, on time, and that's another part of

          1      where hedge funds work hard to get those K-1s out, and

          2      accountants work hard to get them done.

          3                Compliance:  auditors for mutual funds will review

          4      compliance procedures, are not required to do that in hedge

          5      funds.

          6                Basically, in short, those are the major

          7      differences between mutual fund auditing the hedge fund

          8      auditing.  It could go on in little details, but I don't

          9      think it's critical for what we're talking about.

         10                MR. ROYE:  So the audit requirement is largely

         11      driven by what is in the private placement memo -- 

         12                MR. PRESS:  The private placement memo -- 

         13                MR. ROYE:   -- that the funds will agree to have an

         14      audit once a year?

         15                MR. PRESS:  All hedge funds that I've ever been

         16      associated with in my 35 years in the business have a

         17      certified audit all at the year end, and obviously get out

         18      their tax information and report to the partners.

         19                Some hedge funds reports give a capital letter,

         20      which shows information with regard to the personal capital

         21      letters.  CFDC, in certain instances, requires that.  But

         22      everyone gets a financial certified statement and tax

         23      information.

         24                MR. ROYE:  And time constraints in terms of

         25      delivering that information is as outlined in the private

          1      placement memo?

          2                MR. PRESS:  The private placement memo normally

          3      defines it will be out in 75 or 90 days, could take longer. 

          4      Funds of funds will take longer because, until you gather all

          5      the information, depending on the size of the hedge fund,

          6      what strategy, it takes a longer period of time, and in that

          7      case, almost always, the tax information is well after April

          8      15th, but that's disclosed to the investors, also.

          9                Offshore funds also are audited under the same

         10      requirements as domestic hedge funds, but we will report. 

         11      There is the board, a William indicated, in offshore hedge

         12      funds, and there will be a board reporting.

         13                And we're seeing a small movement to audit

         14      committees on some of the larger hedge funds, where we will

         15      report to an independent board, even in domestic hedge funds

         16      on the larger size, and in offshore.

         17                MR. ROYE:  How about procedures like confirming

         18      account balances for hedge fund investors?  Is that something

         19      that's typically done as part of a check?

         20                MR. PRESS:  There's rigorous testing on

         21      reconciliation of broker balances, confirmation of positions,

         22      verification of location, custodianship, and so forth.

         23                Hedge funds don't -- are not required to use a

         24      third party custodian, mostly use prime brokers.  To the

         25      extent there's executory contracts or derivative contracts,

          1      there's an elaborate confirmation procedure, but again, not

          2      required to do 100 percent testing on a controlled testing

          3      basks.

          4                MR. ROYE:  Okay.  I just wanted to touch on sort of

          5      the use of hedge fund indices.

          6                A number of you construct indexes of hedge funds. 

          7      You gather information from hedge funds.  Information is

          8      reported to you.

          9                What level of confidence do you have in that

         10      information that's reported to you, the performance numbers,

         11      the information that you get from the hedge funds that

         12      report?

         13                MR. SCHULMAN:  It's not audited.  It's audited, as

         14      Joel just said, at the end of the year.

         15                It is directionally correct.  We think it gives

         16      very good information for someone who is interested in how

         17      the industry has done.

         18                There are two types of indexes.  One, your

         19      capitalization weighted indexes, like the S&P 500.  You have

         20      non-capitalization weighted indexes, like the Dow Jones.

         21                There is some move afoot from people like S&P and

         22      CSFP to launch products that track these indexes, with some

         23      degree of success relating to the launching of that.

         24                I think they're indicative of how the market does,

         25      and I think they're a reasonable benchmark and a much better

          1      benchmark for the hedge fund business.  The indexes and the

          2      sub-indexes are much better benchmarks because they're

          3      absolute return benchmarks, and that's the way you should

          4      measure absolute returns in the marketplace.

          5                As Charles said earlier, when the market was going

          6      up 30 percent a year and hedge funds were doing 18 and very

          7      proud of it, they had nothing to compare to.

          8                When the market was going down 30 percent a year

          9      and hedge funds were doing 10, they had nothing to compare

         10      to, but were still very proud of it.

         11                These indexes give us a chance to have some

         12      reasonable institutional benchmarks and some reasonable

         13      retail benchmarks, so that someone has some idea of what a

         14      good outcome is versus a bad outcome.

         15                Are they perfect?  Is every manager pure in the

         16      style in which they're included?  No.

         17                Are they directional, are they statistically

         18      accurate, are they directionally correct?  Yes, they are.

         19                MR. ROYE:  Charles?

         20                MR. GRADANTE:  I think Bob answered the question. 

         21      You know, the only thing I can add to it is that, you know

         22      hedge funds do take that heir performance fees, so it

         23      behooves them to have accurate numbers, and the internal

         24      auditing procedures centered around that are very rigorous,

         25      from what I've seen.

          1                MR. NEWTON:  There's a fairly widespread

          2      misapprehension, particularly in some of the media that goes

          3      out there, is that the numbers that we're using -- I believe

          4      this is correct at Bob's shop -- we are reporting net

          5      performance figures.  We occasionally get a cunning little

          6      manager who says, "Oh, I didn't understand that," but they

          7      normally get smacked fairly hard when we find them, and, you

          8      know, given the overall weightings.

          9                But the numbers that are going out there are net,

         10      so it's after the management fee -- 1, 2 percent -- it's

         11      after the performance fee -- 20 percent, 30 percent, whatever

         12      it is.

         13                So you're seeing a very -- you know, you're seeing

         14      the actual return that the investor gets, and I think that's

         15      something very important to keep in mind, because obviously,

         16      we all know that in the mutual fund area, you don't see that.

         17                MR. SCHULMAN:  And it is more complex than it

         18      sounds, because of something that was talked about when we

         19      talked about administration, which is there isn't one correct

         20      number when you're the administrator of an offshore and

         21      onshore fund.  It depends on when the investor came in.

         22                Our policy is, we track someone as if they had

         23      invested fresh on January 1st.  The numbers you see in our

         24      database are a fresh investor on January 1st, not making up a

         25      high water mark, not necessarily suffering from whatever

          1      happened in January and February. 

          2                That's just a matter of policy, and we state that

          3      when we publish the task database.  Other databases take

          4      slightly different approaches, but we're all trying to get an

          5      accurate read as to what an investor gets.

          6                MR. PRESS:  And the investors get monthly or

          7      quarterly performance information, and many of the investors

          8      today get these databases and look at them and go back to the

          9      funds and say, "Are you within reason, or if you're out of

         10      that strategy, why are your numbers slightly different?"

         11                There's comprehensive review by investors and the

         12      managers to maintain accuracy of their performance

         13      information.  Then, of course, the audit information provides

         14      performance information, which then gets put into the

         15      databases, also.

         16                MR. SCHULMAN:  And if you're a qualified investor,

         17      you can get that information directly off half a dozen

         18      different web sites, at no expense, at a zero charge; so you

         19      can check your own results against the results that are

         20      published by the manager.

         21                So you have all those investors out there who are

         22      our control and who are the managers' control as to where

         23      those numbers might be very different.

         24                COMMISSIONER CAMPOS:  Is there any need or would it

         25      be possible to have indices by hedge style, in terms of the

          1      different matters that -- you know, because we're talking

          2      amalgamating everything that may be a hedge fund in these

          3      indices, I suppose.

          4                MR. SCHULMAN:  We do produce -- 

          5                MR. GRADANTE:  Earlier, I mean, we have 23

          6      different sub-indices to the indices, so yeah, there is.

          7                MR. SCHULMAN:  And we have 11, and again, they're

          8      all up on the web sites.  People can see them.

          9                MR. GRADANTE:  You know, we even go as far as

         10      having, you know, sector indices, like Latin America,

         11      technology, telecom and media, and things like that.

         12                CHAIRMAN DONALDSON:  We've got a few more minutes

         13      left for our panel, and I think maybe it might be appropriate

         14      to conclude by asking each of the panelists, really, to talk

         15      about sort of the state of the hedge fund industry as they

         16      see it.

         17                You know, we see a lot of institutional interest in

         18      hedge funds today.  We see funds being created.  You know,

         19      the industry has changed.  I guess it might be described as a

         20      fairly young industry, even though hedge funds have been

         21      around since 1949, at least.

         22                But I wonder if maybe each one of you could kind of

         23      give your assessment of where the industry is, and trends,

         24      and where you see it going?

         25                COMMISSIONER GLASSMAN:  Paul, can I just add one

          1      thing to that question?

          2                As you answer that, if there are any problems or

          3      issues in the current industry that you think the SEC needs

          4      to deal with, that would be helpful.

          5                MR. PRESS:  I guess I'll start.

          6                I think the industry is just a growing, dynamic

          7      industry with tremendous opportunity.

          8                There have been three studies, one by Putnam

          9      Lovell, one by Greenwich, and one by DeutscheBank, talking

         10      about growth in the next five to 10 years in excess of $1

         11      trillion, potentially 9,000 new hedge fund market funds, and

         12      it's clearly a growing industry for entrepreneurs with great

         13      opportunity.

         14                I think one of the things we didn't talk about is

         15      the technology support that prime brokers, developments that

         16      allow for valuations and reporting has improved dramatically

         17      in the last five years, and the changes in the next three

         18      years are just tremendous for helping in terms of valuing

         19      difficult instruments and the derivatives as we grow.  I

         20      think it's a great class, obviously.

         21                And issues -- one of the concerns, as an auditor,

         22      is technology and fraud, in terms of the ability for

         23      technology to make fraud a little bit simpler today and more

         24      difficult to find.

         25                We've seen it in the commercial markets, whether

          1      it's massive fraud at an Enron, or a Michael Berger in a

          2      hedge fund industry.  These are issues, of course, all

          3      accountants and all people in the industry, whether prime

          4      brokers or not, are all concerned about.

          5                But in general, this industry has had, I think, a

          6      lower percentage of issues, and I think it just has

          7      tremendous breadth and potential.

          8                MR. SCHULMAN:  Okay.  Joel covered everything.  No.

          9                Average life of a hedge fund, because it was one of

         10      the questions that we had talked about, is about six-and-a-

         11      half years.

         12                The business is moving from an entrepreneurial

         13      business to a smaller number of very large players who have a

         14      lot more bells and whistles and a lot more controls, who look

         15      a lot more institutional.

         16                So the entrepreneurial zeal is there, and some

         17      people agree to stop growing when they reach the

         18      entrepreneurial constraints of what they can do with a few

         19      people, and there are a few large organizations that have

         20      gone out to build what we would call mega-hedge fund

         21      organizations relating to the number of funds they run and

         22      the amount of money that they run.

         23                We have some performance challenges in the hedge

         24      fund business, not because the markets are bad, because

         25      people expect hedge funds to perform less well when the stock

          1      market does less well, but performance equally is tied to the

          2      level of rates and the level of volatility in the market

          3      across the hedge fund universe of strategies, and with lower

          4      rates and lower volatility, you probably will see continued

          5      sub-part hedge fund performance, which, by the way, does not

          6      mean negative performance.  It means sub-part relative to

          7      what hedge funds have done historically in the strategies

          8      that are not long, short, equity.

          9                You're beginning to see specialty structures

         10      develop, where guaranty products are finding their way into

         11      the United States, whereas they've been a big feature in

         12      Europe and they're now becoming a way of packaging this to

         13      the qualified investor that's going to become more popular as

         14      time goes by.

         15                You're also beginning to see leverage offers to

         16      high net worth investors that allow them to take these sub-

         17      par returns and, at their own risk, in a fully disclosed

         18      basis, leverage them up to take advantage of it.

         19                You're seeing the financial institutions -- not

         20      hedge fund financial institutions, but traditional financial

         21      institutions -- get behind the idea of making those loans as

         22      relatively safe, securable loans for them to make in the

         23      practice of their business, which is making loans.

         24                The other big feature that's going on in the

         25      marketplace as the market becomes institutionalized is you're

          1      seeing a move towards risk transparency, as, in addition to

          2      having to get registered, more funds are being pushed down

          3      the road or going down the road of becoming transparent in

          4      what their portfolios are, at least to a third party player,

          5      so that it becomes practical for financial intermediaries,

          6      whether they be administrators or fund of fund operators or

          7      institutional advisors, to deliver them an understanding of

          8      what the risk of the portfolio is, without delivering them an

          9      understanding of what the positions in the portfolio is,

         10      which would be considered death in the industry -- death to

         11      the opportunity to perform well would be to disclose

         12      positions.

         13                So they're kind of going halfway down the line and

         14      saying, "We'll tell you what the risks are," which probably

         15      are more important than the positions, from a disclosure

         16      standpoint.

         17                MR. KEUNAN:  I guess I just wanted to echo Joel's

         18      point, that it's a continually and continuously evolving

         19      industry, and as such, it's a joy to work in it.

         20                But we see different cycles in a hedge fund, in the

         21      evolution of a hedge fund.  There are small hedge funds;

         22      there are medium-sized hedge fund; and there are large hedge

         23      funds, and it's our challenge, and we partner together with

         24      the auditors, the prime brokers, and the lawyers, and

         25      obviously, the investment advisors, to ensure that the

          1      process is appropriate for the type of hedge fund that we're

          2      servicing, and that's the challenge. 

          3                And the bottom line is that it's a learning curve

          4      for us all.  We don't pretend to be the experts in all of the

          5      securities that the investment advisors invest in. 

          6      Otherwise, we wouldn't be administrators.  But we do, I

          7      believe quite successfully, as an industry, develop a

          8      methodology that is appropriate for each fund, and as such,

          9      we act from that methodology.

         10                MR. NEUS:  I think that the two main themes that

         11      have come out today are institutionalization and

         12      retailization, and both of them from both the investor

         13      standpoint as well as from the process of the investment

         14      advisor.

         15                On institutionalization, I think that's a good

         16      thing for the industry, both with respect to the investors

         17      coming in being more institutional, having a greater degree

         18      of understanding of the products, and frankly, having a

         19      greater muscle in ensuring that they get the level of

         20      information that they want.

         21                In terms of hedge fund managers, I think you're

         22      continually seeing entrepreneurs who come out and think

         23      they've got a better mousetrap, and that they're going to

         24      come out with something new, but where the industry is

         25      evolving is that some of that is occurring in startups as

          1      part of broker-dealer/mutual fund complexes or larger

          2      institutionalization of hedge funds.

          3                And while you will never have a situation where

          4      there aren't pure startups -- you know, two guys in a garage

          5      who are hiring a prime broker and administrator -- I think

          6      because the support network has evolved around startups, that

          7      you're seeing a greater degree of professionalism within the

          8      industry as a whole.

          9                With respect to retailization, I think there are a

         10      couple notes there.

         11                One is that the media inquiries tend to focus on

         12      the fact that now there are registered funds of funds and

         13      that hedge funds have gone down market, and I think if you

         14      actually parse through what's happening, what you'll see is

         15      that retail fund of funds has lowered the bar to entry into

         16      individual hedge funds by aggregating them, so that you would

         17      have an investor who invested in a hedge fund fund of funds,

         18      and the fund of funds then may invest in 20 different hedge

         19      funds, and the individual may only have to put as low as

         20      $25,000 into the hedge fund of funds.

         21                However, to my knowledge, all registered funds of

         22      funds currently require the investors to be either a credited

         23      investor, qualified purchaser, or qualified clients under the

         24      Advisors Act, and so the concept out there is that hedge

         25      funds are going down market and are retail, but the reality

          1      is that it's the same qualification of the investors who can

          2      invest in a single hedge fund are investing in a basket of

          3      hedge funds, and I don't necessarily think that's a bad

          4      thing.

          5                That being said, I think there are specific issues

          6      about retail investors going into individual hedge funds, and

          7      per Commissioner Glassman's request to point out things that

          8      the Commission should look at, I think where you have a 3-

          9      C(1) standard of a $200,000 income, $300,000 with a spouse,

         10      or $1 million net worth that's 20 years old is something that

         11      the Commission should look at.

         12                The second thing I think the Commission should look

         13      at is in overall education.

         14                I would say, anecdotally, 80 percent of articles I

         15      read on hedge funds use somewhere the adjectives "shadowy,"

         16      "mystique," "offshore."

         17                I think that what really happens, and hopefully,

         18      you've had a sense for it today, is that it's a highly

         19      professional, highly organized industry which, because of

         20      restrictions on advertising or holding yourself out to the

         21      public, we are not capable of sharing with the general public

         22      what we do, and I think the fact that the Commission is doing

         23      both a hedge fund sweep and these panels is extremely

         24      laudable, and I think that's something that will help dispel

         25      some of the myths around the industry.

          1                MR. ROYE:  Charles?

          2                MR. GRADANTE:  With respect to the retailization of

          3      hedge funds, from what I gather, you know, in the hedge funds

          4      or in the arbitrage business, many of them, there seems to be

          5      a feeling that there's a regulatory arbitrage going on

          6      between mutual funds and hedge funds, and the best thing to

          7      do is to close that loophole.

          8                The belief that mutual funds and hedge funds should

          9      be on the same playing field may be misguided, but let me

         10      clarify that.

         11                We do not think that the capital markets are best

         12      served by regulating all hedge funds as mutual funds.  Only

         13      those hedge funds that want the retail market should go

         14      through the registered public offering process.

         15                We should not interfere with the freedom of hedge

         16      funds to determine how best to meet their objectives. 

         17      Perhaps the degree of regulation should be a function of the

         18      market needs.  We need to protect the retail investor, and at

         19      the same time, allow capital formation to meet other investor

         20      needs, whether they be hedge funds, venture capital, or

         21      private equity.

         22                It would not make sense to permit investors to have

         23      ownership in a startup venture capital company through an

         24      unregistered private placement, but not allow a similar

         25      investment in a hedge fund.

          1                MR. VAUGHN:  I think we've had pretty good coverage

          2      already of where the industry stands today, but I would like

          3      to add one thing, which I think is probably not directly in

          4      what we've been considering here today the hedge fund

          5      industry, the unregistered fund industry, but a related

          6      development in the industry, which I think goes to some of

          7      the discussions we had here.

          8                That is these registered funds that are engaging in

          9      strategies that are similar to or sometimes the same as what

         10      hedge funds traditionally have engaged in.

         11                There are registered funds out there, both directly

         12      managed and now the funds of funds products, where they offer

         13      investors, maybe not pure retail investors but accredited

         14      investors on a larger scale, investment strategies that are

         15      -- that had been only available to institutional investors

         16      and high net worth individuals to allow them to diversify

         17      their portfolios.

         18                I think that's a positive development, especially

         19      in the context of the registered funds with these more

         20      retail-type investors, where they have Commission oversight,

         21      registration, the limitations of the Investment Company Act. 

         22      They're simply engaging in strategies now, because those

         23      strategies are thought to be good for diversification, that

         24      had traditionally been the purview of hedge funds.

         25                Now, they're not as leveraged.  They don't go short

          1      as much as hedge funds.  And, you know, maybe that's right. 

          2      Maybe at the margins there maybe could be an adjustment or

          3      two.

          4                But in general, that gives the investors who don't

          5      qualify to go into the traditional hedge funds at least an

          6      ability to get some exposure in their portfolio to similar

          7      strategies without giving up the protections that the more

          8      retail investors have come to rely on and benefit from.

          9                MR. LINDSEY:  Almost everything has been said, but

         10      I'll repeat some of it, maybe.

         11                One of the things that maybe hasn't been entirely

         12      made clear is that I think the hedge funds, the bigger,

         13      biggest ones are actually getting bigger, and they're not

         14      getting bigger in the fact that more assets are being

         15      deployed within each one of those strategies, but rather,

         16      their organizations are growing as what I'll call umbrella

         17      organizations of hedge funds.

         18                So those large hedge fund families that have the

         19      infrastructure, the legal support staff, the compliance

         20      structure, the trading capabilities, are seeding new hedge

         21      fund managers.  They are kind of growing within their

         22      organization a diversified strategy of hedge funds.

         23                And sometimes, we kind of lump that all together

         24      and talk about a hedge fund of a particular size, and a lot

         25      of times, of course, the hedge fund itself isn't of that

          1      size, it may be in eight, 10, 12 hedge funds of much smaller

          2      size aggregated under one umbrella.

          3                So that's important, and I think that will continue

          4      to happen as this industry matures and becomes, in and of

          5      itself, a little more institutionalized in the way that it

          6      runs.

          7                In each case like that, they try to preserve that

          8      entrepreneurial attitude, because that's really what makes

          9      these individuals successful.

         10                Robert said earlier that there were really two

         11      types of hedge fund managers, and I agree with that, that

         12      there are really hedge fund managers that are traders.  They

         13      have some extra synapses in their brain that somehow allow

         14      them to trade and do very well at it.

         15                And then there are hedge fund managers that are

         16      essentially people that do very strong and very fundamental

         17      analysis of either trends or financial statements of

         18      corporations, et cetera.

         19                We derive, in whole, in aggregate in the financial

         20      marketplace, a great deal of benefit from these individuals,

         21      and I'll hearken back to a little bit of economic theory,

         22      that in our economy we talk a lot about efficient markets,

         23      and we talk about the value of disclosure, and we talk about

         24      the value associated with the filings that corporations make

         25      with the SEC.

          1                Well, a large part of what happens in the hedge

          2      fund world is that people spend an enormous amount of time,

          3      effort, energy, and talent into looking really deeply into

          4      those numbers, looking at the bond covenants to decide

          5      whether or not this bond versus that bond has some arbitrage

          6      opportunity.

          7                That reflects itself, in the end, in the efficiency

          8      of prices in the marketplace.  It reflects itself in the end

          9      in the overall efficiency of how our markets work.

         10                So there's a huge value that should not be

         11      discounted by this you know individual of entrepreneurial

         12      activity.

         13                I would also say that the investors are becoming

         14      more and more institutional and more and more sophisticated. 

         15      The last thing I think that any institutional investor wants

         16      to do is go before the committee of their institution and

         17      say, "I lost money in this hedge fund."  They aren't paid

         18      well enough to try to do that, and in general, they try to

         19      avoid it, so they do an awful lot of due diligence and expend

         20      effort. 

         21                The other thing is that we have to keep things in

         22      perspective.  Even if we roughly double, and we take the size

         23      of the hedge fund industry to $1 trillion, which, you know,

         24      there are some forecasts of that, at $1 trillion, hedge funds

         25      still represent a small fraction of the overall financial

          1      marketplace and the overall investable assets.

          2                There is a lot more activity that goes on than the

          3      hedge fund activity.  It gets a lot of press.  It makes --

          4      you know, because some people seem to think that they're very

          5      mysterious or very secretive or very whatever, that it makes

          6      nice things to write about.

          7                But there's more press about hedge funds than there

          8      is financial activity in the marketplace by hedge funds, so,

          9      you know, we should try to keep that perhaps in perspective.

         10                I think that when I look at any of the things that

         11      have gone wrong in the hedge fund world over the last decade

         12      or so, if there was anything that was illegal, it was already

         13      illegal, that there is not, you know, a need for additional

         14      qualifications.

         15                You know, fraud, at least when I worked here, was

         16      illegal.  I think it still is illegal.  And, you know, a lot

         17      of times, it's a matter of making sure that we enforce the

         18      things that happen when things happen.

         19                MR. ROYE:  Greg?

         20                MR. NEWTON:  I will just very quickly say I think

         21      everything, you know, has obviously been covered, but I think

         22      the important thing, and we've just alluded to it in a couple

         23      of speakers along here, about the fact that hedge funds have

         24      been perceived as being relatively secretive.  I think they

         25      are relatively secretive, but the regulatory regime under

          1      which they work exacerbates that condition.

          2                Speaking as a media person, we're generally in the

          3      business of, wherever possible, casting light, and anything

          4      that goes to removing this, you know, this almost ethereal --

          5      the words, you know, mysterious, shadowy, offshore, et

          6      cetera, are sort of hyphenated when hedge funds appear in the

          7      general media, and it's not justified.

          8                And I think that I would just, in closing these

          9      part of my remarks, say that I believe that this process

         10      which the Securities & Exchange Commission has been running

         11      for the last 12 years -- it's 12 months, I believe, I'm

         12      sorry.  It just seems like 12 years.

         13                (Laughter.)

         14                CHAIRMAN DONALDSON:  More for the staff, I think. 

         15                MR. NEWTON:  Like this panel.

         16                (Laughter.)

         17                MR. NEWTON:  But, you know, I think that the

         18      process, you know, I think the process, certainly for

         19      educating the regulators, which is never a bad thing, and

         20      also for just educating the people in the webcast out there,

         21      is going to be extremely valuable in the long run for this

         22      business and this great nation's financial services sector.

         23                MR. ROYE:  Well, we've gone over our time.  We're

         24      going to take a 10-minute break, but I'd like to thank our

         25      panelists for an excellent discussion starting off our

          1      roundtable.

          2                We're going to return in 10 minutes with a

          3      discussion on distribution and marketing of hedge funds.

          4                (Applause.)

          5                (A brief recess was taken.)

          6                MS. OSTERMAN:  My name is Elizabeth Osterman.  I am

          7      an assistant chief counsel in the Division of Investment

          8      Management.  And this is a panel on hedge funds marketing and

          9      distribution.  Before I start, just one sad note, recently

         10      one of our former directors of corporation finance passed

         11      away and some of our panelists will be leaving to attend his

         12      funeral, which is this afternoon.

         13                We are going to, as I said, be discussing marketing

         14      and distribution of hedge funds and funds of hedge funds. 

         15      Let me start off by introducing the members of this panel. 

         16      Starting from my far left is Craig Russell.  Craig is the

         17      managing director and global head of sales and marketing for

         18      Deutsch Banc Absolute Return Strategies.  Craig is the global

         19      head of sales and marketing for DB's hedge fund products,

         20      including their registered fund of hedge fund product that

         21      went effective last year.

         22           Seated next to Craig is Michael Tiedemann.  Mike is the

         23      president of the Tiedemann Investment Group Domestic and

         24      chief operating officer of Tiedemann Investment Group or TIG. 

         25      TIG manages a number of hedge funds.

          1           Next to Mike is Leroy Cody.  Leroy is the managing

          2      director of the Alternative Investments Unit of American

          3      Express Asset Management Group.  Leroy heads a team dedicated

          4      to the distribution of his firm's proprietary hedge funds.

          5           Between Leroy and me is Michael Butowsky.  Michael is a

          6      partner at the New York Law Firm of Mayer Brown Rowe & Maw. 

          7      Michael serves as counsel to various members of the hedge

          8      fund industry, including investment advisors, hedge funds and

          9      prime brokers.  

         10           On my far right, jumping a bit, is Judson Reis.  Judd is

         11      the founding partner of the Sire Group of Partnerships, Sire

         12      Management Corporation.  Judd is primarily responsible at

         13      Sire for Sire's funds of hedge funds.

         14           Next to Judd is Clark Hooper.  Clark is the executive

         15      vice president of regulatory policy and oversight at the

         16      NASD.  Clark is responsible for directing regulatory

         17      activities relating to advertising and investment companies

         18      issues at the NASD and is particularly interested in

         19      suitability issues as they relate to the sale of hedge funds

         20      and funds of hedge funds.

         21           Next to Clark is Alan Beller.  Alan is the director of

         22      the Division of Corporation Finance here at the Commission

         23      and senior counsel to the Commission.  Alan is responsible

         24      for administering our laws relating to the offer and sale of

         25      all securities and to our full disclosure program and in

          1      developing policy with respect to those laws. 

          2                Finally, next to Alan is James Hedges.  Jim is the

          3      founder, president, and chief investment officer of LJH

          4      Global Investments.  LJH Global Investments is a hedge fund

          5      advisory firm with a global presence.  His firm helps

          6      investors navigate the complexities of hedge fund investing.

          7                I hope that this panel is going to pick up and

          8      explore a number of the topics that were identified and

          9      briefly mentioned, sometimes more than briefly mentioned at

         10      this morning's first panel.  These issues are particularly

         11      interesting in the environment that we are today where a

         12      number of people are now raising above the standards that

         13      traditionally have related to investors who may invest in

         14      hedge funds and also in the new products that are available.

         15                Hedge funds operate under a regulatory regime that

         16      assumes that investors in hedge funds can fend for themselves

         17      and don't need the general protections of federal securities

         18      laws.  Because of rising incomes, inflation, and new

         19      products, more and more investors are now investing, both

         20      directly and indirectly, in hedge funds.  Our job today is to

         21      determine or consider whether those investors, like hedge

         22      fund investors from years past, continue to be able to fend

         23      for themselves or at least are getting regulatory protection

         24      so that the same protections available before, the same

         25      sophistication that played into hedge fund investors before

          1      still continues to exist.

          2                As you know, hedge funds are marketed and

          3      distributed in ways very different from registered investment

          4      companies.  They are prohibited from offering and selling

          5      their shares to the public.  This traditionally limited the

          6      types of investors who may invest in hedge funds.  And I am

          7      looking forward to hearing from the panelists this morning as

          8      to whether these limitations make sense in today's

          9      environment and economy.

         10                The prohibition against public offers and sales of

         11      hedge fund shares also limits the amount and type of

         12      information generally available about hedge funds.  Hedge

         13      funds may not, as we all know, engage in any form of general

         14      solicitation or general advertising.  This has always been

         15      problematic for the hedge fund industry.  But the

         16      Commission's attention has been redrawn to this prohibition

         17      in light of the ever-increasing use of the Internet by hedge

         18      funds to keep their investors informed and also by the

         19      increasing use of the public to gather information about

         20      everything, including hedge funds.

         21                Some hedge funds are sold through traditional

         22      broker distribution channels, raising traditional suitability

         23      issues.  More often, hedge fund managers turn to other

         24      channels to attract investors.  Hedge funds frequently rely

         25      on a network of personal associations and existing investors'

          1      recommendations to obtain new investors.  They also are

          2      hooked up with investors through third-party intermediaries,

          3      such as the consultants, some of whom you have heard speak

          4      today, and prime brokers, who may perform other services for

          5      the hedge fund manager.  

          6                Judging by various reports, interest in hedge funds

          7      has been on the rise and sales of hedge fund shares are

          8      booming, and it is not institutions or the King or Queen

          9      Midases who are getting in on the action today.  Inflation

         10      has caused many investors to qualify as investors in these

         11      products, although they would not have qualified even a few

         12      years ago.   As I mentioned before, I am very interested to

         13      hear from the panelists today whether this new pool of

         14      investors has moved hedge funds as an investment opportunity

         15      to a group of investors who perhaps should not be investing

         16      in hedge funds.

         17                Inflation and higher incomes are not the only

         18      reasons for increased accessibility of hedge funds to

         19      investors.  Many fund complexes now offer or are in the

         20      process of offering a relatively new investment product. 

         21      This product is known, as we have discussed already today, as

         22      a fund of hedge funds.  As its name implies, it is a fund

         23      that invests in a pool of hedge funds.  The Commission is

         24      seeing a rise in the number of these funds who work their way

         25      through the registration process and then are offered to the

          1      public.  As a publicly offered product, these fund of hedge

          2      funds raise an entirely new set of concerns that did not

          3      exist 10, or maybe even two, years ago.  Among other things,

          4      this panel will discuss the conundrum that this new product

          5      creates:  Investors, who are prohibited, from directly

          6      investing in hedge funds but may invest indirectly in the

          7      hedge funds through this new product.

          8           With that, I would like to start by asking Alan Beller

          9      and Michael Butowsky to explain and comment a little bit on

         10      the eligibility requirements for investors in these hedge

         11      fund products.

         12                MR. BELLER:  Thanks, Liz.  One has to think about

         13      eligibility requirements for hedge funds in sort of

         14      categories of types of hedge funds, I think some of which

         15      were discussed a little bit in the first panel.  Most large

         16      hedge funds are established pursuant to an exemption under

         17      the Investment Company Act under Section 3(c)7.  And that

         18      dictates a particular type of sales restriction that I think

         19      I am going to ask Michael to chat about for a couple of

         20      minutes.

         21                MR. BUTOWSKY:  Oh, all right.  Well, as Alan

         22      mentioned, there are -- I guess just to describe 3(c)1 and

         23      3(c)7 generally.  There are two exclusions from the

         24      definition of the Investment Company Act within the

         25      definition of an investment company, under the Investment

          1      Company Act of 1940.  And those exclusions -- and it is an

          2      important distinction that they are not exemptions from the

          3      40 Act, they are exclusions from being defined as investment

          4      companies.  One is 3(c)1.  One is 3(c)7.  3(c)1 being one

          5      that is very old.  It has been around I think since the

          6      beginning of the Act.  And 3(c)7, I think being around since

          7      '96.  3(c)1 is an exclusion that is available for funds that

          8      have 100 or fewer beneficial owners other than owners of

          9      certain short-term securities.  3(c)7 was adopted under the

         10      premise that wealthy people don't need the protections of the

         11      40 Act.  And to qualify, to buy a qualified purchaser fund or

         12      a 3(c)7 fund, there are various different categories of types

         13      of people that meet the standards of being a qualified

         14      purchaser, essentially individuals who have $5 million or

         15      more in investments.  There are family companies that have $5

         16      million or more in investments, corporate entities or other

         17      vehicles that are managed by a money manager or invest for

         18      themselves that have $25 million or more in investments.  And

         19      there are a few others, including qualified institutional

         20      buyers under 44A.

         21           I think, Alan, I guess I will turn it back to you, the

         22      point about on the 33 Act side, how those are actually

         23      offered though.

         24                MR. BELLER:  Right, that is fine.  The premises of

         25      the two exclusions, as Michael points out, are very

          1      different.  The 3(c)7 exclusion is premised on the category

          2      of wealthy investors that can presumably get on without the

          3      protections of the 40 Act.  The 3(c)1 exclusion, which is

          4      50-plus years old, was really designed to draw a ring around

          5      small, private investment companies that didn't rise to the

          6      level of a regulatory interest justifying registration, I

          7      think would have been the original justification.

          8                There is no restriction under the 40 Act itself

          9      with respect to who can buy one of these funds, hedge funds

         10      or other funds limited to 100 beneficial owners.  That takes

         11      you back into the Securities Act, which proscribes offering

         12      restrictions for sales of securities generally.  The

         13      restriction that would be applicable in terms of these small

         14      funds is actually quite a bit less restrictive than the

         15      restriction with respect to so-called 3(c)7 funds.  The

         16      restriction is on offers and sales to so-called accredited

         17      investors.  They are defined to include most institutions,

         18      institutions with assets of $5 million or more of various

         19      sorts.  The definition also includes individuals. 

         20      Individuals who are accredited investors are those who have

         21      with their spouses $1 million of net worth or those who have

         22      $200,000 of income in the last two years and a reasonable

         23      expectation of that in the current year or $300,000 together

         24      with their spouse.  Those tend to leave you with a quite a

         25      bit larger category of potential investors than the qualified

          1      purchaser exemption of 3(c)7.

          2                And I do think that one of the issues that

          3      confronts the staff and the Commission in thinking about

          4      marketing is whether that accredited investor definition is

          5      where it should be.  It is a definition that applies across

          6      the spectrum of the securities laws so that offers in --

          7      private offers and sales completely outside the hedge fund

          8      context are also in certain circumstances governed by the

          9      accredited investor limitation.  And that has raised a number

         10      of issues over the years, including things like small

         11      business capital formation, which is presumably outside the

         12      purview of this group but it is one of the things that has

         13      complicated approaching the accredited investor definition.

         14                I want to mention one more thing about offerings

         15      here, which is generally applicable and which I think is very

         16      important, especially as Liz mentioned it in the Internet

         17      context.  All offerings of these unregistered funds, other

         18      than the offerings of registered funds of funds, has to be

         19      done under the general private offering rules under the

         20      securities laws.  And, in particular, they have to be

         21      accomplished without what is referred to as general

         22      solicitation and general advertising.  That is a limitation

         23      on publicity outside the universe of eligible investors, and

         24      indeed outside the universe of eligible investors who have

         25      been in some sense pre-qualified as accredited investors. 

          1      And one is the reason that under our rules, as we believe

          2      they should be interpreted, there really should not be

          3      publicity about hedge funds and offerings of hedge funds. 

          4      And there is an important point in there.  If you are an

          5      operating company, let's say you are a car manufacturer, we

          6      don't view your advertising of cars, if it is the sort of

          7      advertising that always in the ordinary course is done, as

          8      necessarily conditioning the market or as necessarily

          9      impermissible publicity for an offering by that car

         10      manufacturer.  But in the context of hedge funds, and I know

         11      Michael has thought a lot about this and may want to chime

         12      in, in the context of hedge funds, they are not in the

         13      business of doing anything other than offering securities and

         14      managing a portfolio.  And therefore there really isn't an

         15      exception, at least that we have been able to identify for

         16      kind of ordinary course communications in the hedge fund

         17      context.  And that does complicate the life of hedge funds

         18      when it comes to general solicitation and general

         19      advertising.

         20                The use of Internet, and then I will stop for a

         21      minute because I think we will get back to that later, the

         22      use of the Internet, you have to think about particularly in

         23      the context of the restriction on general solicitation and

         24      general advertising, a web site that does not have some

         25      protections against anyone from the public or anyone who is

          1      not pre-qualified as an accredited investor getting on to

          2      that site where that site includes communications about hedge

          3      funds that might be construed as either an offer or as

          4      publicity amounting to general solicitation is problematic. 

          5      And we will talk some about that later.  But that kind of is

          6      the general universe of restrictions on offerings other than

          7      registered offerings of registered funds of funds.

          8                MS. OSTERMAN:  And, Alan, you are right.  I hope to

          9      get back to that point because that is an incredibly

         10      important point, and one that I hear come up time and time

         11      again is how funds are brought through the Internet to the

         12      public if they are.

         13                I would like to move back a little bit before we go

         14      there to the qualifications of investors who invest in these

         15      hedge funds.  One thing I think -- Michael you wanted to

         16      raise one interesting perhaps point about the 3(c)7 funds.

         17                MR. BUTOWSKY:  Yes, I just wanted to point out, I

         18      didn't mention this before, when you look at the two

         19      exemptions or the two exclusions, the 3(c)1 has the 100

         20      person limitation.  Technically, under 3(c)7, there is no

         21      limitation at all on the number of people that can invest in

         22      them.  Sometimes people in the industry, you will hear them

         23      talk about a 499 investor limit but actually from a statutory

         24      point of view there isn't any limit.  What there is though

         25      under the Exchange Act, there is a point at which you have

          1      enough investors that you have to actually register the

          2      vehicle under the Exchange Act and start doing public

          3      reporting.  So I think it is a self-imposed industry

          4      standard, that people limit the qualified purchaser funds to

          5      499.

          6                MS. OSTERMAN:  I have heard a lot of discussion and

          7      I have seen a lot of paper on the qualification standards,

          8      the accredited standards.  And, Judd, I wonder if I could ask

          9      you to talk a little bit about your views on what the

         10      accredited standard means and how it works and whether it

         11      does work?

         12                MR. REIS:  Well, I think it works in the sense that

         13      it certainly limits the number of people to that group.  Now,

         14      as Alan points out, that group of people who are accredited

         15      may be a lot larger than it was five or 10 years ago.  And I

         16      think somebody this morning referred to the fact that the

         17      million dollar net worth or the $200,000 and $300,000 income

         18      test were devised 20 years ago.  So you could argue just with

         19      the way the world has changed or with inflation that maybe

         20      that test ought to be somewhat higher to get back to the

         21      level in an economic sense that was intended 20 years ago. 

         22      And I can't speak for others, I know speaking for our

         23      business, it really wouldn't make any difference.  It might

         24      make a difference on some of these registered products, which

         25      I am not really an expert on but there are others here who

          1      are.  But I can't think of anybody who doesn't adhere to

          2      those tests very carefully, who doesn't knowingly go to

          3      people who wouldn't be qualified.  I think everybody I have

          4      seen in the industry is careful about it.  We all have

          5      documents that require people to sign off on that.  Certainly

          6      in our case, we know so many of our partners, we sort of know

          7      they are there anyway.  But it is not that hard to ask them

          8      for a couple of references, a bank reference, a tax

          9      accountant reference if you think there is some problem

         10      there.  But most of us run most of our lives most of the time

         11      assuming that people we deal with are honest and if they fill

         12      out the forms, they are doing it correctly.  So I think it

         13      works.  If you are worried that there are some people now who

         14      couldn't qualify 20 years ago, I don't think it would hurt to

         15      change it a little bit.

         16                COMMISSIONER GLASSMAN:  Can I just ask a question? 

         17      When you say it doesn't make a difference, are you suggesting

         18      that most people are well above those minimums so it is

         19      irrelevant, so it doesn't matter or that it really doesn't

         20      matter if the standard is a little higher?

         21                MR. REIS:  No, I am saying it doesn't matter if the

         22      standard is a little higher.

         23                COMMISSIONER GLASSMAN:  Okay.

         24                MS. OSTERMAN:  Of course, one of the things we have

         25      been focusing on over our last year of investigation is the

          1      so-called retailization of hedge funds.  And I wonder if any

          2      of the other panelists have an idea about your views on this

          3      phenomena where inflation or whatever other economic effects

          4      are raising people's net worth and making them eligible for

          5      these products and if you want to comment on that?

          6           MR. RUSSELL:  Yes, I think I have two comments.  One is

          7      if you look at the industry, and again I think Judd is

          8      correct when he says that people today who are participating

          9      in the industry I think are paying a lot of attention to the

         10      status of investors and who is eligible for which products. 

         11      But I think if you look particularly at the larger players,

         12      and I think that would fall into the bulk of the industry, if

         13      you do the math on funds that are offered as 3(c)1 funds, as

         14      an example.  And you pick a minimum investment then someone

         15      would typically see, perhaps a minimum on a fund like that

         16      might be $100,000 or $500,000, certainly we see them higher. 

         17      And you are limited to 99 investors and you think about the

         18      economics of running a fund that size.  You open a fund with

         19      $100,000 minimum, it is 3(c)1 fund.  You could find yourself

         20      running a $10 million fund.  And I don't really think if you

         21      look at the industry and the size of numbers that we are

         22      talking about today, that the bulk of the industry is out

         23      offering accredited investor funds in reasonable size

         24      minimums because you basically limit the size of your fund,

         25      which is going to have big impacts on you as a manager and

          1      also investors.

          2                So typically, and again I think somebody brought it

          3      up in the last panel, the bulk of the industry has been done,

          4      I don't know if there are some statistics that talks about

          5      it, certainly more than half comes from offshore where you

          6      don't have these investor account issues.  But when you look

          7      inside the U.S., the majority of funds that we see are 3(c)7

          8      funds that typically have much higher minimums.  The much

          9      higher minimum standard as a definition almost drives the

         10      typical investor up off the accredited investor standard.  If

         11      you look at the accredited investor standard either being --

         12      call it an income test or a net worth test, net worths have

         13      obviously been driven up by real estate values and coasts and

         14      things so a lot more people clearly qualify in the last 20

         15      years that didn't before, but typically looking at the

         16      minimum investment size of the fund is going to drive the

         17      sort of status of that investor far higher I think than the

         18      accredited investor standard.  I don't think any small change

         19      in that is going to have a big impact on the majority of

         20      investors who are invested in this space.

         21                MR. HEDGES:  I would like to touch a little bit on

         22      the accredited investor status because from my perspective I

         23      do believe that is anachronistic, that it is not necessarily

         24      a standard that is reflective of where the industry might

         25      need to require people to be today in terms of financial

          1      sophistication.  But I would also rather decouple the notion

          2      of financial sophistication and education from net worth

          3      standards.  It is my feeling as an investment manager and an

          4      investment advisor in the hedge fund space, that we also

          5      operate, whether it is on a self-regulating basis or in terms

          6      of best practices, we operate as fiduciaries.  We have to

          7      help our clients get educated about not only the category but

          8      also the product.  Keep in mind that this Commission itself

          9      has been working over a year to educate itself on the

         10      category.  And so I think there are monumental steps that

         11      have got to be taken for investors in terms of suitability. 

         12      It is not just $200,000 or $300,000 of annual income.  It is

         13      the ability to be educated the different strategies and the

         14      different types of risk and return parameters that are out

         15      there.  It is the ability to differentiate products.  And

         16      maybe most importantly for investors, it is the ability to

         17      have realistic expectations.  So how that ties back into

         18      accredited investor status is a little sticky because there

         19      is no test for whether or not your investor has got realistic

         20      expectations.  But I believe part of that onus lies with the

         21      advisor who is serving as a fiduciary and counsel to

         22      investors in looking at these investments.

         23                MS. OSTERMAN:  I would like to explore that issue

         24      of suitability in perhaps a layman's term a little bit. 

         25      Before we go there, I am interested by something, Judd, you

          1      said, and perhaps everyone could jump in, which is something

          2      that also came up in the course of our investigation.  And

          3      that is the standard and the way that people selling hedge

          4      fund products make sure that an investor actually does have

          5      the ability or the qualifications that they say.  So

          6      frequently we were faced with the answer to the question of,

          7      well, who is doing the due diligence on the investor buying

          8      into the fund?  And we were answered with, well, they sign a

          9      piece of paper that says I am accredited.  And I would truly

         10      like to have your views on how that works and why you think

         11      that is an appropriate way of policing -- self-policing that

         12      particular point?

         13                MR. TIEDEMANN:  I think if I could take stab at

         14      that.  I think the process when the hedge fund launches

         15      generally starts with a 3(c)1.  As they grow, they then

         16      launch a 3(c)7 fund.  While they are in the 3(c)1 stage, and

         17      really from the inception, they are gathering friends and

         18      family money, people they know quite well.  And I think

         19      echoing what the first panel mentioned, much of the growth,

         20      if not the bulk of the growth in the industry has been

         21      institutionally driven, pensions, endowments, foundations,

         22      and fund to funds.  So the retailization is I think possibly

         23      a major issue going forward, thus far has been less of an

         24      issue.

         25                The one thing I think -- the two changes possibly,

          1      raising the million dollar standard and the income standard

          2      is something that should be considered.  I think the other is

          3      possibly forcing managers to see brokerage statements or

          4      actual proof of income from the investors.  Currently, if I

          5      ask for that from a potential investor, there is no chance

          6      that they would give that to me.  But if we were forced to do

          7      that by regulation, possibly that would open up another

          8      avenue to really regulate the investments.

          9                CHAIRMAN GLASSMAN:  Can I ask a question here? 

         10      Just a couple that are related to this.  One is my assumption

         11      is that the income standard was intended to be a proxy for

         12      suitability in some sense.  So is there another proxy that is

         13      relatively objective if the income standard isn't

         14      appropriate?  And the other part of the question is what is

         15      the investor's responsibility, if they are signing that form

         16      saying they are accredited, what is their responsibility?

         17                MR. TIEDEMANN:  I would like to take a stab at the

         18      suitability because I think that is a broad issue, as Jim

         19      mentioned.  Suitability in terms of percentage of liquid

         20      assets that an individual has that is invested within a

         21      certain strategy, then that brings on the whole issue of what

         22      is that strategy, is it long/short equity, is it fixed income

         23      arbitrage, and down the line, is that suitable?  Is it a tax

         24      inefficient strategy that returns anywhere from 8 to 12

         25      percent a year, but in a bull market when the equity markets

          1      are returning 30 percent a year, is that suitable?  I think

          2      there are a variety of ways that can convolute the issue on

          3      the suitability issue.  And so I think that is why we are

          4      sitting here today.  But ultimately I think the economic and

          5      really the easiest thing to focus on is the percentage assets

          6      of an individual that is investing in the fund.

          7                MR. BUTOWSKY:  I just want to add a point to that. 

          8      I guess about 20, 30 years ago, there was once in Reg D a

          9      minimum investment standard and it was dropped.  So a lot of

         10      issues relating to minimum investments in funds has been sort

         11      of bantered about as an issue about whether or not a certain

         12      lower level would constitute retail.  And people have talked

         13      about that with raising issues about, well, does that mean a

         14      really, really rich person can't invest a little in a fund? 

         15      That is one question.

         16                And the other thing I think, in answer to Liz's

         17      question about who has got the duty, I think you have to look

         18      to who is actually involved in selling the fund.  While I

         19      agree with these gentlemen here that a lot of the large

         20      institutional -- a lot of the growth has come in the

         21      institutional side, there you have brokers and you have to

         22      look at the NASD rules and the issues on that side.  But

         23      there are many funds that are sold directly by the general

         24      partners of the funds, taking advantage of what is viewed as

         25      an issuer exemption.  And for them there is a question about

          1      whether or not there is a suitability obligation at all. 

          2      There, I think the issue really turns on whether or not the

          3      person who is running the fund is otherwise acting as an

          4      investment advisor to those people that are coming to invest

          5      in the fund.  If somebody comes along who has a relationship

          6      with the general partner and asks to invest in the fund, does

          7      that somehow create a fiduciary duty on the obligation of the

          8      general partner to do a suitability analysis on the investor. 

          9      It is an interesting question because there may not have been

         10      an advisory relationship created by virtue of that.

         11                MR. CODY:  Well, just to add to what Michael

         12      mentioned before.  I think the financial standards, the

         13      income or net worth test of some sort is a good starting

         14      point.  Whether it is suitable or not, I don't think it takes

         15      away from the need for the hedge fund or the fund to funds to

         16      determine suitability on the basis of a number of different

         17      levels.  But it is certainly a reasonable starting point to

         18      start qualifying.

         19                The other item that I would mention is I don't

         20      think we have talked about having pre-existing relationships

         21      and kind of knowledge of the investor ahead of time, before

         22      really offering the product or making it available to them. 

         23      I think that is an important part to mention as well.

         24                MR. REIS:  Can I maybe take a slightly different

         25      tact on that and that is that I don't think it is our

          1      responsibility to determine suitability of all our investors. 

          2      I think it is our responsibility to give them the information

          3      where they can make the decision as to whether it is suitable

          4      or not.  And I think that is a very important distinction as

          5      who is ultimately responsible for that individual's

          6      investment, he or she or us?  And I would say very strongly

          7      it is he or she who is making the investment.  But in

          8      fairness, they ought to have what they need to make a

          9      reasonable choice.

         10                MS. HOOPER:  It is really interesting to me to sit

         11      back and listen to all of this good conversation because it

         12      is quite apparent that there are very disparate levels, if

         13      you will, of the way these vehicles are being sold.  And,

         14      obviously, at the NASD we are focusing on what our members,

         15      the broker-dealers, are doing in the course of selling "hedge

         16      funds."  And I say that in quotes because one of the things

         17      we have found is that there are variety of different types of

         18      investments that are sort of generically being categorized as

         19      hedge funds, should be of some concern and interest to the

         20      people who are marketing and constructing bonafide hedge

         21      funds, I might add.  But to the individual investor, who is

         22      after all the person that we are trying to protect and make

         23      sure they are educated, to the individual investor, a lot of

         24      those distinctions are transparent.  And what they are

         25      hearing from their stockbroker, the intermediary that is

          1      generally selling them the fund, as opposed to the types of

          2      investors that have been alluded to here, that are being

          3      dealt with directly with the funds, they are from the

          4      feedback that we have gotten to date, not as clear on the

          5      issues involving hedge funds and whether or not they are

          6      suitable to them.  Jim, I thought for a minute that you might

          7      have worked for the NASD at some point, as you were saying so

          8      many of the same points that we have dealt with.

          9                If I could just take a second here and talk about

         10      some of the positions that we are exploring.  And they really

         11      came out of issues that were raised with us by our members

         12      who were finding materials and sales promotional pieces in

         13      the industry, self-regulation at its best, you might say.  I

         14      think competition had a lot to do with it because these are

         15      investments that were being described in such ways that

         16      almost categorized them as mutual funds but when one got

         17      through the rhetoric, we realized that was not what we were

         18      dealing with.  And actually we first started addressing this

         19      last summer when we issued an investor alert because we found

         20      that some of the information that was being disseminated

         21      simply did not clearly educate the investor, and worse fear,

         22      that the people who were disseminating it were not educated

         23      either about the investment.

         24                As you are probably aware, we issued a notice to

         25      members in February of this year that was really just sort of

          1      a heads-up to our members, saying, hey, look, these are the

          2      obligations that you are under.  You have a heightened

          3      obligation as a matter of fact when dealing with a certain

          4      type of investment that involves a higher degree of risk. 

          5      And we were really focusing on a couple of areas.  One of

          6      them is in the disclosure area, the fact that a lot of the

          7      materials that we were seeing were lopsided.  They were

          8      focusing on the potential for growth.  I mean this is after

          9      all the beauty, if you will, of such investments is that they

         10      are offering an opportunity in a bad market condition to give

         11      investors something to cling on to and hopefully have their

         12      investments grow.  But at the same time, if they are not

         13      balanced with obviously the more opportunity there is for

         14      growth, the more opportunity there is for risk.  And we are

         15      adamant that our members distribute materials that make it

         16      clear that these investments are indeed full of risks,

         17      illiquid, that they aren't necessarily required to provide

         18      any kind of periodic pricing, and that they aren't first and

         19      foremost subject to the same regulatory requirements, for

         20      example, that mutual funds are.

         21                The other thing that we are particularly looking

         22      for concerns this whole issue of suitability.  And at the

         23      NASD, we have requirements that our members make certain that

         24      there are two prongs of suitability that are met.  One of

         25      them is a reasonable basis, that there is a reasonable basis

          1      for assuming that is a suitable product or investment for the

          2      investor.  And the other one is that it is suitable for that

          3      individual or that particular investor.  So we are looking

          4      for these things.

          5                We did a sweep, we are still in the process of

          6      doing that sweep.  We have gotten about 1,000 pieces of

          7      material.  We have found that approximately 50 percent of th

          8      firms submitting materials, a little more are getting

          9      comments back.  The biggest problems are in balance and

         10      disclosure.  And as a result of that sweep, we have actually

         11      taken an enforcement action against one of our members.  I

         12      might add that that member was selling both private and

         13      public funds.  So I think that there is no way to categorize

         14      this as a problem that is affecting one area more than

         15      another.  If the group that is selling the product to the

         16      investor is so inclined, then they can misrepresent I think

         17      by over-simplifying the investment, by not clarifying the

         18      amount of risk involved, and even by perhaps alluding to the

         19      investment in such a way that it would lead the reader to

         20      think it is a different type of an investment than it is.

         21                MR. BUTOWSKY:  Clark, if I could just ask one

         22      question relating to the notice to members.

         23                MS. HOOPER:  Sure. 

         24                MR. BUTOWSKY:  I think a lot of the people that I

         25      deal with in the industry on the broker side were a little

          1      concerned that -- I think the industry has pretty much taken

          2      the view that when it comes to selling a fund to somebody who

          3      is an institutional investor, that for an institutional

          4      investor they don't really need to do a customer-specific

          5      suitability analysis, that they distinguish institutional

          6      investors from retail investors in that regard.  And I was

          7      just wondering if you could comment on what I understand some

          8      people have been saying that the notice to members can be

          9      taken to be interpreted that the NASD doesn't see a

         10      distinction?

         11                MS. HOOPER:  Well, I guess my answer to that, my

         12      response to that is that certainly we see a distinction

         13      between institutional and retail investors.  However, having

         14      said that, it doesn't mean that one isn't accountable for

         15      ensuring that the investment is suitable, whether it is to an

         16      institution or whether it is to a "retail investor."  One

         17      cannot simply find a safe harbor in a definition of investor

         18      and dismiss the need for assuring that it is a suitable

         19      investment.

         20                MS. OSTERMAN:  Leroy, I wonder if you could comment

         21      on your practices with respect to making sure that

         22      investments are suitable for the investors that your firm

         23      attracts?

         24                MR. CODY:  Okay, I think the first thing I will say

         25      is that, like many of my colleagues here on the panel, is

          1      that our business is focused on institutional investors. 

          2      That is where our hedge funds, first hedge funds were spawned

          3      really, from the institutional asset management end of our

          4      business.  That has been our focus and the overwhelming

          5      client base growing from that.  And that is where the

          6      dollars, the bulk of the dollars are coming from.  But I

          7      would agree with Clark that because we are dealing with

          8      institutional investors who are sophisticated and are savvy

          9      and are doing their own levels of due diligence, doesn't in

         10      our mind really absolve us from responsibility to make sure

         11      that we are having conversations with those investors about

         12      certainly understanding what our product is and how it fits

         13      in, does this fit in with what they are trying to accomplish

         14      in their particular fund.

         15                But, generally speaking, I would say there are

         16      probably about five areas that we are going to focus on with

         17      investors to determine suitability, and that is overall

         18      financial status, assets that they may have, and what their

         19      investment objectives are, also a lot of focus on their

         20      individual risk profiles, is it really suitable for -- are

         21      they willing to take more risk, do they have the stomach for

         22      more risk?  And sometimes even institutional investors will

         23      have difficulty with that, believing that they can swing for

         24      the fences and then finding out with the first hiccup that it

         25      is uncomfortable for them.  Third, liquidity -- fourth,

          1      liquidity.  And that is that there are lock-ups on most of

          2      these products and they have to be able to live with that. 

          3      And, again, just back to the whole concept of understanding

          4      what it is that we are doing.  Our best clients are those

          5      that really do understand what we are trying to achieve in

          6      our investment strategies, can understand it, can get their

          7      hands around it, and understand that there are times when we

          8      are going to do well and times when we might not do quite so

          9      well.  And are comfortable with how that fits in with their

         10      overall investment objectives.

         11                MR. ROYE:  Liz, can I ask the panel a general

         12      question and that is as we get overseas and attract money

         13      from overseas, there are aggragators overseas who are

         14      "institutions."  And my question is have people on the panel

         15      had experience dealing with those aggragators and what is the

         16      responsibility to go beyond the aggragator to the ultimate

         17      customer and see what difficulty have you had doing that? 

         18      And is this an area that the SEC should be looking at?

         19                MR. CODY:  I will take a stab at that because over

         20      time a large percentage of our investors have been non-U.S. 

         21      And we have been careful to try to abide by the letter and

         22      the spirit of our regulations.  And it has been frustrating

         23      in many, many cases where there are barriers to really

         24      knowing who that end investor is.  So we have gone to great

         25      lengths to try to get at stations really from those

          1      administrators or others that are the fiduciaries that we are

          2      dealing with directly, that they know who the investors on

          3      the other side are and that they can attest that they are

          4      accredited to the best of their knowledge.

          5                MS. OSTERMAN:  I think that raises an interesting

          6      point that I have been trying to get at, which is, Leroy, you

          7      are mentioning how hard you push back at that aggragator to

          8      find out the composition of the pool of money that you are

          9      getting.  Why is it that there isn't more push at the

         10      individual investors, perhaps it is just a prior knowledge of

         11      your investors, you have known someone for a long time, or

         12      maybe it is something else.  But I would really like to hear

         13      someone talk a little bit more about pushing at your

         14      qualified, maybe not so qualified, investor?

         15                MR. RUSSELL:  Yes, I think one thing that hasn't

         16      come up here, I think all of us who work in this business who

         17      have been in it for a while recognize that the Patriot Act

         18      has changed the landscape tremendously among managers and how

         19      much they know about their investors.  I think we are going

         20      places we never went before, and I think that is a good

         21      thing.  And I think the attention being paid to the sources

         22      of capital, who is bringing the capital, obviously both on-

         23      shore and offshore in the last couple of years, has changed

         24      dramatically from where the industry was.

         25                I think that we are honing in on this distinction,

          1      and I just want to touch on it for a minute.  Honing in on

          2      this distinction between individual hedge funds, that may or

          3      may not be registered, going directly to investors versus

          4      typical intermediary channels that operate in the business. 

          5      And there is a little bit of -- it sounds like a little bit

          6      of a mismatch.  I think it is an interesting topic, the topic

          7      of the institutionalization of the hedge fund business, as

          8      well as the retailization.  And, obviously, as a registered

          9      investment advisor and having a registered fund to funds in

         10      the market, the reality is that the retailization of the

         11      market is being done by registered investment advisors.  In

         12      general, I think Bob mentioned on the last panel, maybe the

         13      number of funds that are being offered out there and how they

         14      are being distributed.  They are primarily being distributed

         15      through broker-dealers.  The sort of small entrepreneurial

         16      firm with four employees or 15 employees is not going to

         17      adequately cover the investor spectrum and draw thousands of

         18      barely accredited investors.  It can't be their business

         19      model.  Their business model which we are hearing is going

         20      toward institutional investors.  So I think there should be

         21      some comfort taken that particularly on the registered fund

         22      side, number one, they are expensive to launch.  Number two,

         23      they are going off to a broad-based audience and the way they

         24      are doing it is through intermediaries who I think in my

         25      experience and what I see in the industry is almost all

          1      broker-dealers, which put investors subject to the

          2      suitability test.  So we are focusing in on one sliver but

          3      the reality of the retailization is it is really focused on

          4      places where suitability is in place.

          5                The last thing I would mention is that in terms of

          6      suitability, I think there are also two levels.  And I heard

          7      this distinction on the last panel between single managers,

          8      single-strategy funds and diversified fund to funds.  And

          9      often what we see and what we do in cases is testing

         10      investors, like an example would be that not more than 10

         11      percent of their liquid assets be invested in a single

         12      manager fund and a threshold of say 30 percent being invested

         13      in a diversified fund to fund.  So there is probably, in

         14      terms of risk and suitability, a distinction should be made

         15      between a diversified fund to funds versus a single manager

         16      fund.  And we do that.

         17                MR. BUTOWSKY:  I just wanted to add one thing to

         18      what Craig said on the Patriot Act.  We are seeing more and

         19      more in our practice, the impact where many times investors

         20      who are coming through an intermediary perhaps, that the fund

         21      or the broker for the fund isn't familiar with, if they can't

         22      obtain information concerning the underlying investors, those

         23      investors are being rejected because the intermediary perhaps

         24      isn't deemed someone that the fund feels comfortable relying

         25      on.  So many times the investors coming through an

          1      intermediary, where you can't get all the information related

          2      to the underlying investors, will only be accepted if the

          3      intermediary is deemed reliable.

          4                MR. HEDGES:  I don't know if it is fair to split or

          5      stratify the conversation along these lines.  But it sounds

          6      to me as though there is a bit less concern about

          7      institutional investors in that they appear to have an

          8      additional layer of oversight and regulation, ostensibly a

          9      larger asset base and a degree of professional due diligence

         10      and risk management that is really institutionalized or

         11      systematized.  And I sense that there is a greater degree of

         12      concern with the individual investor.

         13                And the way I was thinking about this conversation

         14      evolving is there is the direct access, be it for a fund to

         15      funds or a hedge fund, to the high net worth or retail

         16      investor.  And I believe that, at least it is my position,

         17      that the manager, the advisor, the consultant has a

         18      responsibility to ensure that there is proper suitability and

         19      education and realistic expectations, as I said before.  I

         20      think one of things that is less clear though is when there

         21      is an indirect relationship, as we were talking about before. 

         22      Our firm is in the business of oftentimes building funds of

         23      hedge fund products, which are then constructed and managed

         24      by us but then sold through intermediaries, like on- and

         25      offshore private banks, broker-dealers, registered investment

          1      advisors, commercial banks.  And so we have a number of these

          2      indirect relationships at our firm.

          3                What has not been mentioned here today, which I

          4      think is a substantial gating factor to the sales process, is

          5      that those intermediaries, again whether it is an offshore

          6      private bank or a NASD-registered broker-dealer, these are

          7      intermediaries who are taking your product to their best

          8      clients.  Their best brokers are offering this client, the

          9      corner office broker to the best clients.  And there is a

         10      tremendous amount of concern, reticence, and care that is

         11      taken at these organizations to line up.  Not to say that, as

         12      you point out, Clark, that a lot of the documentation

         13      requires commentary and what have you.  But we find that

         14      there is a very active dialogue about what is the appropriate

         15      type of messaging to give to properly train the sales force,

         16      the intermediaries, those that are assessing suitability, and

         17      then what standards do they apply on the ultimate investor.

         18                MS. HOOPER:  And I think it is really critical that

         19      that occur because we have seen this in other segments of the

         20      industry as well.  All you need is one or two bad instances

         21      that can smear the entire industry.  You don't want that to

         22      happen.  And therefore when we find situations where there

         23      really are egregious violations of good faith, if nothing

         24      else, then you know that we need to look at these things and

         25      put something in place, which is actually the reason we

          1      started out with our notice to members, to make people aware

          2      of what is expected of them and what high standards they are

          3      being held to.  It is complicated a bit by the fact that in

          4      competition with hedge funds or the managed commodities

          5      pools, for example.  And, once again, I think the

          6      distinctions are often transparent to the investor except for

          7      the fact that there is a difference in the underlying

          8      investment.  But the requirements, for example, of what kinds

          9      of performance can be presented are quite different among the

         10      different types of securities.  And yet there are some

         11      things, for example, that we would outright prohibit.  And we

         12      have actually taken action against some of this whereas in

         13      other instances, other regulators are requiring certain types

         14      of information.  These are the kinds of inconsistencies that

         15      unless explained, and I think that is the critical point is

         16      making sure that people understand that they are educated

         17      both from the seller's perspective as well as the buyer's

         18      that can lead to the confusion and the unsuitable investment

         19      ultimately.

         20                MR. BELLER:  It seems to me that one of the things

         21      that this last colloquy demonstrates is that there really are

         22      two related but separate issues.  One is suitability

         23      determinations and being comfortable you are talking to the

         24      right kinds of investors.  And the second is the disclosure

         25      obligation.  And what Clark is talking about I think in terms

          1      of being education, making sure that the investor understands

          2      what he/she/it is getting into is a matter of disclosure. 

          3      And both have to be dealt with adequately.  You can't

          4      overcome bad disclosure with good suitability determinations

          5      and vice versa.

          6                MS. HOOPER:  Right.

          7                MR. REIS:  Let me take the other side of that for a

          8      second because I think if you give an investor fair and

          9      meaningful disclosure, suitability is very easy to determine

         10      at the extreme.  Somebody is sitting with a huge bond

         11      portfolio that is generating more income than they can

         12      possibly spend a big pile of cash, illiquidity shouldn't be

         13      an issue.  Somebody who has $100,000 and they say to you,

         14      "Look, I may this in the next three months," illiquidity

         15      becomes a huge issue.  But in between those extremes,

         16      suitability becomes looking in the rear view mirror because

         17      if you said to somebody in March of 2000, "These hedge funds

         18      are risky."  They would have said to you three years later,

         19      "They were really suitable.  I lost 40 percent of my money in

         20      a tech fund."  And, likewise, if you said to that same person

         21      in the beginning of 1994 or 1995, "We have got a fund here

         22      for your risk money that is going to 8 percent."  And he

         23      looked back five years later and said, "I could have earned

         24      35 percent a year in the S&P, what do you mean that is

         25      suitable?"  So I think on the extreme suitability is an issue

          1      and then after that disclosure does play an important part

          2      because it lets the investor decide whether it is suitable.

          3                MR. BELLER:  If you give the best disclosure in the

          4      world to an investor who can't read it --

          5                MR. REIS:  Well, we will assume that our investors

          6      are literate.

          7                MR. BELLER:  -- or completely doesn't understand

          8      it.  No, Judd, I think you can fairly assume probably that

          9      your investors are in a category where this issue is largely

         10      irrelevant.  I think as you particularly get into the kinds

         11      of funds where intermediaries do the principal marketing, I

         12      don't think it is a frivolous concern.

         13                The other thing I guess I would say --

         14                MR. REIS:  I didn't say "frivolous," Alan.

         15                MR. BELLER:  That is fair.  The other thing I guess

         16      is we have been talking about investor experience in terms of

         17      suitability.  I think it is worth noting at least that pull

         18      it back to the exemption notion, we have these exemptions

         19      based on net worth and income as really as surrogates for

         20      sophistication.  We don't have direct exemptions based on

         21      sophistication, which I think is probably too hard to define

         22      an exemption around.  But it is interesting to note that

         23      there are some jurisdictions, and I think the UK is the

         24      principal one, the UK has an exemption from our equivalent of

         25      registration for offerings to investors with a demonstrated

          1      degree of investment experience without regard to their

          2      income levels, without regard to their asset levels.  And it

          3      is worth noting that that is out there, it seems to me, as a

          4      different or an alternative approach to the exemption issue,

          5      not just to the suitability issue.

          6                MS. OSTERMAN:  I am going to take a leap and jump

          7      to a different issue for a minute because, Alan, I know you

          8      are going to have to leave us very soon.  If we could talk a

          9      little bit about the use of the Internet and public

         10      solicitation, that would be great.  And I don't know, Alan,

         11      if you would like to start off?

         12                MR. BELLER:  I think probably we are all better off

         13      if Michael starts off.

         14                MS. OSTERMAN:  Okay.

         15                MR. BUTOWSKY:  Okay.  Well, I guess there is a bit

         16      of confusion out in the industry obviously about the use of

         17      the Internet because there is quite a bit out there on the

         18      Internet about funds in general.  And it just adds on to the

         19      point that Alan was making before.  I guess as a premise, as

         20      a requirement to both 3(c)1 and 3(c)7, you need to make sure

         21      that you are not conducting a public offering or proposing to

         22      conduct a public offering.  And there is a wide amount of

         23      interpretation as to exactly what that means.  And when you

         24      look on the Internet, you will see a wide variety of

         25      different types of references to funds out there, both

          1      proprietary sites and non-proprietary sites.  But I think it

          2      is widely viewed as an offer is really deemed to occur when

          3      you are either making a direct offer or possibly

          4      incentivizing people to come to you to ask more questions

          5      about a vehicle.  And when you take a look, you will see on

          6      the Internet that there is, like I said, a wide diversity of

          7      different types of references out there.  And people just

          8      have to be very careful as to whether or not they are

          9      crossing the line between an offer and providing information.

         10      But there are also broad questions, as Alan mentioned before,

         11      about whether or not by virtue of having information on the

         12      Internet as opposed to an operating company, a fund

         13      technically isn't really advertising a product that whether

         14      or not it is conducting something that it shouldn't be.

         15                MR. BELLER:  I guess I would say there are two

         16      elements that one has to be careful about in terms of using

         17      of the Internet or any other form of publicity with respect

         18      to hedge fund activities.  One is kind of the general

         19      publicity issue.  You can't put up a billboard on Time Square

         20      and say, "We have a new hedge fund but please understand that

         21      unless you are an accredited investor, don't call."  There is

         22      a school of thought that so long as you restrict the sales to

         23      accredited investors and are adequate about policing the

         24      people to whom you sell, it shouldn't matter if you put a

         25      billboard up in Time Square.  That is not the law today. 

          1      That billboard in Time Square or equivalent or much lesser

          2      amounts of publicity are inconsistent with our views of a

          3      private offering.

          4                The second part that is very important is the

          5      notion of pre-existing relationships, and this has been

          6      mentioned a couple of times on the panel already.  Even

          7      targeted means of publicity to offer to persons to whom or

          8      with whom the advisor or the other intermediary seller does

          9      not have a preexisting relationship can also raise general

         10      solicitation questions, especially as that targeting becomes

         11      less targeted, if you will.  You send out an e-mail or make a

         12      website generally available and say, "You can buy this but

         13      only if you are an accredited investor" and people with whom

         14      you don't have a preexisting relationship have access to that

         15      page, that itself can be problematic under our current rules.

         16                I think it is fair to say that the kind of the

         17      costs, the benefits and burdens of the rules have been

         18      subject to a good deal of thinking over the years, both in

         19      the 40 Act context and in the general offering of securities

         20      contexts generally.  It is an issue that has been taken up on

         21      and off I think since at least the mid-90's when the Wallman

         22      Commission started thinking about it in general terms, much

         23      of the general thinking is translatable to the hedge fund

         24      context, should there be more focus on sales, should there be

         25      less focus on general solicitation?

          1                I do believe that -- I don't know if SEC staffers

          2      are speaking only for themselves generally on this panel but

          3      I am certainly speaking only for myself on this particular

          4      point, and that is I do think there is a connection between

          5      the relatively low level of the accredited investor

          6      definition and the concern about -- the desirability of

          7      maintaining some level of restriction on the offering side. 

          8      I think the two points are not unrelated, and I think that is

          9      an area that is worthy of some consideration as well.  For

         10      example, to go out of the investment company context for a

         11      moment, general solicitation is arguably a lot less of

         12      concern when you are selling only to qualified institutional

         13      buyers, that is $100 million-plus institutional investors,

         14      which again is not a subject for this panel.  But when you

         15      are selling to individuals with $200,000 or $300,000 of

         16      income, I think it is more of an issue.

         17                MS. HOOPER:  The problem is the more broadly

         18      disseminated that general solicitation is, the more difficult

         19      it is going to be to limit your audience to restrict it.

         20                MS. OSTERMAN:  Alan, because of time constraints, I

         21      would like to push if I could a little bit and have you think

         22      about funds of hedge funds and the possibility that more

         23      information, and not less, is better for those investors who

         24      are making that choice to get into that particular product.

         25                MR. BELLER:  I suppose one solution to that issue

          1      is, of course, on the registered side.  I assume you are not

          2      really talking about registered funds of hedge funds where we

          3      have got public offerings and prospectuses and where my view

          4      would obviously be more disclosure is better, and I don't

          5      think there is an particularly regulatory obstacle to it.

          6                MS. OSTERMAN:  Well, I guess suppose you have the

          7      investor in the funds of hedge funds who wants to do a little

          8      of their own due diligence on the underlying product.  And so

          9      they are trying to find out more information about the

         10      underlying hedge funds that their fund has invested in and is

         11      that a better thing, if there is that information available

         12      to them?

         13                MR. BELLER:  I think presumably that is a better

         14      thing, both in the registered and the unregistered context. 

         15      It points up one of the real I think conundrums of funds of

         16      hedge funds, both in terms of investor due diligence on the

         17      offering side, where I would agree with you, more is better. 

         18      But you come up against some restrictions that I think others

         19      on the panel are much more qualified to talk about than I am

         20      in terms of the practicalities of getting that access.  I

         21      think it is also a conundrum in terms of something that

         22      really falls more into the investment management area, which

         23      is regulating registered funds of hedge funds where their

         24      portfolio consists of securities where there is not a lot of

         25      public access of it -- there may not be a lot of access to

          1      the board of directors of the registered fund, to us as

          2      regulators of the registered fund.  And I think that that

          3      maybe is a related but different question from the investor

          4      question.  I think it is important in both those areas.

          5                MR. HEDGES:  I would like to take a step back and

          6      differentiate between funds of hedge fund investments and

          7      hedge fund investments.  I believe that fund of hedge fund

          8      investing is dramatically, dramatically safer for the

          9      investor.  I also believe that it has been, and will continue

         10      to be, a primary conduit for capital in the hedge fund

         11      business.  There are lower investment minimums.  Therefore,

         12      investors have less at risk individually.  There is arguably

         13      a professionalized due diligence and oversight process. 

         14      There is an ongoing risk management and portfolio inspection

         15      process.  There is the diversification.  Most fund to funds

         16      out there probably have 20 to 40 different hedge funds within

         17      their portfolio.  So there is a high degree of

         18      diversification and then there is also an economy of scale

         19      and cost savings associated with spreading one's bets over a

         20      larger pool of capital.  Ubiquity doesn't equal safety with

         21      hedge funds, meaning that just because these things are

         22      growing, there are more hedge funds out there all the time,

         23      doesn't mean that the industry is getting safer.  I think the

         24      likelihood of the individual investor picking that hedge

         25      fund, which is precisely appropriate for that individual is

          1      very, very low without an advisor.  I think that to the

          2      contrary fund to funds offer a much more secure diversified

          3      lower cost entry, lower feed entry, although there is an

          4      additional management fee for fund to funds, but lower cost

          5      structure with professionalized diligence that I think

          6      warrants suggesting that those standards -- those vehicles

          7      should be looked at differently.

          8                The issue of doing due diligence on the underlying

          9      hedge fund managers within a fund to funds portfolio, I think

         10      is really not necessarily the right question.  Because when

         11      one invests in a fund to funds product, you are hiring not

         12      somebody to give you access to these 10 managers, and you are

         13      getting a flow through, you are hiring that individual to be

         14      in the business of due diligence, professional risk

         15      management, and transparency, and all of those types of

         16      issues.  That is what you are paying for.  And so looking

         17      into the underlying portfolio of 40 funds, I don't know that

         18      that is particularly meaningful.  We don't necessarily go and

         19      look inside of our mutual funds individual security holdings

         20      and ring up our mutual fund manager and say, "I don't like

         21      the fact that you own Enron in the portfolio."  Why then

         22      would we also be in a position to call up and look at a

         23      portfolio of 40 hedge funds and say, "I don't like that you

         24      own XYZ Fund in this portfolio."  So I just wanted to split

         25      that discussion between hedge funds and funds of funds.

          1                MR. TIEDEMANN:  Can I just make a comment going

          2      back to the Internet discussion.  As an unregistered fund,

          3      obviously we are not allowed to, and I think that should not

          4      change, I think marketing hedge funds over the Internet would

          5      be a terrible proposition.  I do think though that once there

          6      is an investor and a qualified investor in a fund and once

          7      they have seen and been given all the appropriate

          8      information, and I have another comment about that, I think

          9      that the use of the Internet is an exceptional way, given the

         10      password and log in and all that, to give updated, timely

         11      exposure of what a fund is investing in, whether it be at the

         12      sector industry level, overall risks within a portfolio.  And

         13      it really helps both parties because as a hedge fund manager,

         14      you are not fielding calls all day explaining your portfolio. 

         15      And if you are lucky enough to have a technology platform

         16      that can automate that process, more power to you.

         17                I do think, just going back to information

         18      disclosure, offering memorandums or obviously legal documents

         19      are complicated to read as an investor, certainly as an

         20      unsophisticated investor, I think you would be hard-pressed

         21      to really get too much out of it if there is a lot of

         22      complicated legal terminology.  I would suggest possibly

         23      having a standardized due diligence document, which focuses

         24      on what I think is as important as anything, the operations

         25      and business risks of the funds, as well as the investment

          1      risks.  Because I think they are often overlooked, less so

          2      now than it was four or five years ago, the business

          3      practices of a fund, their operational practices, their

          4      ownership, et cetera, et cetera, as well as the investment

          5      practice.  But have it more in layman's terms that possibly a

          6      less sophisticated investor could understand.

          7                MR. REIS:  Michael, you can do that now if you

          8      want.

          9                MR. TIEDEMANN:  Yes, I know you can do that but if

         10      it was a matter of practice and really forced upon the

         11      industry, then --

         12                MR. REIS:  Well, if it is a matter of practice and

         13      it is good practice, it will sort itself out.

         14                MR. TIEDEMANN:  I don't think it is a matter of

         15      practice.

         16                MS. HOOPER:  The only thing you have to be cautious

         17      about, and we have seen some disclosure sheets, some sort of

         18      generic disclosure sheets that try to hit on the different

         19      items.  But if there are issues or concerns that are taken

         20      out of context from the rest of the materials being

         21      presented, you have got to be extremely careful to make sure

         22      they are connected to the particular things they are trying

         23      to explain, just to staple or insert a disclosure sheet

         24      doesn't always fully educate the investor about which areas

         25      you are trying to explain.  So you have to be cautious about

          1      that.

          2                MR. RUSSELL:  Okay, one comment to Alan.  I think

          3      one of the challenges that is clearly a conundrum is the

          4      issue that I think investors are struggling to get

          5      information about the business and that is difficult.  If you

          6      pick up popular press and you search for the top 10 articles,

          7      they are always the articles of some flaming failure of some

          8      guys who has three jets, it is a terrible thing.  You rarely

          9      pick up the cover of popular press being, look, the last

         10      three years have been a difficult market for a lot of

         11      investors, here is something that has offered them some

         12      diversifications to their portfolio in a balanced way.  The

         13      conundrum being that we spend a lot of our time with

         14      intermediaries.  I can't tell you how much time I have spent

         15      over the last five years educating intermediary groups and

         16      individual investors and really in a way demystifying hedge

         17      funds, telling them that they are not all shooting for 90

         18      percent returns, that on balance if you looked at a

         19      diversified portfolio of hedge fund returns over the last few

         20      years, they have been albeit positive but modest.  And

         21      getting that information across is very difficult obviously. 

         22      So one of the benefits obviously of creating some more public

         23      information being available is that people would have a

         24      better context for which to view an industry that is clearly

         25      growing and people want to get access to.  Obviously, there

          1      are registered funds out there and literally, I don't think

          2      it would be fair to say for everybody, I don't think

          3      registered fund sales are exploding and they are not running

          4      away, partly because there is a big de-mystification and

          5      education that needs to happen.  And the access to

          6      information for investors, really true information, comparing

          7      performance, like you see in traditional investments, is very

          8      hard for investors to get access to today.

          9                MR. BELLER:  I want to say two things then I do

         10      have to run, both I think in response to these last comments

         11      and Mike's comments in particular.  One, on the use of the

         12      Internet, clearly an incredibly powerful tool that can be

         13      used for the benefit of investors.  And that is why we have

         14      in fact been spending a lot of time thinking about it.  With

         15      things like password protection, it is a way to get

         16      information to your investors that is much more efficient

         17      than paper or anything else that seems to be available.  So

         18      there is certainly no regulatory interest in reducing the

         19      appropriate use of the Internet.  If anything, exactly the

         20      opposite.  It is just that things like password protection

         21      are appropriate devices to do that within the rules.

         22                Secondly, on disclosure.  I think the hedge fund

         23      industry probably suffers from the same malaise that

         24      disclosure generally suffers from, which is that in one

         25      sentence the way I describe what you were talking about is

          1      too much disclosure is written to avoid liability as opposed

          2      to inform investors.  And just as the operating companies of

          3      America would do well to spend more time thinking about how

          4      to inform investors, I think probably the same thing is true

          5      of the hedge fund industry.  Judd is absolutely right.  There

          6      is no obstacle, indeed I think there is nothing but

          7      regulatory encouragement for the kinds of practices that the

          8      two of you are talking about.  And I think it requires a

          9      determination to do it and do it in the right way.

         10                MR. BUTOWSKY:  Alan, I just wanted to react to one

         11      thing that when you and Judd were talking, going back and

         12      forth before about the suitability, just one point.  It was

         13      interesting that you mentioned to Judd that the question

         14      about whether or not people, if they have the information,

         15      can they understand it.  And just thinking, when you look at

         16      the NASD rules on 2310, the suitability rule and one of the

         17      interpretations under it, it talks about in the context of

         18      institutional investors, that really the duty of a broker is

         19      to evaluate whether or not the investor has the ability to

         20      evaluate on their own as a first measure.  And then second

         21      are they making the decision on their own.  So ability to

         22      evaluate and independence.  And so at least in the

         23      institutional context, it at least focuses on that area.

         24                MS. OSTERMAN:  I would like to talk a little bit

         25      about consultants and their roles in connecting investors to

          1      hedge funds.  This is generally considered to be outside of

          2      the brokerage area.  These are people who are not -- who are

          3      frequently not registered as brokers.  And I would like to

          4      talk a little bit or have you all talk a little bit about the

          5      connections that are made and what distinguishes those

          6      practices from brokerage practices, what suitability tests

          7      those consultants do or are responsible for doing in

          8      connecting investors to hedge fund products.  Jim, if you

          9      have any reaction to that?

         10                MR. HEDGES:  Okay, I think the question regarding

         11      consultants needs to be addressed in the context of what the

         12      business model of the consultant is.  Lots of different types

         13      of business models exist in the hedge fund landscape, maybe

         14      in the investment landscape where people are "advisor" or

         15      "consultants."  Ultimately, it is the revenue model of the

         16      business that determines where potential conflicts of

         17      interest lay and therefore what sort of positioning should be

         18      taken in terms of evaluating the efficacy and the

         19      responsibilities of that particular advisor.  So,

         20      simplistically, there are "consultants or advisors" who are

         21      compensated merely on fee only basis in exchange for "X"

         22      dollars or in exchange for "X" percent of assets under

         23      management.  We will tell you what to do with your money. 

         24      Arguably, that is about education, asset allocation, and then

         25      ultimately opining upon managers and helping the investor

          1      invest in managers.  That represents what one might call a

          2      sort of Ivory Snow or 99 percent pure business model of being

          3      purely aligned with the investor.

          4                Then there are consultants, advisors who receive

          5      compensation in the form of directed commission dollars

          6      through various types of broker-dealer relationships with the

          7      investment managers.  That is also a mechanism which may or

          8      may not represent a complete alignment of interest.  It is a

          9      different business model but nonetheless one that has got a

         10      certain set of caveats in terms of the way it is positioned

         11      to the client and the way in which it is positioned with the

         12      investment manager.

         13                Then there are finally investment managers,

         14      advisors, consultants who operate product themselves,

         15      investment management product, whether it is a fund to funds

         16      or a hedge fund product.  And, again, there is a different

         17      axe to grind if we are in the business, if one is in the

         18      business of selling a fund to funds as opposed to simply

         19      "advising" somebody on how they should invest their capital

         20      for a fee only type of relationship.  So the point being

         21      made, you really can't I think generalize about what

         22      consultants are doing, how they are doing it without really

         23      drilling down and looking at the revenue model and how these

         24      organizations are structured because that ultimately tells

         25      where the agenda is.

          1                MR. BUTOWSKY:  Jim, aren't the vast majority of the

          2      consultants compensated by the investment advisory clients or

          3      the investors?

          4                MR. HEDGES:  I don't know the numbers of it.  I

          5      know that all of those models exist.  I think of consultants

          6      that are paid through directed commissions, that get fee-

          7      only, that charge asset-based fees, and that also are what I

          8      think of as effectively glorified contract marketers or

          9      third-party marketers.  So I can't speak to the breakdown of

         10      the number of players out there but I think there are a lot

         11      of different business models out there.

         12                MR. RUSSELL:  I think one thing that is not

         13      mentioned here, which is worth mentioning also, is there is

         14      clearly a large consultant community in the institutional

         15      asset management space that is not sort of completely focused

         16      on hedge funds but clearly have clients who are coming to

         17      them asking for hedge fund advice and there are some who

         18      focus more on endowments and foundations who have a great

         19      deal of hedge fund expertise and there are other investment

         20      consulting firms who have very little expertise.  And it

         21      really runs the gamut.  They are clearly in the advisory camp

         22      but that is a growing portion of people in this business who

         23      are gaining expertise and making asset allocation and manager

         24      advice to clients as we see it.

         25                MS. OSTERMAN:  I know that we are running over a

          1      little bit.  I would like to spend just a little bit more

          2      time on fund of funds.  It is an area that we have been

          3      focusing quite a bit on in our investigation and thinking

          4      about.  And I would open up to the panel, we have talked

          5      about who buys the fund to funds, and I think generally what

          6      we have seen in our disclosure office is that a registered

          7      fund of funds is a product that currently sells to accredited

          8      investors and that the lowest minimum investment is about

          9      $25,000.  I think that is the lowest I have seen at least. 

         10      That is still a pretty big -- that is still a pretty big

         11      investor for these products.  As we all know, however, there

         12      is no legal requirement on funds that makes them stay with

         13      these requirements except for everyone's general concerns

         14      about who is getting into these products.  We do hear people

         15      pushing at these limits.  We hear people asking questions

         16      about should these products be open to any investors

         17      regardless of their net worth?  Should they be open just as

         18      any closed-end product?  Should they be sold just on a

         19      constant basis to anyone who comes in?  And I am very

         20      interested to hear what people think about lowering the

         21      limits so that these funds of hedge funds, with as Jim was

         22      talking about, their professional management at the middle

         23      level between them and the actual hedge fund, if those are

         24      really good investment products?

         25                I guess this morning we heard about, I think

          1      Commissioner Campos said, "So this should be a product open

          2      to everybody because it is low risk, no risk."  Is that

          3      really true?

          4                MR. RUSSELL:  I would say that given some standards

          5      around what the definition of a registered fund to funds

          6      would be.  I think that the appropriateness for this

          7      investment is not determined by whether someone is an

          8      accredited investor.  I think someone brought up the concept

          9      of is there some other measure.  Clearly, if you go outside

         10      of the U.S., retail investors not defined by credit investor

         11      rules have access to these funds in lots of jurisdictions

         12      around the world and they are sold in quite large size. 

         13      There was some mention that they may be hybrids but retail

         14      clients well below accredited investor status are getting

         15      access to these funds outside of the United States.

         16                My view is that these funds are applicable for

         17      investors as long as you take into account the issues that I

         18      think a lot of people brought up, the risk of loss of their

         19      investment, tax issues, liquidity, does it fit into their

         20      asset allocation mix.  But within that context, I think it is

         21      applicable for a lot of investors.  Another way to look at is

         22      I think if a lot of investors who did fit the criteria that a

         23      type of an investment like this would make sense for and had

         24      the ability to invest over the last several years, I think

         25      that would have been a very good situation for a lot of

          1      investors.  And I think it is also worth noting that in a

          2      fund to funds product, we don't see people making -- there

          3      are clearly investors globally who have large portions of

          4      their portfolios in hedge funds.  I think all of us can cite

          5      examples of clients we know that.  But traditionally when we

          6      see investors making initial investments in hedge funds, we

          7      are talking about maybe 5, 10 percent of their investable

          8      assets on the outside.  So our view is that for clients who

          9      it is appropriate for, I think it should be available to

         10      investors who are below accredited investor standards.

         11                MS. HOOPER:  And I might just add that I believe

         12      from our perspective, regardless of whether the investor is

         13      an accredited investor or retail investor, we would still

         14      hold the broker-dealer subject to suitability requirements. 

         15      So if the investment is suitable for the investor, whether

         16      the investor is accredited or whether it is a retail

         17      investor, if it is a suitable investment, then that is what

         18      we would be looking to as the criteria.

         19                MS. OSTERMAN:  Well, I would like to end this panel

         20      the same way Paul did and open up the floor, if I could hear

         21      from everyone on the panel about any concerns, thoughts or

         22      points that they think haven't been made in this panel. 

         23      Again, we have talked about marketing and distribution,

         24      suitability issues, fund to funds.  Give everybody a deep

         25      breath and starting from my right, Judd, would you like to

          1      start off?

          2                MR. REIS:  Sure, I think one of the most

          3      interesting issues is the prohibition on advertising

          4      marketing communication in some sense, which is

          5      understandable, and yet from an investor's point of view

          6      maybe not totally desirable in that most investors who don't

          7      have direct access, either to good fund to fund managers or

          8      directly to hedge funds, really rely on the press for their

          9      education about hedge funds.  Now there are some books and

         10      the diligent investor can find out a lot more from

         11      publications but you will tend to get it from the Wall Street

         12      Journal or local newspaper or some of the financial

         13      magazines.  And they tend, as the press does, to focus on the

         14      sensational.  It is not a very article, somebody mentioned

         15      earlier this morning, to say for the last three years if you

         16      had earned 5 percent, you would have outperformed the S&P by

         17      55 percent.  Don't you wish you had some?  I think I would

         18      say sure but it is much more sane to talk about a burger

         19      flaming out or a beacon hill losing 50 percent of its

         20      capital.  So I think it is an interesting issue for the

         21      Commission to wrestle with, as to what people ought to be

         22      able to say.  Personally, I have no axe to grind.  We don't

         23      care about advertising.  We don't want to go on the speaking

         24      circuit.  But I can why a lot of investors would like to

         25      legitimately learn more than we can tell them now.

          1                MS. HOOPER:  Just building on that.  I think one of

          2      the things we are hearing is the rather broad extent under

          3      which these investments seem to be categorized.  They run the

          4      gamut from being appropriate for multi-million dollar

          5      institutions.  And we are looking at whether or not they are

          6      also appropriate for retail investors.  If you want to build

          7      on that, and it seems to me that if it is a good investment,

          8      and by "good," I mean an appropriate investment, then the way

          9      I think to do that is to provide the investor with as much

         10      information and education about that as possible.  That is

         11      not to say a standard disclosure statement, I believe there

         12      is a former director of the Division of Investment

         13      Management, who once said that, "A prospectus should be read

         14      carefully before you invest or send money because it will be

         15      used against you in a court of law."  And I think that is

         16      exactly the kind of disclosure we are not looking for.  So in

         17      terms of getting information out and making these securities

         18      as they grow in popularity, they will be of more interest to

         19      more of the lower level, if you will, retail investor.  And

         20      they have simply got to understand what is being offered to

         21      them.

         22                MR. HEDGES:  A few conclusions.  About a year ago

         23      the Commission announced that they were putting out what I

         24      viewed as a few hypotheses.  We are concerned about the

         25      pricing of the liquid securities, about conflicts of

          1      interest, about fraud, and there were a number of issues that

          2      they discussed.  My sense is that the industry is, as Joel

          3      Press was very articulate in saying in the previous panel,

          4      highly-professionalized and organized, an industry that has

          5      got a great deal more depth and process and

          6      institutionalization than lay people have historically

          7      understood.  I think that is now getting articulated

          8      publicly.  And these issues, like the incidents of fraud, I

          9      think is very low in this industry.  The incidents of

         10      illiquid securities being improperly priced in portfolios

         11      only applies to a relatively small number of strategies,

         12      effectively only a small number of managers.

         13                So I think a lot of these hypotheses are not

         14      necessarily the headline issues.  Ultimately, to me the

         15      headline issues are if you have an industry that is going to

         16      attract this institutional capital, professionally advised

         17      capital, intermediated capital, then that is an industry that

         18      is espousing that institutionalization.  And I think we are

         19      seeing the industry mature constantly there.  I think where

         20      our concern lays is on that retailization or

         21      pedestrianization of the industry and what about all these

         22      suitability disclosure issues.

         23                Well, ultimately, it is my sense that the lion's

         24      share of the hedge fund industry is actually not interested

         25      in the retail investor.  More hedge fund managers that I talk

          1      to than not have no interest whatsoever in selling their

          2      product in a retail channel.  They like being privately

          3      placed to accredited or qualified purchasers.  They like the

          4      freedom that that enables them to have.  And they are not

          5      interested in getting into a different type of construct in

          6      order to target the retail investor.  

          7                We keep talking about pedestrianization and these

          8      registered fund to funds or registered hedge fund products

          9      but, again, I would underscore that these apply to accredited

         10      investors for the most part and the actual number of 33 Act

         11      open-end fund to funds products I think you can count on your

         12      hands and your toes.  It is a very, very small number of

         13      products out there and a number of products that I frankly

         14      don't see growing dramatically in the near future.

         15                MR. BUTOWSKY:  I would just say that I think you

         16      hear a lot of times out in the press people calling hedge

         17      funds lightly regulated.  And for those who work in the

         18      industry who are very familiar with the laws in the area,

         19      they understand that in truth when you have got a hedge fund,

         20      when it is run by an unregistered advisor, it is very, very

         21      regulated.  I would say that probably 90 percent, 95 percent

         22      of the Investment Advisors Act applies to unregistered

         23      advisors as well as it does to registered advisors.  The

         24      general anti-fraud prohibitions apply.  And that is an

         25      important thing to keep in mind because across the industry

          1      there is a wide disparity as to the level of understanding in

          2      the industry as to what people are subject to and what they

          3      are not.  Obviously, the larger people, the larger

          4      institutional funds, they are always dealing with lawyers and

          5      they are very, very familiar with what they are supposed to

          6      be doing.

          7                And the reason I raise this point is I think as we

          8      go down this road in considering if there is anything that

          9      needs to be done in the industry, I think one of the things

         10      that I would encourage the regulators to do is to think about

         11      rather than regulating through maybe a broad series of

         12      enforcement actions, which people usually read and try to

         13      interpret all sorts of things from, instead to come up with

         14      maybe some sort of concept releases or something that

         15      brutally and clearly tell people what hedge funds, whether

         16      they are run by a registered advisor or not a registered

         17      advisor are subject to.  And go into the marketing point for

         18      one second, the subject of the Internet.  Like I said

         19      earlier, it is all over the place.  And it is a facts and

         20      circumstances analysis and many people aren't in a good

         21      situation to try to figure out exactly what they are supposed

         22      to be doing.

         23                MR. CODY:  I will echo a little bit what Jim said

         24      and I think Craig brought it up as well and that is what I

         25      see as a bit of disconnect because I do believe that most of

          1      the business models for hedge funds and fund to funds are

          2      really focused more on very accredited investors,

          3      institutional investors.  And I am sure there will be those

          4      whose models are going to drill down a little bit somewhat

          5      below that.  But certainly from an economic standpoint, you

          6      want to build a business model that has an ability to attract

          7      some more dollars and stable dollars and people who

          8      understand your product and understand what your strategy is

          9      supposed to be about.

         10                MR. TIEDEMANN:  One of the true issues in my

         11      opinion in the industry that wasn't mentioned explicitly in

         12      the first panel are here is capacity -- everyone talks about

         13      the dollar growth of the industry and it is obviously very

         14      impressive.  It obviously comes with job growth, which no one

         15      likes to point out which has been the terrific saving grace

         16      for the financial services industry.  But every capacity, and

         17      I think if you ask the asset allocators at this panel and in

         18      this room, if their assets doubled next year, would they be

         19      able top with conviction place those assets and managers that

         20      they think could manage them properly and still have the same

         21      return stream.  That is a major issue.  The more the assets

         22      that flow into this industry, the more efficient it becomes,

         23      the less opportunities potentially there will be to make the

         24      returns as we know them.  

         25                Regarding registering or not registered, we are

          1      unregistered hedge fund group.  Our decision to register

          2      would be based on one of two things:  if Chairman Donaldson

          3      told us to or if we based on a business decision wanted to go

          4      after more ERISA money or registered fund to fund products. 

          5      I think there is enough capital that will find its way to you

          6      without advertising if you are superb manager in your space

          7      over time if you are superb manager in your space over time,

          8      which is probably the proper way for it to come to you

          9      anyway.

         10                My only concern about the outcome of this

         11      conference or potential outcome is that a barrier to entry

         12      through regulation could potentially be created, which would

         13      really be too high of a hurdle for less capitalized, smaller

         14      entrepreneurials to enter in the space who have good

         15      intentions, who do not want to grace the covers of

         16      publications but that want to develop a culture and run a

         17      business and co-invest with their investors.  That would be

         18      my only concern as an outcome of the conference.

         19                MR. RUSSELL:  Liz, I was hoping you were going to

         20      start over here and go that way but this is the sweet spot of

         21      going around the table.  Clearly, there has been a lot of

         22      mention about issues around suitability and appropriateness. 

         23      And in my view those are key, and I think we are all spending

         24      a lot of time on those, particularly as a broader set of

         25      investors get exposures to these type of investment vehicles. 

          1      Topics that I think are important for clients, and I think it

          2      has a lot of things -- we mentioned the Patriot Act has

          3      changed the assessment of investors greatly over the last

          4      couple of years.  Transparency has increased tremendously in

          5      the business, not only to professional advisors but also

          6      investors and registered funds who get to see who they are

          7      invested in.  Due diligence has been raised to a different

          8      level.  The first panel mentioned from a client perspective

          9      that people are spending a lot more time on operations issues

         10      and valuation and accounting and that is key.

         11                To us, the value of investing in hedge funds is

         12      compelling.  I think Bob mentioned in the last panel you can 

         13      slice it and dice it, you can look at academic research, it

         14      is a compelling proposition.  And I think one of the biggest

         15      challenges that we have as a business is finding a way within

         16      the sort of suitability appropriateness framework to get that

         17      information out properly to investors.  And I think that is

         18      one of the biggest challenges we face as a large manager and

         19      also as a firm that is an intermediary in the business is

         20      getting that information out in a way that is obviously

         21      proper and credible at the same time.  And right now we are

         22      doing that on foot but it would be great if we could do that

         23      as an industry.

         24                MS. OSTERMAN:  Thank you all for your comments and

         25      for your participation in this panel.  

          1                (Whereupon, a luncheon recess was taken.)

          2                MR. PLAZE:  Good afternoon, and welcome to Panel 3

          3      of our roundtable on hedge funds.

          4                I'm Bob Plaze.  I'm the associate director in the

          5      Division who will be the master of ceremonies, at least for

          6      the next hour-and-a-half here.

          7                Our topic this afternoon is disclosure,

          8      transparency, and performance fees -- three topics -- and

          9      with me this afternoon is a distinguished panel of experts in

         10      the area, who will be offering their opinions.  Let me

         11      introduce them.

         12                Starting from my far right, Mr. Peter Bernard is

         13      chief financial officer of the RiskMetrics Group.  Peter has

         14      been at RiskMetrics for over three years, and during that

         15      time, he's had responsibility for operations of the company's

         16      strategic planning and senior client relationships.

         17                RiskMetrics offers risk analysis that clients of

         18      hedge funds will use to evaluate the risks associated with an

         19      investment.

         20                George Hall is president of the Clinton Group, an

         21      SEC-registered investment advisor with approximately $5.7

         22      billion in hedge fund assets under management, both onshore

         23      and offshore funds.

         24                David Hsieh is professor of finance at the Fuqua

         25      School of Business at Duke University.  Professor Hsieh has

          1      conducted extensive research in the area of hedge funds. 

          2      He's won numerous awards for his work, including the Fisher-

          3      Black Memorial Foundation's 1999 Robert J. Schwartz Memorial

          4      Prize for the best paper on hedge funds, which he co-

          5      authored.

          6                Professor Hsieh holds a Ph.D. in economics from the

          7      Massachusetts Institute of Technology.

          8                Jean Karoubi is president and founder of the

          9      LongChamp Group.  He provides managerial and financial

         10      advisory services, specializing in hedge funds, asset

         11      allocation, to high net worth families, and they have about

         12      $300 million of assets under management.

         13                To my left, Larry Simon is president and chief

         14      executive officer of the Ivy Asset Management Corporation,

         15      another SEC-registered investment advisor.

         16                Through its funds and advisory relationships, Ivy

         17      manages over $7 billion of investor funds.

         18                Next to Larry is David Swenson.  He is chief

         19      investment officer at Yale University, where he is

         20      responsible for more than $10 billion in Yale endowment

         21      assets and several hundreds of millions of dollars of other

         22      investment funds.

         23                In 1990, Yale became the first institutional

         24      investor to pursue absolute return strategies as a distinct

         25      asset class.

          1                He is the author of Pioneering Portfolio

          2      Management, an Unconventional Approach to Institutional

          3      Investment, published in 2000, and prior to joining Yale in

          4      1985, Mr. Swenson spent six years on Wall Street.

          5                Finally, to my left, Michael Tannenbaum, our lone

          6      lawyer on the panel this afternoon, heads the financial

          7      services hedge fund group of the New York City law firm of

          8      Tannenbaum Helpern Syracuse & Hirschtritt.

          9                He has over 30 years of industry experience in U.S.

         10      and non-U.S. hedge funds' structured finance arrangements. 

         11      Mr. Tannenbaum is also director of the Hedge Fund

         12      Association.

         13                Welcome, gentlemen all.

         14                Again, our topics today, disclosure, transparency,

         15      and performance fees.

         16                The first two topics may not be obvious, the

         17      distinction, but I'm going to draw a distinction for purposes

         18      of this discussion, disclosure being the information an

         19      investor obtains or perhaps needs to obtain before making an

         20      investment in the hedge fund; and transparency, information

         21      the investor obtains or needs to obtain to assess his risk

         22      and exposure with respect to a continuing investment in a

         23      hedge fund.

         24                If you're a securities lawyer, you might

         25      distinguish this between the '33 and '34 Act, which, of

          1      course, don't directly apply in this situation.  Nonetheless,

          2      we're going to talk about them today.

          3                Just to kick off, the current disclosure regime

          4      requires delivery of a private placement memorandum to an

          5      investor before the initial investment, but investors feel a

          6      need to do extensive due diligence on an investment in a

          7      hedge fund.

          8                A recent DeutscheBank survey reported that 60

          9      percent of hedge fund investors surveyed take between two and

         10      six months to complete due diligence and make a hedge fund

         11      investment.  Many feel the need to hire a consultant, and

         12      even sometimes a private investigator, to uncover and verify

         13      information before making an investment.

         14                Mr. Tannenbaum, the private placement memorandums

         15      I've read describe what the hedge fund manager will do --

         16      e.g., event arbitrage -- but as I think alluded to earlier

         17      this morning, they then typically allow him to make just

         18      about any other kind of investment he wants or deems

         19      appropriate as the general partner of the fund.

         20                Is this typical, and does this explain perhaps why

         21      private placement memoranda are not particularly useful or

         22      used by investors?

         23                MR. TANNENBAUM:  Thank you.  Everything was fine

         24      until to got to the "not particularly useful" phrase.  We

         25      would differ as to that.

          1                First, let me say that investments of this sort --

          2      and by that I mean hedge fund type investments -- are

          3      typically run, almost virtually always run by opportunistic

          4      entrepreneurial folks who basically are retained in the first

          5      place in order to find investment opportunities, and have a

          6      broad mandate, so as to perform well in virtually all

          7      markets.

          8                There is no question that the documents are, in

          9      fact, drafted very broadly, and that's intended, and I would

         10      suggest that that's favorable to the investor.

         11                They are drafted in a way that permits the manager

         12      to react to changing market conditions, which I think is

         13      crucial; they're drafted in such a way as to allow the

         14      manager to react to a situation that perhaps didn't exist at

         15      the time the document was originally drafted, and it's that

         16      very flexibility that's, I believe, a cornerstone of the

         17      industry.

         18                That's the reason why these funds tend to be so

         19      flexible, so that the lawyer in me, of course, and other

         20      lawyers in the room, and those not in the room, of course,

         21      draft these documents in a very broad way, and that's very

         22      much intended so as to permit that flexibility.

         23                MR. PLAZE:  Do you ever have any concerns that an

         24      investor who, say, isn't a lawyer, reading these documents,

         25      might not appreciate that last sentence in the two-paragraph

          1      description of the investment objectives and policies?

          2                MR. TANNENBAUM:  It's always a concern, and the

          3      concern is where you draw the line between what needs to be

          4      disclosed from a legal standpoint -- and there's plenty to be

          5      disclosed -- and how that is to be written in a way that is

          6      meaningful and legal and artful, and how you make the

          7      documents readable, sufficiently readable so that investors,

          8      a wide range of investors -- admittedly some have more

          9      experience in this asset class than others -- are able to

         10      react in a meaningful way.

         11                What we do, and what I think most lawyers in this

         12      industry do, is to have a summary section which tends to be,

         13      as the name suggests, more of an executive type summary of

         14      the transaction, followed by many pages of explanatory

         15      material that backs up the summary, and I think that's

         16      somewhat unavoidable at this point.

         17                MR. PLAZE:  Professor Hsieh, you've described, in

         18      one of your writings, private placement memoranda as, at

         19      best, cursory and involve technical descriptions.

         20                Do you have any suggestions as to ways that they

         21      could be improved to be more useful to investors, or would

         22      your advice for directors be not to rely on them?

         23                MR. HSIEH:  Well, I think that it would be useful

         24      to get some summary information of what the funds are exposed

         25      to, but I've read some of these disclosure memorandums

          1      myself, and I think that it's, for a typical investor, it is

          2      very hard to go through and see all the details.

          3                MR. PLAZE:  Mr. Swenson, do you rely on them at

          4      all?

          5                MR. SWENSON:  I guess I would be in the category of

          6      not particularly useful in terms of the disclosure documents.

          7                I mean, what we really care about when we're making

          8      investment decisions is, first and foremost, the quality of

          9      the people, and there's no way that you can look at

         10      somebody's disclosure document and figure out if the people

         11      that you're invested with have the character, the

         12      intelligence, the integrity, the creativity, and market savvy

         13      that you want to have in a partner in this arena or any other

         14      investment arena, for that matter.

         15                When you look at disclosure documents, it might

         16      tell you what the proposed deal structure is, but on the

         17      other hand, if we don't like the deal structure, we'll talk

         18      to the manager and try and negotiate a set of terms that we

         19      think would be fairer; so what's disclosed there may or may

         20      not be relevant to us.

         21                Finally, there's probably some information on

         22      historical track record, but that's all backward looking, and

         23      what the returns were or what the volatility of those returns

         24      were don't really tell you much of anything about what they

         25      might be.

          1                And what's interesting to us what are the

          2      fundamental positions that were taken, security positions,

          3      long, short, or otherwise, that contributed to the record

          4      that was created, not the pure return numbers or the risk

          5      numbers associated with that.

          6                So the disclosure document touches on two of the

          7      things that we care about, but doesn't really address them in

          8      a comprehensive way, and the disclosure document misses the

          9      most important fundamental thing that we care about in making

         10      investment decisions, and that's the character and quality of

         11      the people.

         12                MR. SIMON:  I'd just like to point out that the

         13      private placement memorandum is more end of process than

         14      beginning of process.

         15                For those of us that are registered, we are

         16      basically selling a security, and therefore, you cannot

         17      basically offer a document unless a client asks for it, et

         18      cetera.

         19                Most clients, whether institutional or high net

         20      worth, tend to have this towards the end of the process. 

         21      They want to do their due diligence, they want to know about

         22      process infrastructure, they want to know about returns,

         23      track record, which is usually filled with informational

         24      material.

         25                The second visit or second request may then ask for

          1      the private placement memorandum.

          2                So no client should receive a private placement

          3      memorandum on a first visit, unless they ask for it.

          4                MR. PLAZE:  Mr. Tannenbaum.

          5                MR. TANNENBAUM:  The disclosure process, this

          6      initial legal disclosure process, as opposed to the

          7      transparency side, which is the distinction you made, is

          8      really, in and of itself, two, really two disclosures.

          9                There's an initial -- there's a type of a

         10      disclosure that would satisfy the investors in terms of, you

         11      know, what the deal is about, what the strategy is, what the

         12      risk parameters are, fee structures, those kinds of things

         13      that, for lack of a better phrase, are purely business

         14      oriented, and therefore exceedingly important to the

         15      investor.

         16                There's another type of disclosure, again for lack

         17      of a better phrase, which is the legal disclosures -- pages

         18      of tax materials; pages of materials about the USA Patriot

         19      Act, our new money laundering statute, of course; materials

         20      about the CFTC futures disclosure; descriptions of qualified

         21      eligible participants, which is the 4.7 rules; description of

         22      qualified purchaser, qualified client.

         23                I guess the question is, what do I leave out?  You

         24      know, what does a lawyer leave out of that mix and still

         25      satisfy the needs to make sure that the full disclosure is

          1      made?  And I would suggest it's difficult to leave any of

          2      that out.

          3                MR. PLAZE:  The one item I might notice is the

          4      conflicts of interest disclosure.  That's an important part

          5      of that document, and I would think, Mr. Swenson, as an

          6      investor, that's one area you would look at very carefully.

          7                MR. SWENSON:  Well, I do look at the conflicts of

          8      interest, usually for amusement, because it's an easy way to

          9      eliminate funds from consideration, but aside from that, I'd

         10      like to actually address the issue of using the disclosure

         11      document description of investment strategy as a starting

         12      point.

         13                I mean, the lawyers draft these so broadly that

         14      they're useless.  They take great care to make sure that an

         15      investment manager can do absolutely anything without running

         16      afoul of any strictures that might have been placed on the

         17      manager in the disclosure documents.

         18                So the only way to really find out what a manager

         19      is doing is to sit down and take a look at the portfolio and

         20      go through it position by position.

         21                I think that, because of the legal nature of the

         22      disclosure process, the documents tend to be pretty close to

         23      useless, although I will put a little asterisks by it for the

         24      conflicts of interest, because sometimes those are amusing.

         25                MR. PLAZE:  I was just going to say that it is one

          1      thing in the way of disclosure to have the market power to

          2      take a look at position by position, and that's exactly what

          3      one should do if they can.

          4                The further one gets away from the manager, the

          5      less one can do that, and there I would suggest disclosure

          6      has got to put a greater emphasis on what are the processes

          7      that the intermediary has gone through to put a portfolio of

          8      hedge funds together, what they have done in the way of due

          9      diligence, and I think there's quite a lot that can be done

         10      that isn't being done today on that score.

         11                MR. BERNARD:  I'm -- oh, I'm sorry.  Go ahead.

         12                MR. PLAZE:  I was speaking because I didn't sense

         13      anybody else was.

         14                MR. BERNARD:  Well, one thing I wanted to point

         15      out, I think listeners may get an improper impression.  I

         16      think private placement memorandums vary from one hedge fund

         17      to another, and as we've said before, there are thousands of

         18      them.

         19                You know, the ones that I'm most familiar with,

         20      obviously, are my own, but certain other ones that I've read,

         21      they're very specific in terms of what asset class the

         22      investor -- the hedge fund manager can invest in, what they

         23      can do to hedge it. 

         24                Now, there are some that are very general, and

         25      that's because certain hedge fund managers are generalists,

          1      and they should have the opportunity, and investors want them

          2      to have the opportunity to change from one strategy to the

          3      other.

          4                But in general, I think specialists that have a

          5      particular niche that they focus on, that's pretty well laid

          6      out in the private placement memorandum.

          7                That's not to say that that's enough information to

          8      make a decision.  Obviously, due diligence, looking at track

          9      record, and getting a feeling for the manager and so forth,

         10      is important.

         11                But I think it would be wrong to leave listeners

         12      with the impression that private placement memorandums are so

         13      general that you can't get a grasp on what the strategies

         14      are, because I don't think that's universally true.

         15                MR. PLAZE:  Let me just ask this question to the

         16      group.  How important a role do the consultants play in

         17      ferreting out specific information for investors?  There are

         18      large questionnaires, I understand, that are submitted to you

         19      regularly, so that you must have some people spending quite a

         20      bit of time answering them, from what I've seen.

         21                MR. BERNARD:  Well, that's driven by the investor. 

         22      If the investor wants to hire a consultant to do this due

         23      diligence, then the consultant will do it, and certain

         24      investors do the due diligence on their own, and all

         25      investors, they tend to have different things that are

          1      important to them.

          2                Some information is relevant to one investor, and

          3      it's irrelevant to another, and it's up to hedge fund

          4      managers to answer all these questions that they're willing

          5      to answer as accurately as possible, and the information that

          6      they're not willing to answer, such as positions in the

          7      actual portfolio, then that should be, I think, uniform among

          8      all investors.

          9                MR. PLAZE:  That's a good segue.  Mr. Simon, you

         10      noted that different investors have different disclosure

         11      needs.  Why?  How does that work out?

         12                MR. SIMON:  I think this was something we discussed

         13      recently.

         14                They shouldn't, in reality, have different

         15      disclosure needs, but by the nature of the client, whether it

         16      be an institution looking to place significant money or a 3-

         17      C(7) investor who has investible assets of a certain size and

         18      may have a gatekeeper or asset allocator or accountant or

         19      lawyer who helps make the decision, to the 3-C(1) accredited

         20      investor who may be sold by brokerage house or investment

         21      bank or someone, they all have different reasons for

         22      disclosure.

         23                So if you start with the institution, as was just

         24      stated, you'll be put through a tremendous amount of

         25      questions, because there's a fiduciary responsibility for

          1      most of those institutions that either the trustees are

          2      looking to protect or basically delegate that responsibility

          3      to the hedge fund manager or the fund of funds manager.

          4                Same thing with high net worth families.  The

          5      accredited investor in a 3-C(1) fund is basically buying

          6      performance, pedigree, strategy, and is not going to be,

          7      unfortunately, as thorough as the other two categories, et

          8      cetera.

          9                So clearly, it should be important to every one of

         10      those classes, but it's going to vary by individual

         11      personality and their desires.  Institutions are looking to

         12      make long investments, three to five years.  Unfortunately,

         13      high net worth investors may be chasing performance.

         14                So it's going to vary, and therefore, disclosure

         15      may mean different things to different audiences.

         16                MR. PLAZE:  There are investors who want different

         17      types of information, but there are also situations in which

         18      investors can get different types of information, depending

         19      upon their market power, their ability to band and extract.

         20                I notice with interest there are some guidelines

         21      published by the Alternative Investment Association.  It's a

         22      European organization.  Jean is our designated European

         23      representative here.

         24                MR. KAROUBI:  I need to make a correction here.  I

         25      have been in the U.S. for 26 years.

          1                MR. PLAZE:  Okay.

          2                MR. KAROUBI:  My children are born in New York, my

          3      wife is American.  I have been investing in hedge funds in

          4      the U.S., in the U.S. mostly, for about 24 years.  I know

          5      very little of European.

          6                One thing you can say is that -- 

          7                MR. PLAZE:  I said the wrong thing.

          8                MR. KAROUBI:  He said that you had those guidelines

          9      made in the U.S. in year 2000 by the Managed Futures

         10      Association, and the Europeans copied them.

         11                MR. PLAZE:  Oh.

         12                MR. KAROUBI:  But the difference is that the

         13      regulatory authorities in the U.K. in general, I believe --

         14      again, it's my belief, because I'm not sure of what I'm

         15      saying there -- more seriously and took more attention about

         16      this set of guidelines, that possibly it was done here.

         17                But in terms of disclosure, which in a way these

         18      guidelines address, first we talk about, you know, Larry

         19      talked about using the PPM as an end, as a beginning, as a

         20      start.

         21                I think it's something which is extraordinarily

         22      useful.  It's kind of quite fun to use the PPM as a base to

         23      ask questions and to see how the manager will react.

         24                "You are the manager?  How come you are not the

         25      director yourself of your offshore fund?"  The answer of most

          1      of the managers is, "Because my lawyer told me I should not." 

          2      And of course, don't forget who wrote the PPM.  The lawyer,

          3      paid by the manager.

          4                So it is totally normal that the PPM will not

          5      protect the investor.  It's protecting, obviously, the

          6      manager.

          7                It's up to the investor to use that format to ask

          8      questions detailing, piece by piece what the manager actually

          9      does, what are their actual conflicts of interest, which are

         10      real, and some of them which are so large not to be clear,

         11      and quite frankly, having looked at and read personally,

         12      because as a so-called small investor, I don't have a battery

         13      of lawyers to do for me, read several hundred of them, we

         14      came to a very simple format to dissect out of it what

         15      questions to ask the manager.  It's not that hard.

         16                And the manager, most of them, the overwhelming

         17      majority of them is absolutely willing to go far beyond what

         18      their lawyer has written to limit himself into exactly what

         19      he or she is doing.

         20                MR. PLAZE:  The question is that -- we mentioned

         21      that the guidelines indicate that if a manager gives someone

         22      information, he should provide it available, make it

         23      available to all the investors, the information, and the

         24      question I was going to ask is, should we adopt similar

         25      guidelines in the United States, in terms of -- it's a

          1      fairness question.

          2                MR. KAROUBI:  What do I know?  I can only talk

          3      about my own experience.  I am not here to regulate the SEC.

          4                MR. PLAZE:  Oh.

          5                (Laughter.)

          6                MR. PLAZE:  Anyone else have any views on this?

          7                Before we leave, any suggestions on things that

          8      could be done to improve this disclosure process by which

          9      investors make decisions, very important decisions involving,

         10      sometimes, a lot of money.

         11                MR. ROYE:  Hey, Bob, can I jump in and just ask a

         12      question about the extent to which the greater institutional

         13      interest in hedge funds, how has it shaped or influenced the

         14      disclosure process, or does that really go more to the

         15      transparency issue?

         16                MR. BERNARD:  I think they bleed into each other,

         17      in my experience.  The institutions in their due diligence

         18      exact promises on what they will have access to on an ongoing

         19      basis, and that's one aspect of the decision making process. 

         20                So if they will have access to position level data

         21      in the future, if they will have access to risk statistics,

         22      if they'll only have access to one conversation per quarter,

         23      and a one-page letter, those are factors in the due diligence

         24      process that speak to the openness of a relationship between

         25      the investor and the manager going forward.

          1                MR. PLAZE:  Mr. Hall, do your documents explain

          2      what you will be providing, ongoing information, in that

          3      respect?

          4                MR. HALL:  In the private placement memorandum, I

          5      don't believe it provides for ongoing information.  That's

          6      more informal, more outside of the documents.

          7                But one thing I wanted to mention, this goes back

          8      to the question that Commissioner Campos asked this morning,

          9      when he said that everything sounds great with hedge funds,

         10      why don't we just open the floodgates and let everyone

         11      invest?

         12                I think the question was somewhat rhetorical, but

         13      not fully answered.

         14                The point there is, I think the institutions, the

         15      fact that historically, more sophisticated investors and

         16      institutions have invested in hedge funds, they have driven

         17      this -- you know, I think hedge fund managers, they do the

         18      right thing, they try to disclose accurately.  I think they

         19      have a great level of integrity, by and large.

         20                But the fact that institutional investors and

         21      sophisticated investors have driven this market in the past,

         22      they've caused hedge funds to disclose at, I think, an

         23      appropriate level.

         24                If it does get opened to retail investors, they are

         25      not going to be as sophisticated, and that's probably

          1      something that needs to be considered, that over time, the

          2      quality of disclosure that's demanded by institutional

          3      investors may actually slip downward.

          4                MR. PLAZE:  As a result of retail investors?

          5                MR. HALL:  Well, I think, by and large, the world

          6      of hedge fund investors now is more sophisticated than the

          7      world of retail investors, if you just took the average

          8      sophistication across both segments.

          9                So I think as the sophistication goes down, you

         10      know, all the things that were pointed out that I had agreed

         11      with this morning on the first panel about the positives of

         12      the hedge fund and their ability to self -- not self-

         13      regulate, but to do these things of their own volition, that

         14      potentially, those thresholds could slip a little bit, as it

         15      penetrates a less sophisticated investor group.

         16                MR. PLAZE:  Any thoughts?

         17                MR. SWENSON:  I'd actually like to take a little

         18      bit different tack on that particular question.

         19                I think that hedge funds are unsuitable investments

         20      for unsophisticated investors.  It doesn't matter how much

         21      disclosure there is, how much access they have.  If you have

         22      a group of unsophisticated investors, they're likely to have

         23      a very, very high degree of failure in the hedge fund world.

         24                If you look at the individuals' experience s mutual

         25      funds, we've got thousands and thousands of mutual funds.  On

          1      average, the experience of individual investors is quite poor

          2      there.  They would be far better off with an index fund than

          3      with the high cost active management that they've got in the

          4      mutual fund world.  Of the thousands of mutual funds, there

          5      are probably several dozen that are worthy of investment.

          6                Now, the thing that you've got in the mutual fund

          7      world that is a benefit is that at least the investor gets

          8      the asset class exposure, so if they're in an equity mutual

          9      fund, they get the wind at the back from owning equities over

         10      long periods of time, or if they're in a bond fund, at least

         11      they have exposure to the bond market.

         12                If you go to the hedge fund world, there's no wind

         13      at the back.  There's no asset class exposure.  It's all

         14      active management.  It's all about being partners with

         15      managers that can identify and successfully exploit

         16      inefficiencies in the marketplace.

         17                So the likelihood is that if you get a group of

         18      unsophisticated investors, they're going to end up with a

         19      group of managers that are going to produce poor results and

         20      they're going to pay extraordinarily high fees for the

         21      privilege of getting the poor investment results, and that's

         22      just a terrible combination.

         23                So I would think that it would be best for the

         24      investment world to have extraordinarily high hurdles in

         25      place in terms of allowing unsophisticated or smaller

          1      investors to participate in the hedge fund world.

          2                MR. KAROUBI:  The world of investment in hedge

          3      funds is twofold.

          4                Either you invest directly in a hedge fund -- and I

          5      agree with you, David, on what you said right now.  It's

          6      pretty difficult to select Hedge Fund A versus Hedge Fund B,

          7      and someone with little means first doesn't have really

          8      access to an ability to analyze those strategies.

          9                But Larry here has provided a number of investors

         10      very quality funds of funds.  We do the same in a way for our

         11      own family and other investors, where by buying other

         12      people's expertise into combining strategies and putting

         13      together investment in hedge funds, it does work in retail

         14      format, so far.

         15                I think the danger of developing hedge funds is

         16      simply too much money going to strategies, and wherever this

         17      money comes from.  I think the danger comes more from the

         18      people who are copying you, David, and realize that you have

         19      done so much better than they have done.

         20                And the pension fund, the endowment, the foundation

         21      is big money.  I was stupefied recently, being on a small

         22      group of investors, including $50 billion pension fund, who

         23      needs to provide at least 6 percent return, some others, 8

         24      percent return.

         25                They are desperate to find the yield, to find the

          1      return, any which way, and they are trying to get into a

          2      hedge fund as if hedge fund is going to give a sure way to

          3      get them this kind of return; and this is so much more money

          4      into an industry who may not have the capacity, the retail

          5      investor.

          6                MR. SWENSON:  I mean, I don't think that a fund of

          7      funds is the answer for lack of sophistication.  I think that

          8      it exacerbates the problem, because the unsophisticated

          9      investor is going to be attracted by performance, and if you

         10      judge an investment only by performance, you're going to end

         11      up in the soup, eventually.

         12                The only way that you can do an intelligent job of

         13      judging investments is to understand the fundamentals, and

         14      the unsophisticated investor, by definition, doesn't

         15      understand the fundamentals, doesn't understand what the

         16      managers are doing.  They're simply responding to

         17      performance. 

         18                So if these unsophisticated investors pool their

         19      money in a fund of funds, and they are looking only at

         20      performance, there's a patch of bad performance, they'll pull

         21      the money away, creating instability and creating bad returns

         22      for themselves; so that's not an answer.

         23                I think the answer is that this is an arena for

         24      sophisticated, highly qualified investors, and there's no

         25      simple way to allow the unsophisticated to play.

          1                MR. SIMON:  I just would like to add for the

          2      record, since I seem to be caught between two gentlemen

          3      talking about fund of funds, and since that's the business

          4      I'm in, it's certainly not retail.  As a number of counselors

          5      out in the audience can tell us, it's their lawyers that we

          6      utilize.

          7                The minimum investment in the fund of funds that we

          8      run is $1 million and the minimum investment for

          9      institutional account, private label, is $100 million.  I

         10      don't think that's retail.  So I just want to put that on the

         11      record.

         12                MR. HSIEH:  Can I add something to that?

         13                From the evidence that I have seen, sophisticated

         14      investors also chase performance.  They chase it just like

         15      the retail investors.

         16                (Laughter.)

         17                MR. HSIEH:  My main concern, if we think about

         18      opening these types of investments to the general public, is

         19      that we now have very illiquid, typically, very illiquid

         20      investments.  We have now a lot more hot money chasing

         21      performance.

         22                It will really exacerbate the problem, and then

         23      you'll end up, at the end of the day, if investments go bad,

         24      the retail investor is going to be asking the question, "What

         25      happened, because I can't get out of these funds," and that's

          1      really something that we should be concerned about.

          2                But I don't think anybody in the industry is really

          3      strongly advocating for opening it to the retail investor.

          4                MR. PLAZE:  These are issues regulators all over

          5      the world are struggling with, and coming up with different

          6      answers, I might add.  The U.K. decided not to.

          7                But Hong Kong, a mature market, decided to make

          8      them available to the retail investors, because, "If they're

          9      so good, why shouldn't a great number of people have access,

         10      in at least a percentage of their portfolio?"

         11                One could also argue that, of course, there are

         12      some mutual funds that are offered in the retail area that

         13      involve risk, extraordinary risks, also.  This is a

         14      fascinating debate.

         15                One of the issues, of course, ongoing, and one of

         16      the issues we have on our topic schedule today, is

         17      transparency, and I know a great many of our panelists have

         18      an interest in this issue.

         19                Once the decision to invest in a hedge fund is

         20      made, it's important to investors to be able to assess the

         21      ongoing risks of an investment, particularly if the

         22      disclosure documents are written so broadly, I would suggest,

         23      and particularly an investment that involves substantial, or

         24      could involve substantial leverage.

         25                The President's Working Group on Long-Term Capital

          1      Management, one of the few recommendations that dealt with

          2      the management side, the securities side of the issues, as

          3      opposed to the lending that's dealt with, recommended greater

          4      transparency of hedge fund financial positions, a

          5      recommendation that required legislation to effect, and that

          6      was introduced but never passed by Congress.

          7                Recently, the same issue has arisen in mutual fund. 

          8      The Commission has sought to improve the transparency of

          9      mutual funds by requiring, instead of twice a year, four

         10      times a year disclosure of portfolio holdings, and there have

         11      been suggestions, mostly made, I think, in the press, that

         12      hedge fund transparency requires position reporting.  Others

         13      argue that investors need only a quantifiable risk

         14      measurement to assess the risk. 

         15                But there's no, I think, agreement on measuring

         16      risks, so far.  At least there's no standardized measurement

         17      of risk.

         18                I wondered what kind of transparency do hedge funds

         19      typically provide ongoing, and is it uniform, and has it

         20      changed over years as a result of large investor pressures?

         21                I think, Paul, that was your question coming up

         22      around here.

         23                Mr. Simon?

         24                MR. SIMON:  I don't know if there's an advantage in

         25      sitting next to you, but -- 

          1                (Laughter.)

          2                MR. SIMON:   -- it's a very interesting question,

          3      but it really is strategy dependent.

          4                I've been in this business for 19 years, around it

          5      since 1965.  We use three core strategies, so let me address

          6      it from that perspective.

          7                Clearly, for long/short/equity managers, we tend to

          8      use managed accounts, for a number of reasons, because it

          9      offers us liquidity, transparency, the ability to basically

         10      cut and leave if some manager has style drift or basically is

         11      no longer the star our due diligence thought they were.

         12                So we will get, every single night, a prime

         13      broker's report of all the positions for those managers.

         14                So, for instance, if we have hired a technology

         15      manager -- and again, since this is webcast, I have to offer

         16      apologies to the Bank of New York, but if one of those

         17      managers bought Bank of New York stock, that clearly is going

         18      to set a bell off as to how is that technology, et cetera?

         19                So with long/short/equity managers, there's a very

         20      high percentage of transparency if you tend to use managed

         21      accounts.

         22                That said, in special situation investing and in

         23      what I call multi-strategy managers, and other event-driven

         24      approaches, over the last 19 years, we've seen a marked

         25      improvement of managers willing to share more information,

          1      but not necessarily full transparency.

          2                We are given most of their 15, 20 top positions. 

          3      If it's our player we tend to ask those questions.  Some will

          4      give us a portfolio at the end of a quarter.  I'm not sure

          5      that's of any value as you move into a quarter that has just

          6      passed, and it changes.

          7                The cachet of institutional money coming in

          8      strongly, many of these managers like the cachet of having a

          9      state pension plan, an insurance company, a Taft-Hartley

         10      plan, whatever it may be, and are willing to offer more and

         11      more.

         12                Their letters are going from one page to 10 pages

         13      in terms of what they do, how they do, what the allocations

         14      are for their various strategies.

         15                So sort of the long/short answer to your question,

         16      again, it's strategy dependent, but we have seen a tremendous

         17      amount of movement of more transparency over the last five,

         18      10 years as the institutions have come into this arena.

         19                I'll be candid with you and tell you that the

         20      majority of the high net worth investor does not ask for

         21      transparency, as an institutional client will ask for more.

         22                MR. PLAZE:  Mr. Hall, is that your experience?

         23                MR. HALL:  Well, if I may, can I go back a second

         24      to the President's Working Group, which you alluded to, which

         25      I actually have an excerpt here.

          1                They mention comprehensive measures of market risk,

          2      parenthetically value at risk and stress test results,

          3      without requiring disclosure of proprietary information on

          4      strategies or positions.

          5                So let me contrast that to the mutual fund

          6      business, where most large, particularly large cap mutual

          7      funds, they've got liquid stocks, large cap stocks.  Many of

          8      them, the majority of them are common to the index that

          9      they're competing against, so there are really no great

         10      secrets; so full transparency is really not a detriment to

         11      their operation.

         12                Hedge funds are a different approach to making

         13      money in the financial markets.  They tend to traffic in

         14      securities that may be less liquid, so it's proprietary what

         15      they're doing.  They may not necessarily want other people to

         16      see what they're doing.

         17                One of the things that I think was well understood

         18      during the long-term capital debacle was that as people

         19      sensed what their positions were, that they were trying to

         20      unwind, that there was front running going on, it actually

         21      caused spreads to move out even further.

         22                So position level transparency could be detrimental

         23      to the performance of a hedge fund, because their ideas are,

         24      in some sense, secretive, they're proprietary, they've worked

         25      very hard, done a lot of research to come up with things, and

          1      they need to keep it somewhat to themselves.

          2                The other point about transparency is that position

          3      level transparency is basically meaningless, I think, to most

          4      investors.

          5                The fact of the matter is, hedge funds tend to

          6      participate in strategies that may be more complex, they may

          7      be more quantitative, more model driven, and so forth.

          8      They're more complicated than just buying a portfolio of

          9      stocks.

         10                Now, whether that's good or bad is a different

         11      issue, but the transparency is not going to help, and I think

         12      if you look at most of the well-known blowups and problems

         13      that have happened, first of all, transparency wouldn't have

         14      made investors get out of those investments.

         15                In many cases, investors were somewhat familiar

         16      with what they were doing and they thought it was great until

         17      it didn't work out.

         18                So, you know, I don't think providing transparency

         19      of positions is going to help.

         20                Now, transparency of risk analysis, which there's

         21      no standardized way to do that, and, you know, I'd love to

         22      hear some of your opinions on that, but providing information

         23      about risk and exposures, whether it's to interest rates or

         24      to the stock market or currencies, whatever it happens to be,

         25      is important, and I think investors are forcing managers to

          1      be more informative about what the risks are, and I think

          2      that's appropriate.

          3                MR. PLAZE:  That's a good segue into our next

          4      topic.

          5                How does one go about preparing for offering risk

          6      analysis?

          7                MR. BERNARD:  Thanks for the lead-in, George.  I'd

          8      agree that position reporting is unwieldy, at best, and

          9      unhelpful and misleading to most investors at worst.  So

         10      what's the alternative?

         11                There are certainly -- it certainly doesn't boil

         12      down to a single statistic, a single measure across all hedge

         13      fund styles, across all hedge fund managers.  I think that

         14      there are three components of what might constitute an

         15      appropriate risk disclosure, ongoing risk disclosure kind of

         16      practice.  And those three elements are all, I think,

         17      designed to educate, to communicate and those in order to set

         18      expectations.

         19                What we're really talking about in terms of

         20      disclosure either before or transparency after is to help the

         21      investor understand what he's in for.  What can he expect in

         22      return and what can he expect in terms of the variability of

         23      that return or a worst case return in a crisis environment

         24      from that investment.

         25                The three components that I think make some sense

          1      are one, some element of risk bucketing, understanding where

          2      the bets are placed, how concentrated the bets are.  And this

          3      works in a long/short equity funding works in a merger out

          4      fund.

          5                The percentage of positions, however defined -- I'm

          6      not particularly that interested in getting down to the

          7      precise definition, but what percentage of a portfolio is in

          8      the top three positions or the top one position.  What

          9      percentage is in a particular geographical area, what

         10      percentage is in a particular sector in a long/short equity

         11      fund.  Those are kinds of one easy element.

         12                The second is, I think, any system of risk

         13      practices or risk disclosures needs to have a what-if

         14      element.  George mentioned a value of risk measures that have

         15      been discussed.  That is one approach, a statistical

         16      approach, to a what-if question.

         17                Stress testing is a second approach to a what-if

         18      question.  Back testing.  What has a particular risk system

         19      said about what the returns would be and how do those actual

         20      returns match up to what the system said?  That's a what-if

         21      aspect and reasonably valuable.

         22                The third element is really -- speaks to

         23      consistency.  I think that we should all be probably less

         24      concerned with what distributions are at play, what

         25      algorithms are at play, what statistics are put out there

          1      than the fact that the same -- on a particular fund manager 

          2      -- he ought to be producing the same statistics month after

          3      month.

          4                George mentioned the long-term capital anecdote. 

          5      We had some involvement what the banks post-September 1998

          6      and what was clear is that whatever system one used, their

          7      system, our system, anybody else's system, the firm was

          8      taking significantly more risk in July 1998 than it was

          9      taking in January 1998.

         10                It's an interesting fact that maybe the investors

         11      might have wished to know and I think that the consistency of

         12      approach is far more important than the actual algorithm or

         13      distribution in play.

         14                MR. PLAZE:  Professor Hsieh, you've written

         15      extensively on this subject.

         16                MR. HSIEH:  Yes.  I've been studying hedge fund

         17      strategies and risks since 1994 and this morning I heard that

         18      there's a call for some of the academic research for the

         19      Commission and I am very happy to provide at least a short

         20      summary of this work here.

         21                Let me start, clearly there's no way to present in

         22      a few short minutes the work of over -- almost a whole

         23      decade, but let me just give a vision of what we would like

         24      to achieve and a quick assessment of where we are.

         25                The vision that we would like to achieve, I'd like

          1      to take it back to something that you looked at, equities. 

          2      Now, in the equities market, the kind of risk model that

          3      academics look at are things like the capitalize of pricing

          4      model and the pricing theory.

          5                The idea for those models is that you decompose the

          6      risk of a security, a stock, into two parts, one part that is

          7      related to the systematic part or common to a large number of

          8      securities, and the other part that is idiosyncratic, which

          9      means that it is very specific to that one security.

         10                And the reason why I say that is that at a

         11      portfolio level for an investor of hedge funds, again, if you

         12      have a portfolio of hedge funds, you're really interested in

         13      the common sources of risk across these hedge funds, not so

         14      much the individual single hedge fund that might blow up on

         15      you.

         16                So the goal of this research is really to try to

         17      figure out what are the common sources of risk across hedge

         18      funds.  If we can figure that, then I think we go a long way

         19      to what's understanding for an investor what -- the risk they

         20      face in their portfolio.

         21                We do this in two steps.  First, we look at returns

         22      of a large number of hedge funds and try to extract common

         23      components and then we try to link those common components to

         24      observable market prices and how they move.  Sometimes

         25      they're option prices, sometimes they're interest rate

          1      spreads, sometimes they are different spreads between

          2      different kinds of equity like small cap stocks versus large

          3      cap stocks.

          4                Now, we have been trying to do this for a number of

          5      different styles and I have written papers on at least two of

          6      those styles and hopefully there will be more to go, but let

          7      me give you a quick assessment of how far we have come.

          8                If you take the average return of fund of funds as

          9      a proxy for a large portfolio of hedge funds and you ask how

         10      much of the return variation can we explain using the risk

         11      factors that we have identified so far, we have something on

         12      the order of 70 percent of the return variance can be

         13      explained by the risk factors that we have identified in the

         14      research to date.  And as my research proceeds forward,

         15      hopefully we can bring that percent even higher.

         16                What does this say about disclosure and

         17      transparency?  I think at a minimum someone, either the hedge

         18      funds or the consultants, should provide with investors these

         19      exposures of the funds to these risk factors and then the

         20      investors can then aggregate up at the portfolio level to

         21      understand what the risk factors are.

         22                And then we can do all kind of what-if scenarios

         23      that Peter was talking about.  If we know these risk factors,

         24      we can actually see in history what these risk factors have

         25      done and then we can go back and ask what would the hedge

          1      funds have done in the market environments that we haven't

          2      observed, because we only have about 10 years of good data on

          3      hedge funds and that covered a very short period of time.  We

          4      could not look at that data directly and say what would have

          5      happened in the '70s.  We didn't see it.  We didn't see what

          6      hedge funds did in the '70s.  But if we know what the risk

          7      factors are and we can go back and look at what they did in

          8      the '70s, we can have a good idea.

          9                Now, I'm not saying that we can quantify them

         10      exactly but for a typical investor, that's not what you

         11      really need.  What you really need is some idea of how these

         12      funds would perform in your portfolio.  And I mean the

         13      investor, even for a sophisticated investor.  That's really

         14      what they're looking for.  They're not looking for an exact

         15      distribution of returns.  Of course, for certain purposes,

         16      you can generate that as well.

         17                That's sort of a quick summary.

         18                MR. PLAZE:  This morning we learned that the

         19      average life of a hedge fund is six-and-a-half years.  How

         20      did you deal with survivorship bias issues?

         21                MR. HSIEH:  Well, what we try to do is to group

         22      funds that have similar trading strategies together and keep

         23      all the ones in the sample, keep all the new ones, keep all

         24      the ones that have dropped out, and try to extract a common

         25      source of return across all of them and then try to identify

          1      what this common source of return is.

          2                So this method is also less sensitive to the kind

          3      of survivorship bias that you would encounter if you just

          4      take a standalone portfolio of existing hedge funds because

          5      that would have some survivorship problems.

          6                MR. HALL:  The only comment I would make to that,

          7      which goes back to what we were talking about before about

          8      the flexibility allowed to hedge fund managers if they change

          9      their strategies, and strategies evolve over time, so despite

         10      whatever you can do statistically, I think it's almost

         11      impossible to predict how a hedge fund manager would have

         12      performed in any other environment, be it the '70s or the

         13      '80s.

         14                A lot of the success of the hedge fund is -- it's

         15      not that a hedge fund has a strategy and in various markets

         16      will make that strategy work or make that strategy fail.  The

         17      hedge fund manager is evolving that strategy, modifying that

         18      strategy, getting in and out of the strategy at different

         19      times, so a lot of it is a qualitative assessment of the

         20      manager's ability to do that, not something that statistics

         21      can handle.

         22                That's not to say that I don't admire all the work

         23      that's being done and I think there's a lot of value to these

         24      stress tests and value at risk if it's in the hands of people

         25      that understand their limitations, but I would be careful

          1      about doing this type of analysis and giving investors a

          2      false sense of security about what their risks are because I

          3      think over time it will prove that any statistical test may

          4      give certain comfort that it will fail in market environments

          5      that we haven't seen yet or when we get outside of the normal

          6      market conditions.

          7                MR. PLAZE:  So, for instance, would you agree this

          8      is hard to translate into, say, disclosure to a hedge fund or

          9      fund investor?

         10                MR. HSIEH:  From a single fund to a funds or --

         11                MR. PLAZE:  Right.  No, for that type of investor,

         12      say, a registered product to understand -- deal with the --

         13                MR. HSIEH:  Oh.  I think that this will not be a

         14      single number or something like that that is standard

         15      disclosure.  It might well be that you need to tailor these

         16      to the specific investor, but let me come back and respond to

         17      George's point.

         18                I agree that hedge fund managers change a little

         19      bit what they do and I would call that sort of looking at the

         20      hard to explain part or the idiosyncratic part of a single

         21      fund's return.  

         22                But for my analysis, there is style consistency in

         23      the sense that people who do the same strategies end up

         24      generating the type of returns that I would expect to see on

         25      exactly those environments that I expect to see them, and

          1      that's all that this analysis is really going to be used for

          2      is to ask questions like in different environments, what

          3      would you expect to see.

          4                And I do see quite a lot of consistency in this

          5      type of analysis.  And if I don't live up to this type of

          6      consistency check, I wouldn't be advocating doing something

          7      like this.  But of course a manager can change styles

          8      completely.  Now, that would mean that the historical

          9      analysis conducted on that manager may not work going

         10      forward, but if they do the same thing, they tend to generate

         11      similar types of returns.

         12                MR. SWENSEN:  I would take an even more extreme

         13      position than George on this.  I think qualitative

         14      considerations are overwhelmingly important in the manager

         15      selection and monitoring and evaluation process and that

         16      historical returns and historical variances and historical

         17      correlations are almost useless in making an investment

         18      decision.

         19                I mean, I think it's interesting for a lot of other

         20      reasons but if you're making an investment decision, what

         21      happened in terms of returns and risks and correlations

         22      really isn't helpful.  I think if you look at long term

         23      capitals numbers before they blew up, or David Askin's

         24      Granite funds before they blew up, or the Piper Mortgage

         25      debacle in 1994, on a risk return basis, backward looking,

          1      everything was fine right before it came a cropper.

          2                MR. HSIEH:  No, I don't agree with you on that.

          3                MR. SWENSEN:  And I think if you took a qualitative

          4      assessment or, you know, wrapped your arms around what these

          5      people were doing, you wouldn't have given the money.

          6                MR. KAROUBI:  I would disagree as well.  You give

          7      example of totally opaque funds which we are provided no

          8      information on risk, capturing any kind of alpha out of being

          9      exposed to any specific kind of --

         10                MR. SWENSEN:  The numbers weren't opaque.  You

         11      could --

         12                MR. KAROUBI:  The monthly number, what do they

         13      mean?  They mean nothing.

         14                MR. SWENSEN:  Well, that's what I said.

         15                MR. KAROUBI:  Yeah.  But you are talking of mapping

         16      the picture of risk and one should remember what is the

         17      objective there.  The objective -- there are two kinds of

         18      objective.  One is figuring out do we have ongoing good

         19      manager.  When we hired the manager, we believed he was good. 

         20      We have done all sort of due diligence, all sort of

         21      qualitative analysis and the amount of time with his company

         22      and as a manager.

         23                Then he is getting -- his lifestyle may change, he

         24      may be less focused.  How to monitor -- that's what we're

         25      talking about now, transparencies, monitoring.  If we get on

          1      a monthly basis the type of risk that the manager

          2      systematically gets exposed to month after month after month,

          3      we try to capture some type of alpha to make money some way. 

          4      And suddenly, as we say, we see that type of risk or the

          5      level of risk changing, there are questions to ask.

          6                I think exactly what you said it in terms of risk

          7      factor, we can map the risk of a manager if we get this type

          8      of information and we can monitor them.

          9                MR. HALL:  Well, let's look at a simple example

         10      from '95 until the middle of '98.  If you were long credit

         11      spreads you'd earn positive carry and you'd earn capital

         12      gains because credit spreads tightened.  And then certain

         13      manager -- compare two managers.  

         14                One may have decided, okay, credit spreads are

         15      getting tight so we're going to get out, or there seems to be

         16      too volatility so we're going to get out, and other managers

         17      may say no, I'm going to stick with it.  One, in August of

         18      '98 and thereafter will experience huge losses and one won't. 

         19      That's not going to be in the numbers.

         20                They may have historically had the same exposure to

         21      credit spreads.  So in terms of transparency to a fund of

         22      funds or to a consultant or so forth, the consultant may

         23      decide that they want to get out of the credit market and

         24      then you're transferring the managing the portfolio from the

         25      fund manager to the consultant, and that's up to investors on

          1      who they want to make that decision.

          2                But the decision to at some point in time say it's

          3      time to get out of this asset class, it's time to sit on the

          4      sidelines a little bit to me is impossible to really quantify

          5      in the numbers.  And that really comes down to the things

          6      that Mark mentioned about the quality of the manager, the

          7      discipline of the manager, the appetite for risk that the

          8      manager has and so forth.

          9                MR. PLAZE:  What bout in deciding your particular

         10      asset class?

         11                MR. HALL:  As a manager?  Well, as a manager you

         12      have to look at various asset classes and what gives you the

         13      highest expected return relative to the risk that you're

         14      taking.  You have to look at trends, you have to look at if a

         15      trend is -- you may have earned money on spreads moving in

         16      one direction and then you have to make a decision on whether

         17      they're going to continue to move in that direction or

         18      whether it's time to get out.

         19                MR. PLAZE:  No, I meant from an investor in a wide

         20      range of asset classes directly in stocks and bonds and a

         21      portion of whose assets are in hedge funds.  If one

         22      understands the risk of hedge funds as an asset class, one

         23      can evaluate the portion.

         24                MR. HALL:  Well, again, that depends on who the

         25      investor is.  I think part of this roundtable is about

          1      retailization and so forth and I gave the simplest example I

          2      could think of, which is credit spreads widening or

          3      tightening and I'm not sure retail investors would have a

          4      handle on that.

          5                As the strategies get more complicated, it becomes

          6      harder and harder to quantify what makes a manager successful

          7      and what makes a manager fail and a lot of times it's just a

          8      simple decision to set off the field and get on the

          9      sidelines, and it's very hard to quantify.

         10                I applaud the work that's being done.  I think it

         11      improves the information that people can have but what I'm

         12      most concerned about is a false sense of security based on

         13      statistics.

         14                MR. BERNARD:  The statistics don't provide answers. 

         15      They provide the basis for better questions.  But the

         16      comparison was made this morning between the hedge fund and a

         17      proprietary desk in a big Wall Street institution.  And I go

         18      further.  Fund to funds or a portfolio of hedge funds is a

         19      portfolio of proprietary desks, looks an awful lot like a big

         20      financial institution.

         21                What do they do?  They measure risks everyday and

         22      they ask questions about what those risks look like.  The

         23      statistics are only some common way to take a look at risks

         24      and exposures across desks, across asset classes, et cetera.

         25                I think to suggest that it is not useful

          1      information and is supplanted by only qualitative analysis I

          2      think suggests that the two can't work together and in fact

          3      we see on Wall Street everyday that they do work together and

          4      I would suggest that the same model can be applied to the

          5      hedge fund world.

          6                MR. PLAZE:  Okay.  We're going to have to move on

          7      to our last and third topic which is performing fees.  One of

          8      the defining characteristics of hedge funds is their fee

          9      structure which differs substantially from mutual funds which

         10      we here, at least at the Commission in the division of

         11      investment management, are most familiar with.

         12                Mr. Tannenbaum, could you briefly compare the two

         13      structures and how they operate?

         14                MR. TANNENBAUM:  Sure.  Be happy to.  Generally,

         15      performance arrangements in hedge funds divide along -- major

         16      -- is a major fault line between U.S. funds and non-U.S.

         17      funds.  And I've been careful to say performance arrangements

         18      as opposed to performance fees because there is a difference

         19      between the treatment of this compensation onshore versus

         20      offshore.  This being a U.S.-oriented discussion, I guess

         21      I'll stay with the U.S. markets.

         22                Performance fees in the United States or

         23      performance arrangements in the United States basically are

         24      allocations.  These are transfers of in most cases 20

         25      percent, if that's what the fee structure calls for, 20

          1      percent of the net appreciation generally in excess of a high

          2      water mark.

          3                That amount is allocated to the general partner's

          4      capital account within a partnership or a limited liability

          5      company structure, which is the most tax efficient for U.S.

          6      taxable investors.  And these are structures that essentially

          7      have capital accounts.  Each investor, including the general

          8      partner, has its own capital account and monies flow in and

          9      out of that account.  So about 20 percent of that net

         10      appreciation flows into the general partner's account.

         11                To drill down a little further, you need to get

         12      into the computation of net appreciation.  In 30, 35 years or

         13      so of factors, virtually every fund in our office treats net

         14      appreciation as inclusive, taking into account realized gains

         15      and losses, unrealized gains and losses, to get a true

         16      snapshot of what the profit, so to speak, in a lawyer's terms

         17      would be in the account.

         18                Some clients offset that gross amount with

         19      operating fees so as to reduce the net a little bit before

         20      applying the 20 percent.  Some clients reduce that net amount

         21      even further by the management fee that perhaps was assessed,

         22      that's a net asset value fee, that 1 or 2 percent fee.  I

         23      don't think these are terribly material items but they -- it

         24      is a slight distinction from manager to manager.

         25                By the way, always fully disclose the document. 

          1      Unlike some of the other issues we've heard, transparency,

          2      general disclosure and strategy, this is an exceedingly

          3      simple thing to explain and it's a very easy thing for

          4      clients to understand.  They pay 20 percent of the profits

          5      and there's a methodology by which profits is defined.  So

          6      that's pretty straightforward.

          7                I mentioned high watermarks.  Those are typical in

          8      this industry.  Profits go up to a certain level or go down

          9      to a certain level, a fee is taken or not taken, as the case

         10      may be, and then the fee is not taken again until you go

         11      above that prior mark.

         12                Again, to drill down a little bit further from what

         13      was said earlier today, there are adjustments in the high

         14      watermark area.  For example, if there's a withdrawal from

         15      the fund at a time when there is a loss carryforward, this

         16      loss that needs to be made up before you get to the high

         17      watermark number, typically that withdrawal so to speak

         18      carries with it a piece of that loss.

         19                So -- I'm sure my numbers will be off but I'll take

         20      a stab at the example anyway.  If you started with $1,000,

         21      went down to $500 and then the investor took out $250, the

         22      250 being half of the 500, half of that 500 deficit, so to

         23      speak, half of that loss would disappear.  And that's fair.

         24      Obviously the capital has been cut in half and therefore the

         25      ability to make up that loss has been diminished by that same

          1      percentage so that there's an adjustment there.

          2                I think the -- a couple of other key points.  The

          3      investment advisors who are registered in the United States

          4      are not allowed to take performance fees under current

          5      regulation unless the investor is what's known as a qualified

          6      client.  Qualified client is a defined term, a million and a

          7      half dollar net worth or $750,000 in the transaction.  If the

          8      advisor is not registered, then that rule does not apply.

          9                And the last point I want to make is the investment

         10      manager's position in these funds is precisely aligned with

         11      the interest of the investor in the fund.  Not only is it

         12      very often virtually always the case that the manager has

         13      capital in the fund itself, but because of the allocation

         14      process that I just described, the manager's general partner

         15      account, assuming a profitable fund, is actually growing in

         16      addition to their own capital growing.  So not only are they

         17      partners but there is a growth by virtue of this allocation.

         18                Those funds are all being subjected to the strategy

         19      and as a result, the investor's position is precisely aligned

         20      with this.  To quickly contrast this with the mutual fund

         21      area, virtually always -- in fact, I don't know that I've

         22      ever seen what is known as a fulcrum fee but there is a

         23      fulcrum fee on the books under the '40 Act regulations, and

         24      very simply put, the manager in a '40 Act fund chooses an

         25      index, has a fee that actually increases as the manager beats

          1      that index and has a fee that actually decreases conceptually

          2      as the manager falls below the index.

          3                It's very telling to me, looking at this through a

          4      hedge fund lawyer's eyes, that hedge funds have performance

          5      fees and do very well at them and for a reason the mutual

          6      fund industry tends not to have fulcrum fees and primarily,

          7      with all due respect, would be that they very rarely beat the

          8      index.  The index is very often -- exceeds the return, I

          9      assume statistically of maybe 70 or 80 percent of the mutual

         10      funds in the country.  I would doubt very much that many

         11      mutual fund managers beat the index that they would line up

         12      again.

         13                The last point relates to special situations. 

         14      These first few points related to liquid situations, very

         15      easily measurable.  When you have special situations, you

         16      have illiquid arrangements so that those tend to be a little

         17      bit more difficult to value and therefore you don't have the

         18      ease of assessing a performance fee and typically you simply

         19      wait until those investments liquify before you take the fee.

         20                MR. PLAZE:  Mr. Hall, the method of compensating

         21      the advisor, it's simply not the effect on how he's

         22      compensated but it has a profound effect on management also.

         23                MR. HALL:  Right.  I think the performance fee

         24      model is probably the most important aspect of the hedge fund

         25      evolution, if you will.

          1                Let me contrast that to the mutual fund business or

          2      the traditional long only business.  As you mentioned,

          3      Michael, and John Bogle from Vanguard has spent a lifetime an

          4      the academic research supports the fact that traditional

          5      money managers don't beat the index and the ones that do in a

          6      given time period aren't any more likely to beat it in a

          7      future time period.  So in terms of asset class exposure, it

          8      would seem that index funds would be better.

          9                Because of that, mutual funds have turned out to

         10      be, in my view, marketing institutions and their single, most

         11      important aspect in terms of their profitability is what

         12      their assets under management are.  So the market and they

         13      have a diverse number of products and at certain times

         14      certain products are better than others, and they raise as

         15      much money as they can and that improves their revenues and

         16      their profitability.

         17                The hedge fund model is quite a bit different.  The

         18      most important driver of profitability for a hedge fund is

         19      performance.  The first thing, performance people say 1 and

         20      20 or 2 and 20, for example.  The management fee,

         21      particularly in hedge funds that I think are doing the

         22      appropriate building of infrastructure really goes to cover

         23      costs.  Very few -- there's very little profit, if any, in

         24      the management fee.

         25                So hedge fund managers really only get compensated

          1      if they beat the index.  So you've got a mutual fund industry

          2      where as you've said roughly 70 percent don't keep up with

          3      the index.  Hedge fund managers really only get paid if they

          4      keep up with -- or they beat a particular index.  So their

          5      focus is not on marketing as much.  It's a focus on value-

          6      added.  It's a focus on generating profitability.

          7                And to do that, the -- what I think hedge funds are

          8      bringing to the money management business in general is a

          9      strong emphasis on research, a strong emphasis on value-

         10      added, a strong emphasis in being unique and looking for

         11      niches and I think that's what this business needs.

         12                MR. PLAZE:  Let me just challenge one thing.  A one

         13      to two percent base plus a performance fee would be pretty

         14      good money in a mutual fund world.

         15                MR. HALL:  Well, let me make an analogy.  Mutual

         16      funds, if you look at large public -- large cap mutual funds

         17      -- in a hedge fund world we sometimes refer to them as closet

         18      indexes.  If you look at their portfolio versus the portfolio

         19      of the index, there's a tremendous amount of overlap, 60, 70,

         20      at times 80 percent.

         21                So the real value added of the -- and that portion

         22      of the money in an index fund could be managed virtually for

         23      free.  So the value added of the typical mutual fund is on a

         24      very small portion of the capital and if you look at the --

         25      so the value added is stocks that aren't in the index they

          1      may not have in their portfolio.  Stocks that are not in the

          2      index they may add to their portfolio.

          3                And if you really break it down, the typical mutual

          4      fund turns out to be an index fund for 60, 70, 80 percent of

          5      its capital and then a long/short equity fund for a smaller

          6      balance.  In terms of fees -- and that's what the hedge fund

          7      is.  The hedge fund is a small amount of capital that's

          8      strictly focused on value added.

          9                Hedge fund managers don't put anything in their

         10      portfolio that they don't think is going to make money and

         11      add some value.  They don't put securities in there to

         12      maintain any index or to be sure they don't deviate from

         13      index.  So there's a much stronger focus on value added and I

         14      think that's what the money management business really needs.

         15                MR. PLAZE:  Mr. Swensen, the hedge fund performance

         16      fees would seem to be structured to reward risk taking and

         17      that's why the fulcrum fee arrangements are required for

         18      mutual funds.  There is rewards on the upside and there's

         19      penalties for the downside.

         20                You have written about the need to structure an

         21      investor's relationships with his or her money managers in a

         22      way to align interests.  Does this concern you at all in

         23      terms of managing or someone managing to a particular risk-

         24      adjusted return?

         25                MR. SWENSEN:  Yeah.  I think you have to worry

          1      about the 20 percent profits interest in the absence of other

          2      important parts of the deal and the thing that we really

          3      focus on at Yale, and it was something that Michael referred

          4      to in his description of deal structure, was co-investment by

          5      the general partner.

          6                We care enormously about having the general partner

          7      have a significant amount of money side by side with us

          8      because that moves the equation away from giving the manager

          9      an option, you know, if I win, I get 20 percent, if I lose,

         10      it doesn't cost me anything, to a situation where if the

         11      manager is side by side with us, if they win, they get gains

         12      on their investment plus the 20 percent of profits and oh, by

         13      the way, if they lose, they lose some of their own money.

         14                So there is a much greater symmetry of interest

         15      when the manager has a significant investment along with the

         16      University.

         17                I'd like to push back a little bit on something

         18      that George said.  He was talking about the notion that hedge

         19      fund managers get paid for value added.  We try very hard to

         20      make that the case but I don't think it's the case in the

         21      standard deal.  

         22                If you get 20 percent of the profits, 20 percent

         23      above zero, that's more than 20 percent of the value added

         24      because our money has an opportunity cost and the opportunity

         25      cost of our money is not zero.  So the profits interest ought

          1      to come after the manager has given the investor a return

          2      that's equal to the opportunity cost of funds.

          3                Now, that's a difficult thing to measure.  What

          4      we've tended to do -- and most of these arrangements were

          5      negotiated years ago with the U.S. Treasury was higher -- was

          6      share profits after a return of the one year Treasury.  Now

          7      that it's barely visible with a magnifying glass, that's not

          8      much of a hurdle but maybe it will be again some day in the

          9      future.

         10                MR. HALL:  And I would agree with that but that's

         11      just convention.  I mean, an alternative to 20 percent would

         12      be 22 percent over some hurdle.  I mean --

         13                MR. TANNENBAUM:  20 percent over some hurdle.

         14                MR. HALL:  That's probably why we're not managing

         15      any money for you.

         16                (Laughter.)

         17                MR. GLASSMAN:  David, what are the typical co-

         18      investment rates when you do that?

         19                MR. SWENSEN:  You know, it really depends on the

         20      nature of the manager's financial circumstances.  We're in

         21      situations where the manager has a co-investment that's

         22      larger than the University's and we're usually a pretty big

         23      player.  And there have been other circumstances where the

         24      managers have essentially no net worth and they mortgage

         25      their houses to make a co-investment.  And there, tens of

          1      thousands or hundreds of thousands of dollars is hugely

          2      significant to them.  In other cases, it's tens of millions

          3      or even hundreds of millions of dollars of co-investment.

          4                So the most important criterion for us is that it's

          5      a significant amount of their net worth.  Particularly in

          6      instances where the general partner doesn't have substantial

          7      means, we'll suggest that what they do is take any profits

          8      interest that they earn and reinvestment it in the fund until

          9      that becomes a material amount.

         10                MR. PLAZE:  Let's talk about conflicts for a

         11      moment.  The high watermark concept also raises some issues

         12      there.  For managers managing two funds, one of which has had

         13      substantial losses so that there's no chance of a performance

         14      fee, is there a concern or do you have a concern, Mr. Simon,

         15      that the manager would be incentivized to spend all of his

         16      time and energy and ideas on the fund for which there is an

         17      opportunity to make a performance fee?

         18                MR. SIMON:  I think the question as you've phrased

         19      it is really as a manager runs simultaneously two funds, one

         20      that he sort of loses interest because performance is not up

         21      to snuff and two, his other fund is -- from our perspective,

         22      the way we run our money, that would not be a manager we

         23      would choose.  We want a manager that is focused and

         24      committed to his strategy.

         25                There are some managers that have gotten very large

          1      that have basically lured away talent to offer other profit

          2      centers within their organizations and if the due diligence

          3      and monitoring says that the manager they've hired is a

          4      quality manager, that would be okay but it's a different

          5      thing than you've proposed.

          6                We would basically not invest with a manager that

          7      has simultaneous partnerships.  The only kind of managers

          8      that would have two partnerships, which you tend to see

          9      today, is basically those that have onshore and pursue

         10      offshore for different types of investment partners.

         11                MR. PLAZE:  So that they're managing basically on

         12      the same strategy so you wouldn't see that situation where

         13      you have one significant losses and the other up.

         14                MR. SIMON:  No.  Now, I would say early in this

         15      industry, and there maybe some on this table or not too many

         16      that are of my age -- lucky for them -- there were managers

         17      that would set up with a high watermark, fail to produce,

         18      close down the partnership because they would never earn back

         19      what they needed to pay back their investor, and reopen a

         20      year later with a new partnership.

         21                I think that is no longer something that is in

         22      fashion.  The institutions and fund of funds are far more

         23      sophisticated today and there's a lot of talent to pick from. 

         24      That was something that was early on and I think it was best

         25      demonstrated probably in '87 when most of the merger ops got

          1      killed and reopened a year or two later in a new partnership. 

          2      But we don't see that anymore and I believe David you

          3      probably don't see that anymore, either.

          4                And I just also would like to say David is correct. 

          5      One of the due diligence questions of anybody that goes out

          6      to make a manager selection is we want to see their

          7      commitment, their fire, and most importantly, the majority of

          8      their net worth alongside their investor's.  Without that,

          9      there is no reason to invest.

         10                MR. PLAZE:  Anybody -- of course, the other

         11      conflict issue is side by side management of hedge funds with

         12      mutual funds and other managed accounts that don't have those

         13      types of performance fees and significant conflicts.

         14                Now, there are some conflicts that are measurable

         15      and discoverable by the regulator such as allocation of

         16      trades but the type of conflicts in terms of allocation of

         17      time and energy, that's very hard to measure and even harder

         18      to bring enforcement cases against.

         19                Any suggestions on how we, as a regulator of many

         20      of these advisors now in this business, need to deal with

         21      this issue or is it simply a disclosure matter to clients in

         22      the mutual fund that this may in fact occur?

         23                MR. HALL:  Well, I don't have any particular

         24      solution to that issue.  I'm sorry if I interrupted.  But I

         25      think the first thing is disclosure.  I mean, the question is

          1      when someone invests with a management company, they're

          2      investing with a specific portfolio manager or the company

          3      and all its resources that it can bring to bear.

          4                If the non-performance fee money has a portfolio

          5      manager and there's a Chinese wall between the other

          6      portfolio managers, that may be one solution but I don't

          7      really have any particular solution to that problem.

          8                MR. PLAZE:  Mr. Karoubi?

          9                MR. KAROUBI:  First, while there are relatively new

         10      and relatively small problem in terms of numbers and a lot of

         11      companies who have tried to retain top quality traditional

         12      traders by letting them run hedge funds on the side have very

         13      often got very sorry to have done it because simply as a

         14      hedge fund manager, if he -- once becoming a hedge fund

         15      manager, being good enough, this manager generally is leaving

         16      the company and creating his own company because he is

         17      keeping that entire management fee which George says it's not

         18      relevant but George, when you are 5 or $6 billion, I'm sure

         19      that is little crumbs you can buy your shopping with at the

         20      end of the day.

         21                And very often, the fee structure is more I would

         22      say prone to trigger entrepreneurship than to leave those

         23      manager turn into quality hedge fund manager within the

         24      mutual fund company and we have seen some of the best and

         25      brightest hedge fund manager actually coming out of these

          1      structure.

          2                Disclosure certainly is there.  I'm not a lawyer

          3      but it was an intriguing question and since my name -- I call

          4      my lawyer to ask what he thought of it and he said, you know,

          5      I've heard of breach of fiduciary duty, reputation risk and

          6      all sorts of issues linked to it.  So I think that if a

          7      manager start to divert the best long deals, the best

          8      position into his hedge fund and deprive the traditional

          9      investor from running in a way two different portfolio, the

         10      profitable one within the hedge fund and the less profitable

         11      one into the long only, I think this manager will be faced to

         12      a very, very serious lawsuit by breach of fiduciary duty.

         13                So I don't see how it is a real problem.  Maybe it

         14      is but I don't see it.

         15                MR. PLAZE:  Well, in addition to the allocation of

         16      time and energy you have the ability within a leveraged

         17      situation with a hedge fund to manipulate that market with

         18      the long positions and the mutual fund by just a little bit

         19      and cause the hedge fund to make a lot of money and the

         20      manager to make a lot of money.  And those are very subtle

         21      things difficult to uncover and difficult for an investor to

         22      uncover.

         23                Now, some people have suggested two solutions, one,

         24      which everybody is going to give me a Bronx cheer for, which

         25      is eliminate -- subject hedge funds to similar restrictions

          1      on performance fees as mutual funds are.  The other is to

          2      eliminate the restrictions on mutual funds and allow them to

          3      be managed or performance compensation similar to that which

          4      hedge fund managers have.

          5                Any thoughts, comments on that -- those

          6      alternatives?

          7                MR. SWENSEN:  Well, one of the huge problems in the

          8      mutual fund industry is that fees are way too high.  So

          9      giving the mutual fund industry an opportunity to charge more

         10      for the poor results they deliver I think is a terrible

         11      solution.

         12                (Laughter.)

         13                MR. BERNARD:  I think it would contribute to the

         14      collapse of the mutual fund industry.  I think that the

         15      incentive fee is in part a very strong incentive to keep the

         16      industry small.  I think it is a huge barrier to growth in

         17      the business and if mutual funds charge incentive fees, then

         18      that industry would get smaller.

         19                MR. PLAZE:  Well, there's another school of thought

         20      that if we actually did that, nothing would happen because so

         21      few funds charge performance fees, even the ones that we have

         22      that are allowed today, that it would be calling a party and

         23      nobody arriving.

         24                On that note, our time has expired and I'd like to

         25      thank everyone for their participation today.  I thought this

          1      was a very interesting discussion.  I hope you in the

          2      audience and on the web enjoyed it as much as I did.

          3                (A recess was taken.)

          4                MR. SCHEIDT:  The fourth panel today deals with

          5      issues associated with valuation allocation, use of

          6      commissions and personal trading.

          7                I'll start out first by introducing myself.  I'm

          8      Douglas Scheidt.  I'm an associate director and chief counsel

          9      in the Division of Investment Management of the SEC.  We have

         10      a good group of panelists today and I'll introduce them

         11      starting from my immediate left.

         12                On my immediate left is Tony Artabane.  He's a

         13      partner at PricewaterhouseCoopers in New York and he leads

         14      their global alternative investment management team.  To his

         15      left is Professor Andrew Lo.  He's a professor at the MIT

         16      Sloan School of Management and director MIT's laboratory for

         17      financial engineering.  

         18                Next to Professor Lo is Richard Phillips.  He's the

         19      senior partner at Kirkpatrick & Lockhart and head of the

         20      securities group in their San Francisco office.  And to his

         21      left is Robert Zack.  He's a senior vice president and

         22      general counsel of OppenheimerFunds in New York.  

         23                On my right is Steven Vine.  He's a partner at Akin

         24      Gump Strauss Hauer & Feld and he heads the corporate and

         25      securities group in their New York office.  Next to Mr. Vine

          1      is Mike Dieschbourg.  He's a principal of Silver Creek, LLC

          2      an unregistered hedge fund.  He also serves as an independent

          3      director to a registered closed fund of hedge funds.

          4                And to his right is Professor Bing Liang.  He's an

          5      assistant professor of finance at the Weatherhead School of

          6      Management, Case Western Reserve University.

          7                And at that, we will move to the panel.  I'd just

          8      like to say at the beginning, after listening to the first

          9      panel today I was very struck by how all is well and fine in

         10      the hedge fund industry and I figured that there was no sense

         11      in continuing with the panel today, but since we're all here,

         12      I thought we'd go ahead.

         13                It seemed to me that we were sort of in a Lake

         14      Woebegone situation where all hedge funds were achieving

         15      above average returns relative to other hedge funds and all

         16      hedge funds practices exceeded the best practices in the

         17      industry so that there was really nothing to be concerned

         18      about.

         19                Well, the issues that we're going to talk about

         20      today are issues as to which the abuses have occurred in the

         21      asset management industry, valuation, allocation, use of

         22      commissions, personal trading issues.  This is where the

         23      funny business is in the asset management industry and we

         24      want to talk about some of these issues in the hedge fund

         25      context and in the fund of hedge funds context.

          1                So the first topic today that I want to discuss or

          2      focus on is valuation and I want to start off by saying --

          3      making some points about why valuation is important.  If the

          4      valuations are inflated, then investors pay too much when

          5      they invest in the fund or when they redeem, they get too

          6      much to the detriment of the remaining investors.

          7                If the values are too high, the manager's fee is

          8      too high since the fees are tied to the assets -- the level

          9      of the assets.  And if the valuations are too high, then the

         10      fund's performance will be inflated and investors who rely on

         11      performance to invest will be misled.

         12                There are several incentives in existence for hedge

         13      fund managers to inflate the value of their assets.  One,

         14      they frequently calculate their own assets or their own

         15      valuations and inflating their values will generally permit

         16      them to receive higher fees.  And inflating their assets may

         17      allow them to earn their performance fees more easily.

         18                It will also inflate the fund's performance which

         19      makes it easier for the hedge fund manager to market the fund

         20      and to raise additional money and to raise additional money

         21      for other hedge funds.  Inflating the values may also

         22      discourage existing investors from redeeming their shares and

         23      inflating the value may allow the manager the time to hide

         24      losses temporarily, or perhaps permanently. 

         25                And so several factors contribute to overstatements

          1      of valuation.  One is the lack of transparency of the

          2      underlying investments, lack of independent market prices for

          3      many of the investments held by the hedge funds, lack of

          4      independent pricing services to provide pricing for those

          5      securities.  Audits, if conducted at all, are only conducted

          6      annually and auditors don't secondguess the valuations of the

          7      hedge fund managers.

          8                The managers aren't really required by law to value

          9      their assets in any particular way except in a manner that's

         10      consistent to their disclosure to investors, and valuations

         11      may be provided to them by entities that may have a financial

         12      incentive to ensure that the hedge fund manager is

         13      successful, like a prime broker or others who have economic

         14      relationships with the hedge fund manager.

         15                So with that introduction, I'd like to get the

         16      panelists to talk about how hedge funds value their interests

         17      and how that differs from, let's say, how mutual funds value

         18      their interest.

         19                So start it off.  Dick, do you want to talk about

         20      mutual funds?

         21                MR. PHILLIPS:  Yeah.  I'll start off talking a

         22      little bit about mutual funds and how mutual funds as well as

         23      other registered investment companies are required to value

         24      their assets.

         25                As you know, Doug, valuation of portfolio

          1      securities is a focal point of regulation under the 1940 Act, 

          2      in significant part, because NAVs are critical to the pricing

          3      process for sales and redemptions.  But the Commission has

          4      made clear that the same valuation requirements apply to

          5      closed-end funds because, for the reasons you pointed out,

          6      particularly with the hedge funds, NAV, proper pricing is

          7      critical to the accuracy of performance figures and of course

          8      it's used to determine fees payable to the managers.

          9                Under the '40 Act, funds are required to value

         10      securities by either using market value when quotations are

         11      readily available and fair value when they're not available.  

         12      And fair value is as determined in good faith by a fund's

         13      board of directors.

         14                From a regulatory point of view, market value

         15      determinations which are based upon information fed in by

         16      pricing services have largely been trouble-free.  The key

         17      challenge is to develop a meaningful monitoring system to

         18      monitor prices which are stale, out of line with the market

         19      and to develop controls over portfolio manager overrides. 

         20      That's the issue in connection with market value

         21      determinations.

         22                Fair value determinations from a regulatory point

         23      of view have been much more difficult and have received a lot

         24      of attention.  A fair value determination is not optional. 

         25      They're required whenever it's determined that market

          1      quotations, reliable market quotations are not readily

          2      available.  

          3                They're not readily available often for restricted

          4      securities, illiquid securities, thinly traded securities,

          5      securities, particularly foreign securities, where a

          6      significant event has taken place between the close of the

          7      primary market and the time that the NAV is calculated.

          8                And there are other situations like significant

          9      market fluctuations, et cetera, where fair value

         10      determinations have to be made in order to comply with the

         11      1940 Act.

         12                The SEC has said repeatedly that fair value means

         13      the price that a fund might reasonably expect to receive upon

         14      current sale.  Current sale means not intrinsic value, true

         15      value, not the value that you might reasonably expect to get

         16      when you expect to sell it.  It's the price that you can get

         17      upon current sale.  Often, as a rule of thumb, current sale

         18      means the price you could get if you can sell it within 7

         19      days.

         20                The Commission has also made clear that formulas do

         21      not work with fair value determinations.  Instead, there's a

         22      lot of emphasis on consideration of all relevant factors,

         23      whatever they are, fundamental as well as market factors.

         24                Because fair value determinations require a lot of

         25      judgment, the Commission and the Staff have focused on the

          1      process and the process is far more important than specific

          2      rules as far as understanding the valuation regulation under

          3      the 40 Act.  Some of the rules I and others of my colleagues

          4      disagree with but what we don't disagree with is the emphasis

          5      that the Commission and the Staff have placed on the process

          6      for making these determinations. 

          7                Now, neither the statute nor the Commission rules

          8      specify that a fund has to have a process, has to have rules

          9      and procedures but over the years the Staff has placed

         10      considerable emphasis on the existence of detailed policies

         11      and procedures to valuing securities.

         12                And in fact, they've said hey, Mr. Mutual Fund, the

         13      statute says that securities must be valued at their fair

         14      value as determined in good faith by the board of directors

         15      and if the directors are not in a position to be on hand at

         16      4:00 every afternoon to make the fair value determinations,

         17      then they can delegate only if and only to the extent they

         18      have approved detailed rules and procedures.

         19                If the rules and procedures are not detailed, then

         20      the amount of delegation is necessarily circumscribed.  And

         21      what this emphasis has done is to create within most mutual

         22      fund complexes a discipline and a system of oversight.  That

         23      discipline is derived from the need for detailed policies,

         24      procedures, rules which identify the situations when fair

         25      value determinations must be made, which specify how they are

          1      made and specify the controls that are placed on the making

          2      of those determinations.

          3                A primary control is to recognize that the

          4      portfolio manager, while having the most expertise with

          5      respect to a particular security which requires a fair value

          6      determination has to be monitored, that portfolio managers

          7      fall in love with their favorite securities and they can't

          8      believe sometimes what the market, what the crazy market,

          9      what the irrational market has done to those securities.

         10                And so there has grown up within the fund industry

         11      a system of using valuation committees, sometimes having a

         12      membership that consists of at least one fund director and

         13      the rest staff, that reviews fair value determinations

         14      according to a detailed set of rules and valuation committees

         15      have been a very important part of the controls. 

         16                In addition, the Commission keeps emphasizing that

         17      boards of directors cannot delegate their responsibilities

         18      even though they can delegate day-to-day administration and

         19      therefore they have to continually review rules, they have to

         20      receive reports of fair value determinations and act upon

         21      changes in the rules when changes are required.

         22                In addition to the board of directors and the

         23      valuation committees, we have the auditors exercising

         24      oversight at the time of the audit and you have very

         25      importantly in recent years a relatively rigorous staff

          1      examination process which occurs on a more or less regular

          2      cycle for the larger fund complexes and usually looks very

          3      carefully at the process for making fund valuations of

          4      portfolio securities and if the process appears less than

          5      adequate, then there's an extensive examination.

          6                This combination of discipline and oversight and

          7      accountability I think gives the fund industry and investors

          8      in that industry a maximum degree of assurance that while

          9      prices may not be perfect, at least there's a fair amount of

         10      attention, a fair amount of intelligence and a fair amount of

         11      discipline that goes into the process and therefore the

         12      prices at which they buy and sell securities, the prices at

         13      which or the numbers at which performance is measured, and

         14      how the fees are paid represent a high degree of integrity

         15      and consistency, and that's all investors have a right to

         16      expect.

         17                MR. SCHEIDT:  So hedge funds don't have a lot of

         18      those controls, do they?  What kind of -- there's no board of

         19      directors, there's no requirement for an audit.  How does the

         20      hedge fund industry -- how do hedge fund managers value their

         21      assets?  They frequently -- or some may not invest in

         22      securities for which market quotations are readily available. 

         23      How is it that they value their assets and what controls, if

         24      any, are in place?

         25                MR. ZACK:  Doug, that's actually a complex question

          1      to answer because there are of course registered hedge funds

          2      and those are the types of funds that OppenheimerFunds

          3      currently offers.  We also have a hedge fund affiliate,

          4      Tremont Advisors, which offers other types of private hedge

          5      funds.

          6                Surprisingly, I think you will find that more and

          7      more of the hedge fund industry is moving closer to the type

          8      of model that the mutual fund industry has been using for

          9      pricing and that I think most hedge fund managers do rely on

         10      market quotations obtained from reasonable and reliable

         11      sources to value their securities on a daily basis, if not

         12      providing that information for daily net asset value

         13      calculations.

         14                And what we have done -- again, it's a model that

         15      we have followed to try to provide a reasonable degree of

         16      assurance and comfort to investors not only in our registered

         17      hedge fund products but in the other hedge funds that are

         18      offered by our affiliate.  

         19                To assure the quality of the valuation process, we

         20      have used and are using and require underlying managers to

         21      use a third party service to receive those daily valuations

         22      from the hedge fund managers, to review those valuations

         23      against market quotations and other valuations obtained from

         24      the same sources that we price our mutual funds against, and

         25      to compare those to see whether they meet certain stress test

          1      limitations.

          2                I don't think that's necessarily the answer for

          3      everyone in the industry.  I don't think that's necessarily

          4      something that needs to be required by regulation.  It is a

          5      particular model that we have found a useful way and a good

          6      way to deal with offering registered hedge funds and to

          7      provide the necessary comfort for the underlying valuations

          8      of those underlying managers.  Additionally, that helps us to

          9      meet our diversification testing requirements. 

         10                So I think that's one possible model, but I think

         11      if you look at the hedge fund industry in general, there's

         12      probably general agreement in this room that many of the

         13      managers, certainly the larger managers are using market

         14      quotations for their valuations of their portfolios.

         15                MR. DIESCHBOURG:  I would agree with that.  Mike

         16      Dieschbourg from Silver Creek.  When you think about the

         17      valuation process, we're an unregistered fund to funds and

         18      it's important for us to get the proper valuation from our

         19      underlying managers.  But we use them not only from a

         20      standpoint of proper valuations but that's also part of the

         21      investment management and due diligence process.  

         22                We want to make sure that they're getting proper

         23      pricing for the underlying securities, that they have a

         24      process and procedure in place and as a fund to fund, it's

         25      our responsibility to make sure that that's happening so we

          1      can get the proper pricing.

          2                And just as you have the opposite side of the coin

          3      of wanting to have possibly the mispricing of securities, we

          4      want to have securities properly priced because we want the

          5      fees to be accurate.  We want the volatility to be correct. 

          6      From a portfolio management standpoint, it's our

          7      responsibility as fiduciaries to manage the portfolio from a

          8      construction standpoint to the best of our ability and to our

          9      investment objectives.

         10                So there are a lot of things that we do, such as

         11      having an audit since inception in our firm and having the

         12      auditors actually review both the onshore and offshore funds

         13      and seeing -- looking for discrepancies because you're

         14      running them -- you have the CFO in the firm checking --

         15      making sure that they're independent of the portfolio traders

         16      and the portfolio managers.  

         17                We have an investment committee so we're looking at

         18      the prime brokers to get information when we do our due

         19      diligence checks on these managers, are they pricing them

         20      properly.  We do have registrations with the various other

         21      industries' organizations.  We do have a third party

         22      administrator for the offshore funds.

         23                So when you think about what we're doing -- and we

         24      also file under the fraud provision because whether you're

         25      registered or unregistered, based upon the acts that are out

          1      there today, there's plenty of regulations that if you're

          2      creating fraud you're creating fraud.  And all of us are

          3      trying to run a good business and to grow our business and

          4      whether you're registered or not, are subject to follow 99

          5      percent of all the same laws.

          6                MR. SCHEIDT:  Well, Mike, how representative is

          7      your situation and yours, Bob, where it appears from what

          8      you're saying that the underlying hedge funds are willing to

          9      provide you with information about the securities that they

         10      are holding so that you can assure yourself that the actual

         11      valuations for those holdings are in the ballpark?

         12                What else -- what we've been hearing is that the

         13      underlying hedge funds aren't willing to provide that

         14      information to anybody in most cases so are your

         15      circumstances different?  Are they unusual?  What are they?

         16                MR. ZACK:  Well, they may be slightly unusual in

         17      the sense that this is a fairly new model but I think, again,

         18      the underlying hedge fund managers don't provide us the

         19      portfolio data daily to preserve their lack of transparency

         20      for legitimate investing reasons.  

         21                Providing it to a third party, however, as a

         22      condition of our -- in our due diligence process of using

         23      them within our fund to fund structure, they are willing to

         24      do that.  That is one of the conditions of their

         25      participation in the program and they have been willing to do

          1      that.

          2                The larger managers, even smaller managers,

          3      managers who are willing to get onto the program, they have

          4      to meet a lot of due diligence tests but they recognize that

          5      this is the way the industry is gravitating, that degree of

          6      transparency is something that you're going to see more of, I

          7      think.  Whether, again, it's the model that I suggest or

          8      another model, I think that it's there.

          9                As Mike said, it's also very key that the -- there

         10      are very similar processes for compliance review at the hedge

         11      fund level that are reviewed in the due diligence process by

         12      us when we go in to select these managers.

         13                Additionally, the auditors annually do audit the

         14      portfolios just as they do with mutual funds.  Mutual fund

         15      auditors do not do an audit more frequently than once a year,

         16      typically and they will go and test some of those securities

         17      prices as well.  So you have the same type of protection in

         18      that sense from the audit process.

         19                MR. PHILLIPS:  Let me raise a question.  If in fact

         20      there are no valuation problems in the hedge fund industry,

         21      then it raises a question whether there's a need for

         22      valuation regulation in the mutual fund industry unless you

         23      think that mutual fund managers are more prone to fraud and

         24      abuse than hedge fund managers.

         25                MR. VINE:  Well, Dick, part of the answer to that

          1      may be that the hedge funds have actually looked to the

          2      mutual fund standards for their best practices.

          3                MR. PHILLIPS:  I think that's right.

          4                MR. VINE:  When we write the disclosure documents,

          5      we will often lift out provisions from the statute,

          6      provisions from the rule and build those into the partnership

          7      agreements because this is an area in which I don't think

          8      hedge fund managers regard being unregulated as providing any

          9      particular license.

         10                I think unlike performance fees, unlike avoiding

         11      some of the leverage restrictions, valuation is not an issue

         12      where they look at the regulated work as having inappropriate

         13      approaches to the issues.

         14                MR. PHILLIPS:  I think the question is whether in

         15      the absence of regulatory requirements there's enough

         16      incentive for hedge fund managers to spend the money on the

         17      compliance systems and the time it takes to set up and

         18      administer those systems as you would do if it were required

         19      as a matter of regulation.

         20                MR. ZACK:  Well, competition is a great driver of

         21      integrity and I think that in order to get onto platforms

         22      where managers have not been present before, they recognize

         23      the need to do this and as Steve said, this is -- the model

         24      that they're following is the mutual fund model.  

         25                I am missing a valuation committee meeting right

          1      now as we're speaking, by the way, for my own complex so I

          2      know these processes are very important in the mutual fund

          3      industry.  I don't want to see them removed.  And I know you

          4      were asking that as a rhetorical question rather than a --

          5      but I do think that the hedge fund industry does recognize

          6      the importance reputationally also of providing good prices.

          7                You don't want to go back after your audit to

          8      discover that you've had significant pricing errors and have

          9      to recalculate, redo -- delay further your tax returns, your

         10      K-1s and everything else because of a pricing error that

         11      occurred during the course of the year that shows up in an

         12      audit.

         13                So there's a tremendous reputational stake that

         14      they have in the integrity of the pricing process as well.

         15                MR. DIESCHBOURG:  Part of that reputation risk is

         16      also a business risk because we value the performance fee

         17      structure and since a lot of us have a substantial amount of

         18      our own capital invested in it, and we're actively protecting

         19      that capital to make sure the valuation is proper and also

         20      protecting the performance fee because that is an incentive

         21      that drives the talent for the intellectual capital that

         22      helps drive this business.

         23                So we have an inherent value at stake which is our

         24      own capital and our own integrity and our own reputation and

         25      our businesses as we go forward.

          1                MR. PHILLIPS:  What controls do you find in hedge

          2      fund organizations over portfolio manager determinations of

          3      portfolio securities valuations and overrides of information

          4      received from the pricing services?

          5                MR. VINE:  I think -- two-part answer to that. 

          6      Certainly, there's a distinction between the domestic arena

          7      and the offshore arena.

          8                In the offshore world, by and large pricing is done

          9      primarily on an out source basis by third party

         10      administrators so you certainly have some checks and balances

         11      there.  Domestically, I think the real distinction is between

         12      the large organizations and the small ones.  

         13                The large organizations tend to have sophisticated

         14      robust accounting -- internal accounting staff who report

         15      directly to the proprietors of the firm.  We're now seeing a

         16      move toward having risk officers who are associated with that 

         17      function and who get actively involved in some of the

         18      difficult pricing issues.  We are not seeing that in the

         19      smaller firms but I think in the larger ones, competition is

         20      pushing in that direction.

         21                MR. SCHEIDT:  I was going to say there are issues

         22      about side by side management of hedge funds and mutual funds

         23      but this is an area probably where there's a benefit, where a

         24      mutual fund manager enters the hedge fund business, has this

         25      robust system, has this discipline that the '40 Act has

          1      imposed on it and it will be sensitized to these kinds of

          2      issues and hopefully will carry them over into the hedge fund

          3      valuation.

          4                MR. ARTABANE:  I would just echo Steve's comments

          5      and Bob's comments with respect to best practices and the

          6      businesses evolving.  It's very typical in larger

          7      organizations where there is a dedicated focus, much like a

          8      institutional traditional manager, if you will, in terms of

          9      pricing, independent checks and balances on the pricing and

         10      review by the manager.

         11                So I think the standards are moving but the

         12      industry is really bifurcated into smaller, middle and larger

         13      players and the control systems for a very small hedge fund

         14      may not be the same as in a larger hedge fund.  

         15                Having said that, as we heard early this morning,

         16      if you look at the hedge fund industry, about -- I think the

         17      number was about 35 to 40 percent is a long/short strategy,

         18      equity strategy.  And those are, by and large, readily

         19      tradeable securities when there are market prices.

         20                The prime brokers will usually see all the

         21      positions in those types of strategies.  They offer somewhat

         22      of a check and especially if they extend margin leverage

         23      because they're valuing the book for collateral purposes, if

         24      you will.  So there's some check and balance there.

         25                And then because those securities are readily

          1      available to price in most instances, the outside

          2      administrators or the internal processes will be able to

          3      validate that.

          4                Now, is there a formal process of reject pricing,

          5      you know, a manager rejects a price that comes up as in a

          6      mutual fund?  In the larger organizations, there are.  In the

          7      smaller organizations typically there is not, but that

          8      usually is highlighted, that particular issue and what is

          9      done.  And managers by and large do not want to have a

         10      problem either inter-month -- I'd say between months they are

         11      redeeming or in their annual audit.

         12                So oftentimes we will be contacted or the prime

         13      broker or the administrator will be contacted on a particular

         14      issue to get advice or counsel in Steve's case and I'm sure

         15      he's had a lot of questions on fair value.  So you have to

         16      look at the industry in terms of the sophistication of the

         17      people managing the money, the number of people and the other

         18      systems.  

         19                When you get into a very complex strategy, that's

         20      not a very easy one to price.  There are no -- perhaps no

         21      good market values for some of the strategies, the stress

         22      debt, for example, or a sophisticated mortgage-type strategy. 

         23      So there has to be other controls built in and that's where

         24      you get the question of how easy is it for someone to check

         25      that price and validate that price.  And, you know, you need

          1      more robust controls so in most of those situations there are

          2      more robust controls.

          3                MR. SCHEIDT:  What's the role of the auditor in

          4      this process for hedge funds that do get audited?  What does

          5      the auditor --

          6                MR. ARTABANE:  Well, it's a good question.  It's

          7      not merely not objecting to management, as you summarized,

          8      but the auditor does not --

          9                MR. SCHEIDT:  Second guessing.

         10                MR. ARTABANE:  Second guessing.  Okay.  We do

         11      secondguess.  We're objective and we secondguess.  What we

         12      don't do is substitute ourselves as an appraiser or an

         13      appraisal expert.  I don't put myself in the place of George

         14      to try to understand and appraise a particular mortgage-

         15      backed security, you know, very esoteric, IO Trust or

         16      whatever, but I have to understand the process that the hedge

         17      fund goes through and I have to determine that that process

         18      is reasonable.

         19                Now, the current audit guidance is audit guides of

         20      investment companies and, see the word investment companies,

         21      it covers '40 Act funds, it covers hedge funds.  However, if

         22      I don't believe I have the sophistication to understand a

         23      particular model if a model is used, then I should consider

         24      under other audit guidance, SAS-73, to be specific, using an

         25      expert.  And we, as the other big four firms, have global

          1      risk management units that have people who used to trade with

          2      George and understand the markets and that type of thing so

          3      we will have them come in and look at the model to rely on

          4      that.

          5                So it's not simply accepting.  It's understanding

          6      the process, it's going through it, it's looking at the

          7      documentation but if a judgment is made by management and

          8      it's a matter of -- it's a relatively reasonable accepted

          9      model or there's some discretion in the discounted cash

         10      flows, if they're within a band of what are experiences in

         11      the marketplace, we will accept that and make sure the

         12      appropriate disclosures are made in the financial statements.

         13                And sometimes there's push back and forth as to the

         14      level of disclosure but it's very similar to a mutual fund

         15      when you have a fair value issue.

         16                But that's the process.  So I don't want to give

         17      the impression that it's passive.  There is a process but we

         18      are not going to evaluate as an appraiser.

         19                MR. SCHEIDT:  Do you check the valuation of 

         20      every --

         21                MR. ARTABANE:  Well, that's a good question.  Joel

         22      I think gave a high level summary of the difference between

         23      auditing a mutual fund and auditing a hedge fund.

         24                You're required by the audit guidance -- and also

         25      that's part of the regulatory requirements.  I'm not sure at

          1      what section of the Act that is required.  But you're

          2      supposed to, in a mutual fund audit, confirm the assets that

          3      you're in 100 percent and value the assets that you're in

          4      independently from the manager 100 percent.  That's a

          5      requirement of the law.  That's what an audit does.

          6                Having said that, the audit guide that was revised

          7      and effective May 1, 2002 understands that the control

          8      structures in funds, which is a typical fundamental principle

          9      of auditing, is to understand the control structure and

         10      design an audit sufficient so that you can gain comfort as an

         11      auditor on the assertions of management which flow up into

         12      the financial statements.  So test sampling is a generally

         13      accepted procedure when auditing.

         14                In the mutual fund area, you're required by law to

         15      do 100 percent at year-end, even if you test the systems and

         16      determine that the systems are very reliable.  

         17                In the hedge area, recognizing that the requirement

         18      is not regulatory driven, you do not necessarily need to

         19      confirm 100 percent or test 100 percent of the prices but you

         20      still have to evaluate the system and if your system is less

         21      control-oriented, then you'll do more substantive testing and

         22      that's the words Joel used this morning, just to describe at

         23      a high level, they're more substantive in nature, audits of

         24      hedge funds.

         25                In many cases, auditors choose to confirm 100

          1      percent of the positions.  As a matter of fact, it's kind of

          2      rare that you don't.  It has to be an extremely well-

          3      controlled environment.  And again, these are my views, not

          4      the views of PricewaterhouseCoopers.

          5                But in terms of valuation, again, it may be very

          6      efficient to test 100 percent.  Frequently we test 100

          7      percent of the prices, particularly in the more sophisticated

          8      instruments and that is where you get into some of the

          9      subjectivity where you have a complex instrument or an

         10      illiquid instrument, where there are very few broker quotes

         11      out there or perhaps a counter-party quote.  And there is the

         12      determination of, Dick, is it market price as defined under

         13      the '40 Act, readily available market, or is it a fair value.

         14                And that's typically the more complex securities in

         15      the more complex areas so you have to look at what the

         16      process is in place, test it and make sure that the

         17      disclosure is reasonable.

         18                CHAIRMAN DONALDSON:  In a family of funds, we have

         19      the auditor reporting to the family fund manager or do we

         20      have a coordinated set of audits?

         21                MR. ARTABANE:  Yeah.  Let's just -- to set the

         22      guidelines, typically the U.S. hedge fund is a partnership in

         23      form or an LLC so there's a general partner or a managing

         24      member.  There is not a board of directors.  Offshore, there

         25      is a board of directors generally because it's a corporate

          1      format.

          2                So in the partnership agreement, the investor in

          3      the limited partner cedes to the general partner a wide

          4      degree of authority and fiduciary responsibility to

          5      administer the partnership's affairs.  So the auditor will be

          6      engaged by the general partner to audit the partnership and

          7      the report will go to the general partner and the limited

          8      partners.

          9                Now, we don't send them directly.  We give them to

         10      the general partner in most cases and they'll make a

         11      distribution probably along with the K-1s.  They try to get

         12      them together or shortly after.

         13                So a formal management report, if it's necessary,

         14      will be given to the general partner but the audit report

         15      will be a distribution report free to limited investors.

         16                CHAIRMAN DONALDSON:  So if you have a family of

         17      hedge funds --

         18                MR. ARTABANE:  Right.

         19                CHAIRMAN DONALDSON:  -- is each particular hedge

         20      fund getting audited in some respect or --

         21                MR. ARTABANE:  Yes.  Yes.  Well, again, when I say

         22      -- you're right.

         23                CHAIRMAN DONALDSON:  The auditor then is

         24      coordinating those audits?

         25                MR. ARTABANE:  When I say yes, it depends on the

          1      documentation because if the document says there will be an

          2      annual audit, which in most cases it says -- that's typical -

          3      - I think even today, the sensitivity, due diligence, it's

          4      going to be very hard to sell a product without an audit, at

          5      least an annual audit.

          6                Steve, I don't know if you would --

          7                MR. VINE:  Yeah.  We don't see hedge funds being

          8      formed without a requirement for an annual audit.

          9                MR. ARTABANE:  So to answer your question,

         10      Commissioner, the audit requirement would normally apply to

         11      each fund and each fund would be audited.  If there is a

         12      common control system, the auditor may take that into account

         13      and do cross fund testing, if you will, but at each period

         14      end there is some testing and perhaps 100 percent testing of

         15      the verification of the assets by confirmation and the

         16      pricing.

         17                MR. SCHEIDT:  I have a question about GAAP.  If

         18      these things are audited against GAAP or international

         19      accounting  standards, is there a fair value standard

         20      inherent in those principles?

         21                MR. ARTABANE:  Well, yes.  There is no one

         22      recognized method of fair value.  That's embodied in the

         23      regulatory literature under Section 2(a)(41).  I'm  little

         24      rusty on my mutual fund side.

         25                But it's recognized there's no one way to do it.  

          1      The interpretive letter, which was very well written, 2001

          2      interpretive letter, which Doug had a lot to do with on

          3      valuation, recognizes that, too.  But having said that, there

          4      is a process.  

          5                There is guidance that the SEC had put out for

          6      mutual funds and other investment companies in what were

          7      accounting series releases 118 on valuation and illiquid

          8      investments and 113 on restricted investments and then these

          9      current interpretive letters in 1999 and 2001.

         10                So there is a body of literature out there.  The

         11      audit guide has encompassed pretty much those standards in

         12      terms of you look at various things, you look at the models,

         13      you look at pricing.  If it's a private security that's being

         14      valued, you might look at a discounted cash flow, budget to

         15      actual, third party potential second round financing and

         16      competitor pricing.  Things like that you would do in a

         17      valuation.

         18                And management will look at that.  We would observe

         19      what management did.  We would look to see if it's reasonable

         20      and then is it documented.  That's part of the process.

         21                Now, having said that, there is a GAAP standard but

         22      there is a wide degree of applicability.  However, the

         23      offering document and partnership agreement govern whether

         24      you get a U.S. GAAP report, an unqualified report, and if

         25      it's audited in accordance with U.S. GAAS.  That's the

          1      typical requirement but there are some exceptions to that.

          2                MR. SCHEIDT:  And before we move on to the next

          3      thing, I just want to -- audits only focus on the portfolio

          4      as of a particular day in the year, isn't that right?  So

          5      audits don't necessarily reflect on how the hedge fund

          6      manager has valued its assets throughout the year.

          7                MR. ARTABANE:  Doug, you have to -- you're

          8      reporting on the balance sheet and on the profit and loss. 

          9      Now, because of the issue of capital subscriptions and

         10      redemptions and the potential for dilutions as you had

         11      explained earlier, you have to be sensitive to that as the

         12      auditor and look at the controls so you may test

         13      substantively the cash flows in and out, if you will, and you

         14      may look at the process at an interim date if there is a

         15      process, usually it's the same as of year-end reconciliation

         16      to the prime broker, et cetera, and determine that the

         17      process is reasonable to rely on those interim prices without

         18      doing a lot of testing.

         19                What you would consider, is there an independent

         20      administrator, is there an independent unit within the group

         21      that does the pricing, is there a very competent financial

         22      staff that does that.  And if you find that there isn't, you

         23      ought to do more pricing which is the substantive nature of

         24      the testing.

         25                But before I leave fair value, the one thing that's

          1      implicit is that these judgments are inherently subjective,

          2      it's usually disclosed very prominently in the financial

          3      footnotes that the fair value investments are subjective and

          4      inherent and could materially change based upon the actual

          5      factors that play out.

          6                So it is quite possible that you have a good

          7      structure, a good process in place, a fair value that's done,

          8      and then, you know, perhaps because of market changes a month

          9      later the market liquidity dries up.  You have a very

         10      significant depreciation when you go to sell those assets

         11      similar to what happened in 1998. 

         12                Liquidity shrunk.  It first started with the

         13      Russian securities.  Then it went to high yield.  Long-term

         14      capital happened, and then it went into mortgages and other

         15      types of asset classes where the liquidity that was there

         16      three months before wasn't there anymore, and pricing that

         17      was reasonably valid at the time it was made became, you

         18      know, substantial losses three months later.  So I just want

         19      to present that there are inherent subjectivities. 

         20                MR. ZACK:  Right.  But you have that in any

         21      situation, Tony, and that points out the importance of a

         22      process that would look at those fair valuations on an

         23      ongoing basis. 

         24                One little footnote to your remarks on valuations

         25      and the possibility of the effect of pricing errors at least

          1      the hedge fund-to-funds model by the diversification that you

          2      obtain in having a larger body of hedge funds, the ability of

          3      that pricing error in any one hedge fund to materially affect

          4      the valuation of the hedge fund-to-funds NAV is abated quite

          5      a bit. 

          6                So that's another protection that makes those,

          7      perhaps, a more palatable vehicle than was thought of in some

          8      of the remarks earlier today. 

          9                MR. DIESCHBOURG:  In addition, you also have

         10      holdback provisions usually when people withdraw from a fund. 

         11      Unlike a mutual fund which has daily liquidity, in a hedge

         12      fund-to-fund, you'll have a 10 percent holdback withdrawal so

         13      that when you settle up based upon the audit at the end of

         14      the year so that adjustments can be made. 

         15                MR. SCHEIDT:  Well, we have the benefit of some

         16      academics here.  There have been several academic studies

         17      that have called into question the accuracy of hedge fund

         18      statistics and hedge fund data, particularly performance data

         19      which is based on the valuation performed by hedge funds. 

         20                So if I could start with Professor Liang, you've

         21      written several papers on this topic.  Have you found

         22      relationships between audits and the quality and accuracy of

         23      hedge fund data? 

         24                MR. LIANG:  Well, I'd like to mention a few points

         25      here.  The first point is some funds are probably easier to

          1      calculate their asset value return than others.  I think my

          2      fellow panelists already mentioned this. 

          3                For example, on some unleveraged funds, you don't

          4      use short selling.  They don't borrow money.  They don't

          5      use -- positions.  Probably it would be easier to calculate

          6      the net asset value than the others. 

          7                And also, for some funds, investing in a variety of

          8      regions, countries, you can imagine, you know, they use

          9      different kinds of currencies.  There's different kind of

         10      trading times, and timings are different, so those funds

         11      probably would be harder to calculate the valuations. 

         12                So there are differences across funds.  I will not

         13      say they're all the same.  The other factor I would like to

         14      mention is the manager efforts.  You know, some funds they

         15      probably will have more manager efforts.  For example, if you

         16      have your personal investing in that, you'll be more keen to

         17      verify whether those numbers are more accurate for your own

         18      sake or not.  So that's one dimension. 

         19                The other dimension is, for example, fund-to-fund. 

         20      We talk about, you know, the managers could have more due

         21      diligence in term of they don't do daily tradings, and they

         22      probably will spend more time in double checking the numbers

         23      are correct. 

         24                And also, there is a self-selection issue. 

         25      For fund-to-fund managers, they probably would choose some

          1      well-established funds, large funds, effectively audited

          2      funds.  So we should expect fund-to-fund probably will have

          3      some kind of accurate valuations than the others. 

          4                The third item is transparency.  Some funds are

          5      more transparent than the others.  For example, some funds'

          6      shares are traded on exchanges, like foreign exchanges, you

          7      know, like European exchanges.  So those funds could be more

          8      transparent than the other funds. 

          9                And also, some funds are open to public investors

         10      not only for the club members.  So you can expect these funds

         11      are more transparent than the other funds.  So these are the

         12      three dimensions I will like to mention when we consider

         13      valuations, because that could put differences in term of

         14      valuations across different funds. 

         15                And I've done a study about the accuracy of hedge

         16      fund on returns in terms of auditing.  The preliminary

         17      conclusion is auditing will make a difference.  I mean,

         18      that's an obvious conclusion.  Based on some 2,000 hedge

         19      funds, I find vast majority of hedge funds have auditors, as

         20      my fellow panelist argue.  However, there are some hedge

         21      funds they don't report auditing dates, which means we don't

         22      know when they were audited or if they were really

         23      effectively audited. 

         24                And that could raise a question.  I mean, the

         25      question is can we rely on these numbers over time or across

          1      different databases?  One way to check that is we know some

          2      funds report to different vendors, so we can check a

          3      particular hedge fund that returns on a particular month. 

          4                For example, let's say October '92 they should

          5      report the same number to different vendors.  If they're not,

          6      then there's an issue here.  So I do find for funds with

          7      missing auditing dates some of them they will have some

          8      inconsistent problem, which means they report one number for

          9      Vendor A and then report another number to Vendor B. 

         10                MR. SCHEIDT:  We might want to refer to people to

         11      Enforcement for further inquiry. 

         12                MR. LIANG:  And the other finding is for smaller

         13      funds they tend to have more missing days than the larger

         14      funds.  I mean, that's expected because larger funds probably

         15      they can afford to spend money to hire very good auditors. 

         16      Basically, a large fund they tend to have very good auditors

         17      than smaller funds. 

         18                So the conclusion is larger funds tend to be more

         19      effectively audited than smaller funds.  So as an investor,

         20      if you want to choose hedge funds or as a fund-to-fund

         21      manager want to choose hedge fund, probably want to avoid,

         22      you know, some smaller or less established funds because

         23      there could be some minor issues. 

         24                But saying that, I will not say the issue is very

         25      significant.  Because they are smaller funds their market

          1      shares are not so big, so probably the issue is not that

          2      significant.  

          3                COMMISSIONER GLASSMAN:  Doug, I have a question

          4      going back to a comment that was made a few minutes ago.  How

          5      liquid are the investments in the funds of funds.  If they're

          6      more liquid than the investment in the underlying funds,

          7      what's the implication of the holdback on the underlying

          8      funds?  Does that make sense? 

          9                MR. SCHEIDT:  I'll try to answer the liquidity

         10      issue.  The underlying hedge funds usually are not very

         11      liquid.  They may allow the top tier fund of hedge funds to

         12      get in and out on a quarterly basis or, perhaps, a semiannual

         13      basis.  There may be developments where the underlying hedge

         14      funds may allow investors to get in and out on a more

         15      frequent basis. 

         16                I think there have been rumors about having an

         17      open-ended fund of hedge funds that would invest in those

         18      kinds, but the practice now is quarterly at best. 

         19                COMMISSIONER GLASSMAN:  In the underlying fund? 

         20                MR. SCHEIDT:  In the underlying. 

         21                COMMISSIONER GLASSMAN:  What about the fund-to-

         22      funds? 

         23                MR. SCHEIDT:  The fund-to-funds is going to be --

         24      the fund itself, the top tier fund, is going to be closed-

         25      end, and it, too, would at best offer periodic purchases and

          1      redemptions on a quarterly basis. 

          2                COMMISSIONER GLASSMAN:  Okay.  So it's pretty much

          3      are in line with the underlying fund, so that not an issue. 

          4      Okay.  Thanks. 

          5                MR. SCHEIDT:  Well, it is for valuation purposes,

          6      because if the top tier fund is getting investors in and out

          7      at a time when it doesn't have pricing information, current

          8      pricing information for the underlying hedge funds, then it

          9      has got to fair value -- well, it has got to come up with a

         10      valuation for those hedge funds. 

         11                And if the hedge funds aren't providing them with

         12      the current information, what are they going to do?  How are

         13      they going to come up with a fair value? 

         14                COMMISSIONER GLASSMAN:  So they don't have the

         15      holdback that the underlying fund has --

         16                MR. SCHEIDT:  No. 

         17                COMMISSIONER GLASSMAN:  -- so then it may be an

         18      issue? 

         19                MR. SCHEIDT:  Yeah.  Professor Lo, you've done some

         20      academic studies, and you have some interesting points, among

         21      others, about performance smoothing. 

         22                MR. LO:  When I was an undergraduate thinking about

         23      majoring in economics, somebody told me that an economist was

         24      a person who knew the price of everything but the value of

         25      nothing.  It took me a while to really understand what that

          1      meant, and I think that this hedge fund discussion highlights

          2      that because I think there is a concern that there's a gap

          3      between price and value, particularly when there is no price.

          4                So I guess I'd like to just make two general points

          5      before getting into the specifics of the research.  The first

          6      point is that valuation issues are not new.  I think that the

          7      venture capital and private equity community, real estate

          8      investors I think have long understood that it's sometimes

          9      very difficult to value illiquid instruments, but I think

         10      that the reason we're focusing on this now is because the

         11      hedge fund industry is growing rapidly both on the

         12      institutional side and perhaps, to some degree, on the retail

         13      side. 

         14                And so concerns about valuation that are not

         15      particularly obvious to those investors I think have to be

         16      made clear, and disclosure I think is critical. 

         17                The other point I want to make is that while

         18      valuation issues are not new there is a very important

         19      distinction between valuation in mutual funds versus

         20      valuation in hedge funds, and that has to do with the fact

         21      that mutual funds are required to have a daily NAV, but, in

         22      many cases, hedge fund investors are looking for the kind of

         23      opportunities that simply can't be obtained by managers that

         24      have to strike daily NAVs. 

         25                For example, I think it's -- those of us who are

          1      investing in exchange-traded securities like IBM, it turned

          2      out that today IBM closed at 88 and 69, 88/75.  That's a very

          3      tight spread.  We know what IBM trades at. 

          4                But if I ask the audience, "What's the price of

          5      this building?"  Well, that's a different matter.  It's

          6      actually pretty hard to come up with a price.  I couldn't

          7      figure out to within 5 or 10 or 20 percent what the value of

          8      this building is, and yet there are many hedge fund managers

          9      that add value by being able to come up with valuations

         10      faster, better and in many ways superior to what can happen

         11      out there in the marketplace. 

         12                So I think that one concern is that we really have

         13      to understand what the purpose of valuation is and whether or

         14      not the valuation process is something that is consistent

         15      with the mandate of the particular investment vehicle. 

         16                In terms of the research that I've done, the way

         17      that I got interested in this really was by looking at hedge

         18      fund returns data, and I noticed something rather odd.  The

         19      odd thing was that for certain hedge funds the returns were

         20      extremely smooth, that they didn't seem to bounce around a

         21      whole lot and that positive months tended to follow positive

         22      month, and negative months tended to follow negative months. 

         23                And this is particularly striking in comparison to

         24      something like the S&P 500 where there's very little of this

         25      kind of persistence.  And so in digging deeper, it became

          1      clear that part of the reason for certain hedge funds having

          2      this kind of smoothness property is because of valuation

          3      issues.  That is that the returns that are being reported are

          4      being reported either inadvertently or deliberately in ways

          5      that make them look a bit more smooth than they otherwise

          6      might be. 

          7                Now, I have to emphasize that there are many

          8      different explanations for that most of which have nothing to

          9      do with any kind of manipulation.  For example, you can have

         10      a hedge fund manager that requires brokers to provide them

         11      with quotes on all of their securities on a month-end basis

         12      and take the average of all the quotes, and if the brokers

         13      are using simple formulas to try to extrapolate the prices of

         14      the securities that are highly illiquid you'll get a rather

         15      smooth set the returns. 

         16                That may very well be the best prices available but

         17      nevertheless may mislead investors into thinking that the

         18      returns are somewhat safer than they are.  In particular,

         19      when you have smoother returns, they look less volatile, and

         20      that tends to make the performance on a risk adjusted basis

         21      look better. 

         22                So from the research that we've done, I guess our

         23      conclusion is that there's a great deal of heterogeneity

         24      among hedge funds in this particular characteristic, this

         25      kind of return smoothed property and that disclosure is

          1      really the most important cure for this to make sure that

          2      investors are aware that this kind of smoothness is very

          3      often an indication of a highly illiquid investment and that

          4      they need to act accordingly. 

          5                COMMISSIONER CAMPOS:  Is this very different from

          6      the mutual funds that have illiquid assets? 

          7                MR. LO:  It's not different in principle, but it is

          8      different in degrees, because hedge funds, given the nature

          9      of their mandate, can invest in even more illiquid

         10      instruments than the typical mutual funds can, so no. 

         11                In fact, there's a problem that mutual funds suffer

         12      from which is stale prices.  The stale price phenomenon is

         13      where mutual funds use prices that have been set quite a

         14      while ago to compute their NAVs.  The problem with that, of

         15      course, is that there are some outside investors that can see

         16      this kind of staleness.  They can forecast mutual fund price

         17      movements and can game these kinds of prices to the point

         18      where they, essentially, transfer money from existing

         19      shareholders to new shareholders. 

         20                So it's very much the same type of problem.  And,

         21      in fact, in the study that we did, we found mutual funds that

         22      had just as high a degree of smoothness as hedge funds.  It's

         23      just that it's a matter of degree.  With hedge funds, there's

         24      much more latitude.  Investors are looking for that kind of

         25      opportunity.  For illiquid investments, you earn money in

          1      many cases by bearing illiquidity risk.  The key, though, is

          2      really to disclose that to the investor. 

          3                MR. ZACK:  But I think you have to go to the

          4      idiosyncracies of the specific mutual fund, its investment

          5      style and nature of its investments.  For example, I can

          6      think of high-yield bond funds that might have, you know,

          7      fairly what are considered liquid securities.  They don't

          8      trade very frequently.  We look at those prices even though

          9      they don't move from time to time.  So it's going to be a

         10      little hard to game those types of prices. 

         11                You can look at municipal bond funds where a

         12      manager may characteristically take all of the issues, very

         13      small issuers in a widely diversified portfolio.  They may

         14      not be deemed to be terribly liquid securities, but at the

         15      same time, and they're not going to move in price very much

         16      either. 

         17                So you have to look at each of the different types

         18      of circumstances to determine what is it that causes that

         19      smoothing effect. 

         20                MR. LO:  In fact, I would argue that the same holds

         21      true for hedge funds.  You have to look at the style of

         22      investment to gauge whether or not the source of illiquidity

         23      is genuine or inappropriate. 

         24                For example, distress debt as an asset class, the

         25      way that managers make money from that particular strategy is

          1      to identify securities that the public has said, "It's a

          2      disaster.  I want nothing to do with it.  Get it out of my

          3      portfolio."  And they will buy at bargain basement prices. 

          4      Their valuation is different from the public's valuation, and

          5      they make money from it, highly illiquid but highly

          6      profitable. 

          7                MR. PHILLIPS:  But they're not governed by the

          8      current sale rule which mutual funds are, and therefore

          9      they're not under the same pressure to keep varying the price

         10      every day as the market turns because they're not -- they're

         11      buying distressed debt, and they're going to hold it for a

         12      while. 

         13                And therefore, they're not looking at an illiquid

         14      market and trying to gauge what price they would receive upon

         15      current sale. 

         16                MR. LO:  Right. 

         17                MR. PHILLIPS:  I happen to think that the current

         18      sale rule does an injustice in the mutual fund world in some

         19      situations like distress debt. 

         20                MR. LO:  Well, the current sale rule is actually a

         21      very interesting issue to take up for certain kinds of hedge

         22      fund investment styles because I would argue that the current

         23      sale rule is a very difficult standard to implement

         24      particularly for highly illiquid investments. 

         25                I mean, anybody who has ever tried to sell a house,

          1      can you imagine selling your house in seven days and what

          2      kind of price you would have to get in order to be able to

          3      make that sale in a seven-day period?  That price is probably

          4      very different from what you think your house is really

          5      worth. 

          6                MR. SCHEIDT:  Well, I would say that that current

          7      sale standard is perhaps being misinterpreted.  I would say

          8      that on any current sale basis if you know that it's going to

          9      take you an amount of time to dispose of the security you

         10      should factor than in and say assume that I've gone through

         11      the reasonable process of, if it's registering the security

         12      or finding the willing buyer, and what would that willing

         13      buyer find after that reasonable period of time, what would

         14      that willing buyer be willing to pay me not on a fire sale

         15      basis within seven days from the time I started but, having

         16      going through the process, what would he pay me today for it.

         17                MR. DIESCHBOURG:  But has a hedge fund manager,

         18      that's part of the opportunity for intellectual capital to

         19      gain the market, not to game it but to actually gain an

         20      opportunity for investment. 

         21                So one of the things you don't want to do for this

         22      industry is you don't want to over-regulate it.  There's

         23      plenty regulation right now.  And getting the daily pricing

         24      and fair valuation gets that issue of too much information

         25      takes away the opportunity to make money in this marketplace. 

          1      It's the intellectual capital that's bringing the --

          2                MR. SCHEIDT:  Well, nobody's talking about taking

          3      away value.  If you buy distressed debt at what it's worth

          4      today because you think intrinsically it will have more value

          5      in the future, you shouldn't value it today at what you think

          6      its value will be in the future.  You should value it today

          7      at what they should -- what it can go for. 

          8                And if you're right, your intellectual capital is

          9      right, it will pay off, and the investors who want to stay

         10      with you in the fund to bear that out will benefit, and those

         11      that want to bail won't.  So the value of current price and

         12      current sale pricing is that it rewards those who go in for

         13      the long haul, and it doesn't reward those who bail out. 

         14                So why should they get the benefit today when they

         15      bail out of the future gains? 

         16                MR. ZACK:  Another way to put that is that there's

         17      a liquidity premium that investors, essentially, get paid for

         18      for bearing that kind of illiquidity risk, and that's part of

         19      the return that they're garnering from these kind of

         20      investments. 

         21                We should also remind ourselves, too, that the

         22      hedge fund industry does help provide a tremendous amount of

         23      the liquidity in the market that helps assure the flow of

         24      these types of securities through the market. 

         25                MR. LIANG:  I would like to echo Professor Lo's

          1      point.  I think his point is illiquidity cannot be measured

          2      by the traditional measurement like a standard deviation or

          3      sharp ratios.  For example, if some asset are illiquid, you

          4      don't have a very active price on a daily basis, so probably

          5      you can only use the past price, and then the price will be 

          6      flat. 

          7                A definition of "standard deviation" is the

          8      volatility is zero.  So you cannot use standard deviation or

          9      regular volatility to measure the illiquidity.  Then you'll

         10      have to think about something else like odd correlations,

         11      like a correlation between today's price and yesterday's

         12      price and the day before to see what is the correlations over

         13      time.  So that's what we call the odd correlation. 

         14                So that's why we have to think about something

         15      different from hedge fund managers, you know, than the mutual

         16      fund managers.  They're just different.  One follows very

         17      active trading strategies on a daily basis, and a mutual fund

         18      probably will not trade that often. 

         19                So the traditional managers would be probably

         20      questionable when we talk about hedge fund performance.  And

         21      especially I'm going to talk about a little different issue

         22      here in terms of distributions. 

         23                When you look at the distributions -- because

         24      somebody this morning used the term "skewness" and

         25      "cartosis."  I believe I can use that term, too.  If you look

          1      at all these terms, the skewness are kind of negative, which

          2      means they're not center.  They're probably heavy skewed on

          3      the left side.  The cartosis, basically, measure the fat

          4      tails, which means hedge fund may have extreme events,

          5      extreme losers and extreme gains, so they're not normal

          6      distribution. 

          7                So all the traditional measures based on standard

          8      deviation volatility, sharp issues should be probably

          9      revisited.  I think that's exactly Professor Lo's work on

         10      smoothing and illiquidity. 

         11                MR. SCHEIDT:  Let's move on to non-valuation

         12      issues, some other conflict of interest situations that arise

         13      in the operation of hedge funds that arise in the operation

         14      of not only one hedge fund in relationship to another or one

         15      hedge fund in relationship to a mutual fund that's also

         16      managed by the same manager or private accounts managed by

         17      the same manager. 

         18                There are issues related to allocation of

         19      investment opportunities some of which were touched upon in

         20      the previous panel, and there are various incentives for the

         21      manager to, perhaps, favor one of its clients, one of its,

         22      say, hedge fund clients over another client. 

         23                That could be the performance fee that that fund

         24      might pay, the fact that that particular hedge fund might be

         25      more in a position to pay the performance fee than another

          1      either private client or another hedge fund and the fact that

          2      if the manager is managing a fund or in a private account

          3      along with a hedge fund, the manager has a lot of his own

          4      personal investments in the hedge fund and would have a

          5      temptation, if not more, to favor the hedge fund in the

          6      allocation of investment opportunities. 

          7                And I'm not just talking about hot IPOs.  I'm

          8      talking about the best ideas or more valuable opportunities. 

          9      How do hedge funds deal with these conflicts of interest? 

         10                MR. ZACK:  Doug, those conflicts exist actually not

         11      just in the hedge fund industry but in any side-by-side

         12      management situation in the asset management business.  While

         13      our shop, for example, does not have the type of hedge fund

         14      where portfolio managers who manage retail mutual funds are

         15      also managing hedge funds.  As a matter of corporate policy,

         16      we do not allow that, but we also only offer hedge funds of

         17      funds, which precludes the arising of that type of situation.

         18                But if you're managing wrap accounts, if you're

         19      managing private assets through your institutional money

         20      management arm, you have those same types of issues.  One of

         21      them --

         22                MR. SCHEIDT:  But it's exacerbated in the hedge

         23      fund --

         24                MR. ZACK:  It is.  It is.  And one of the ways,

         25      obviously, is disclosure to clients of the existence of those

          1      potential conflicts of interest.  You can do some things such

          2      as isolation of trading desks, having trading allocation

          3      policies and procedures in place to make sure that trades are

          4      fairly allocated among different clients. 

          5                Those are, obviously, somewhat prophylactic in

          6      nature.  The most complete prophylactic, obviously, is to

          7      have completely separate organizations and not allow the

          8      conflict at all. 

          9                MR. PHILLIPS:  I agree with Mr. Zack that conflicts

         10      of interest are hardly raised by hedge funds and hardly novel

         11      to the investment management in the street.  Conflicts exist

         12      any type a manager has two clients.  Conflict exists when a

         13      manager has one client, and he also trades for his own

         14      account.  Same kind of incentive in the latter situation as

         15      in the hedge fund situation. 

         16                And the fact is that the investment management

         17      industry over time has learned it has got to manage the

         18      conflicts so that the management results in allocation of

         19      investment opportunities and other trading opportunities pass

         20      a basic test of fairness, and that's done by having a set of

         21      rules and procedures tailored to the particular kind of

         22      operation. 

         23                It makes a big difference the kinds of securities

         24      that are being traded.  It makes a big difference whether the

         25      portfolio managers who raise the conflict are housed in the

          1      same room or housed 3,000 miles away.  A lot of different

          2      factors affect the nature of your rules. 

          3                If you do have a focus on the issue, you do develop

          4      rules and guidelines, practices and procedures, you do have a

          5      system for monitoring the implementation of those rules, and

          6      most of all you do have support from the top of the

          7      organization for dealing with problems when they're

          8      identified. 

          9                If you have that, then the conflicts can be

         10      handled, and I think that's equally true of side-by-side

         11      conflicts managing a mutual fund, a hedge fund, wrap

         12      accounts, whatever.  They have to be handled.  They can be

         13      handled, but take support from the top and the development of

         14      a system of rules, policies and procedures and a system for

         15      monitoring implementation. 

         16                MR. SCHEIDT:  What level of assurance can you have,

         17      though, about these issues in the hedge fund industry that's

         18      not regulated, not subject to examination by the SEC,

         19      allocation issues aren't considered by the funds' auditors? 

         20      Is it a you've got to trust me situation? 

         21                MR. PHILLIPS:  I can tell you from my own

         22      experience that since the SEC has been able to improve its

         23      inspection staff with the formation of OSE there has been

         24      much more focus within the mutual fund organizations on

         25      compliance, allocation compliance as well as other conflict

          1      of interest issues because they're aware that not this year

          2      but maybe next year or the year following there will be an

          3      examination, and they do not want to get long deficiency

          4      letters that they have to explain to their boards of

          5      directors. 

          6                MR. SCHEIDT:  But you don't have that level of

          7      deterrence in the hedge fund industry.  And I'll tell you,

          8      until the SEC started bringing enforcement cases against

          9      registered advisors for fraudulently or preferentially

         10      allocating investment opportunities you didn't have that

         11      attention is my understanding.  And, in fact, I heard because

         12      the SEC first sued advisors to private clients that the

         13      principles didn't really apply in the fund context. 

         14                And it wasn't until the SEC sued Dryfuss Funds for

         15      preferential allocations that that message got through that

         16      it did apply.  So I'm personally concerned that the private

         17      advisory managers don't fully appreciate their fiduciary

         18      duties and don't fully appreciate some of the things that we

         19      may take more for granted in the regulated industry. 

         20                MR. PHILLIPS:  To the extent you've got a hedge

         21      fund that has a sophisticated institutional base of

         22      investors, you may find that there is some surveillance and

         23      monitoring of the situations.  To the extent they don't, then

         24      you rely upon the personal integrity of the manager. 

         25                MR. ZACK:  You also get that in the due diligence

          1      process.  If they have a family of hedge funds, how are they

          2      going to allocate trades among those hedge funds?  What are

          3      the procedures that they use to monitor the personal trading

          4      accounts of their staff members as well? 

          5                MR. SCHEIDT:  And you'd probably look after the

          6      fact that the relative performance of the different vehicles

          7      to the extent that they're comparable to see if there are

          8      major disparities in returns. 

          9                MR. VINE:  Doug, I also think that as one of the

         10      panelists in the last panel said, it's fairly unusual for a

         11      hedge fund manager to be running a variety of different

         12      products, and I think there is some correlation between the

         13      size of a hedge fund firm and the number of products that its

         14      able to run. 

         15                In the larger firms, from a compliance point of

         16      view, do tend to look much more like the large mutual funds

         17      in terms of having a culture of compliance and having the

         18      tools in place to monitor that. 

         19                So I think in the hedge fund arena, the temptations

         20      by and large don't exist for the garden variety hedge fund

         21      manager.  He has got one product, and he has got a lot of his

         22      money in it. 

         23                MR. DIESCHBOURG:  And also, for the fund-to-fund

         24      shops, it doesn't exist because we're hiring individual

         25      managers, and we're looking at their strategies.  And if they

          1      do have a dual strategy, or if they do have separate

          2      accounts, we monitor that separate account versus a limited

          3      partnership account that we might be invested in because that

          4      creates another allocation issue, when you have a separate

          5      account, how you're going to allocate. 

          6                MR. PHILLIPS:  Let me ask you, when you do your due

          7      diligence, how much focus do you place upon allocation, rules

          8      and procedures and trading room rules and procedures to

          9      prevent unfairness? 

         10                MR. DIESCHBOURG:  Our CFO is very serious about

         11      that process, so we go into a lot of detail.  We actually go

         12      back and talk to the prime brokers, too, and ask them about

         13      various trades, get the book, look at it.  It's a major part

         14      of our process.  We'll not hire great managers just because

         15      we don't like their back office.  They don't have a good

         16      audit trail.  They're not using a major firm or major law

         17      firm.  

         18                So the operational and administrative side to the

         19      business are critical to evaluate the business success,

         20      because you're also investing in the small business, when you

         21      think about this, for your fund.  So from a fund-to-fund

         22      standpoint, we are taking all those things into consideration

         23      when we make those decisions, and we actually shy away from

         24      funds that have separate accounts in addition to limited

         25      partnerships because of that allocation issue. 

          1                MR. PHILLIPS:  So what you're saying from your

          2      experience is that the emergence of fund-to-funds whether

          3      registered or not exerts a healthy pressure in developing a

          4      compliance culture at the hedge fund level? 

          5                MR. DIESCHBOURG:  Yes. 

          6                MR. ROYE:  Question for Michael and Bob.  How often

          7      do you walk away from investing in underlying hedge fund

          8      because you're concerned about those issues? 

          9                MR. DIESCHBOURG:  A lot.  We reviewed over 400

         10      managers last year, and we only hired ten. 

         11                MR. ROYE:  Yeah, but was that for performance or

         12      some of the discussion we've heard so far, isn't it?  Isn't

         13      that a little inconsistent with some of the discussion we've

         14      heard about earning problems? 

         15                MR. DIESCHBOURG:  Well, it's a question of your

         16      structure.  We're looking for specific managers that have a

         17      specific style, consistency of return.  We don't like a lot

         18      of leverage.  We don't like securities that are too difficult

         19      to value, obviously, and we're looking for shops that are

         20      using major accounting firms that have an audit file. 

         21                So we're just going through that whole process.  We

         22      like older firms versus younger firms.  There has been a

         23      proliferation of new managers in the last couple years.  Our

         24      average manager has been managing for 14, 15 years versus the

         25      new managers -- over the last, you know, 6,000 managers that

          1      are out there today, 2- to 3,000 have formed the last three

          2      years. 

          3                MR. ZACK:  Paul, it would be a question of how all

          4      of the factors fit together in the due diligence process

          5      rather than you would go in and expect to find, you know,

          6      blatant fraud that you've discovered in your due diligence on

          7      valuations or on trade allocations.  But you might not have a

          8      comfort level about the overall operations, or it might not

          9      fit the experience level. 

         10                I can't speak really for the folks in our Tremont

         11      affiliate.  They do this day in, day out.  They have a huge

         12      staff of people who go in and kick the tires, and they may

         13      have a discomfort level about one aspect of a manager's

         14      operations, but that didn't necessarily mean there is a

         15      "problem" with that manager. 

         16                MR. SCHEIDT:  What about conflicts with respect to

         17      the use of the fund's commissions?  The fund's commissions

         18      can be used to benefit the fund.  The fund's commissions can

         19      be used to reimburse people who refer investors to the hedge

         20      funds.  It could be used to generate soft dollar benefits for

         21      the manager.  It could be used to generate personal expenses

         22      paid for the manager.  It could generate payments for capital

         23      introductions. 

         24                How do hedge fund managers deal with use of

         25      commissions and conflicts of interest, and how do they

          1      satisfy their best execution obligations? 

          2                MR. ZACK:  Well, again, since I'm looking at it

          3      from the point of view of hedge fund to funds manager and

          4      looking through the due diligence process of how we would

          5      look at or how our Tremont affiliate would look at the

          6      operations of the underlying managers and are they getting

          7      best execution, how do they define it, what do they consider

          8      and how do they test it, that is part of the process that

          9      they will go through in the due diligence process. 

         10                It would probably be better to have someone who is

         11      actually a hedge fund manager commenting on the actual use of

         12      the brokerage allocations.  To the degree that you're dealing

         13      with registered investment advisors that are hedge fund

         14      managers, and there are some out there, they're going to be

         15      looking at 28(e).  

         16                They're going to be looking at the same

         17      considerations under the Investment Advisor's Act, and

         18      clearly that gives you a much greater level of comfort about

         19      the allocation of brokerage commissions. 

         20                MR. SCHEIDT:  I don't mean to put you on the spot,

         21      but does your firm consider for investment a hedge fund whose

         22      manager fully discloses that it can use brokerage commissions

         23      to pay its business expenses or to reward people who

         24      introduce investors to the hedge fund?  Is that a

         25      consideration? 

          1                MR. ZACK:  Yes to the former and no to the latter. 

          2                MR. VINE:  Let me jump in on this.  One of the

          3      first things that we talk about when we meet with someone

          4      setting up a hedge fund is this very issue.  What flexibility

          5      do they want to have to use commission dollars, and what do

          6      they want to use them for?  And there is generally fairly

          7      detailed disclosure in the private placement memos on this

          8      issue. 

          9                What we see is that start-up managers do tend to

         10      want to use soft dollars to the extent available to help them

         11      get their business going.  They are prepared to go outside of

         12      the 28(e) safe harbor and, in general, I think the kinds of

         13      investors who are interested in investing with fledgling

         14      managers don't mind that.  They understand the needs that the

         15      manager may have to get going. 

         16                What we see is that as managers mature and get

         17      larger, in general, they are living within 28(e), and I think

         18      that's, to some extent, driven by investor demand.  The

         19      institutions tend to want to see that.  To some extent, it's

         20      driven by the fact that they are more likely to have an ERISA

         21      account out there, and it's very difficult if you've got an

         22      ERISA account and a hedge fund account to figure out how you

         23      can use soft dollars for one and not the other outside the

         24      safe harbor. 

         25                So I think we do see that kind of distinction, and

          1      I think we actually find we spend more time than we'd like to

          2      trying to interpret some of the boundaries on 28(e) I think

          3      it would be helpful to hedge fund managers and others to get

          4      some more guidance on some of the points that were left open.

          5                MR. SCHEIDT:  Do you have any thoughts about the

          6      effect of eliminating the safe harbor of 28(e)?  Congress has

          7      expressed some concern in the mutual fund area about fund

          8      fees and expenses and about use of soft dollars, and they've

          9      thrown open the question if not directly then indirectly

         10      about whether 28(e) is a good idea, whether it has produced

         11      anomalies in the market that have prevented transparency and

         12      have allowed managers through fine disclosure and a large

         13      private placement memo disclose, basically, that they're

         14      going to use the client's assets for their own benefit?  And

         15      is that a good thing from a policy perspective? 

         16                MR. VINE:  Again, I think the hedge fund arena in

         17      some ways has some built in checks and balances on it.  The

         18      fact that there's a performance fee, the fact that the

         19      manager typically has a lot of his own personal net worth

         20      tied into the fund means that the benefit of being able to

         21      use the soft dollars is often outweighed by the detriment of

         22      not getting best execution. 

         23                So I think there's some real advantages in the

         24      hedge fund structure that may not exist in some of the other

         25      areas of investment management. 

          1                MR. SCHEIDT:  We're getting towards the end of the

          2      program, and I've been asked to allow a little bit of extra

          3      time here for the panelists to express their views, if they

          4      have any, on the Commission's inquiry on the issues that have

          5      been presented today about whether there's a need for

          6      regulation in this area, whether it be registration of the

          7      hedge fund manager at one end or registration of the hedge

          8      fund itself whether under the 40 Act or under a 40 Act light

          9      regime or anything in between, mandating that all hedge funds

         10      in the United States must use an independent valuation agent

         11      or limited the amount -- and this is way I don't know the

         12      scope of this panel -- but limiting the amount of leverage

         13      they could use. 

         14                Do any of the panelists have any thoughts on any of

         15      those topics? 

         16                MR. ZACK:  Well, Doug, I've never hesitated to

         17      respond to your challenges on any panel we've been on

         18      together.  Actually, I think I want to say first that I do

         19      really commend the Commission for holding this round table

         20      and with the staff's efforts to gather the information needed

         21      to evaluate the industry. 

         22                This is the way that the process really should

         23      work, and it will result I'm sure in an intelligent and well

         24      thought out response. 

         25                Having said that, I think that if we look at hedge

          1      funds compared to other asset managed vehicles there is a

          2      reason for their difference and distinction, and I would urge

          3      caution in the adoption or consideration of rules unless

          4      there is a clearly articulated need for regulation to deal

          5      with a clearly articulated problem that has been identified. 

          6                I haven't yet heard today any problems rising to

          7      the surface that suggest the need for regulation, at least of

          8      a sweeping variety, and I don't think we want to make hedge

          9      funds look like mutual funds.  I think they are two very

         10      distinct asset classes that serve a very vital, very vital

         11      role in the liquidity of our markets and capital formation in

         12      our markets. 

         13                MR. PHILLIPS:  Let me chime in in this respect.  I

         14      don't think that the Investment Company Act is an appropriate

         15      vehicle for regulation of hedge funds.  It's much too

         16      contradicted.  In many respects, it's outmoded, and I think

         17      that attempting to place hedge funds under the Investment

         18      Company Act would dislocate a very important, increasingly

         19      important industry in ways it could never recover and operate

         20      and perform the service it does. 

         21                On the other hand, I have great difficulty in

         22      understanding why if I have a half a million dollars to

         23      invest and I go to a money manager and ask him to invest it

         24      for me in a wrap account or a separate account, I can look

         25      the person in the eye, I can negotiate the terms of the

          1      contract, I can put restrictions on what he or she does, et

          2      cetera, and I have a personal relationship, and yet I also

          3      have the protections of the Investment Advisor Act. 

          4                I take that half a million dollars and put it in a

          5      hedge fund, an impersonal mechanism, I have much less

          6      negotiating ability, much less ability to -- much less

          7      contact with the manager.  I don't understand the

          8      justification for not regulating hedge fund managers under

          9      the Advisors Act. 

         10                In looking at the Advisors Act, there are only two

         11      ingredients of the Advisors Act regulation as important.  One

         12      is the ADV mechanism of disclosure and, two, the Commission

         13      examination.  That would bring -- I don't think there are

         14      large-scale problems of fraud and abuse in the hedge fund

         15      industry, but regulation is not meant for the mainstream of

         16      any industry.  It doesn't work.  It's meant for the margins. 

         17                And I would urge the Commission to consider an

         18      unobtrusive system of regulations on the Advisors Act that

         19      brings hedge funds within the Commission's radar through

         20      registration of investment advisors, an ADV that's tailored

         21      to the operation of hedge funds which requires that they put

         22      their policies and procedures for handling conflicts, and

         23      things like that, out on top of the table with disclosure and

         24      a system of Commission examination that looks to see whether

         25      those policies and procedures have been followed. 

          1                To me, that's a constructive regulatory move and

          2      one that should not contradict 99 percent of the hedge fund

          3      industry and over time will develop a compliance culture that

          4      will be second to none if properly implemented. 

          5                MR. LO:  Well, let me just comment on, sort of, the

          6      broader questions that you raised regarding the need for

          7      further regulation in the industry.  Let me mention at the

          8      outset, in the interest of full disclosure, that in addition

          9      to my academic point I'm also a principal in a hedge fund. 

         10                And contrary to what you might think that kind of

         11      conflict of interest might produce, I actually think there is

         12      a need for additional regulation of a particular sort.  I

         13      think there are three outstanding issues that both this panel

         14      and others at this conference are grappling with. 

         15                The three issues are investor education, risk

         16      transparency and systematic risk exposures.  And I think that

         17      there's a need both in the industry as well as on the

         18      regulatory side to provide better analytics, better

         19      regulation to address each of these three issues. 

         20                And I know we don't have time to get into it, but I

         21      just want to mention briefly we've talked about investor

         22      education and the notion of a sophisticated or accredited or

         23      qualified investor.  I think that needs to be revisited. 

         24                Risk transparency.  I think we've discussed in a

         25      number of ways how hedge fund risks are, essentially,

          1      different from the risks of more traditional investment asset

          2      classes.  And so additional tools and I and other academics

          3      and people in industry are developing I think are going to be

          4      important providing that risk transparency. 

          5                And the third issue which I don't think has been

          6      mentioned at all today -- maybe it will be a topic for

          7      tomorrow's conversation -- is the fact that every once in a

          8      while we have a situation where a hedge fund blowup has

          9      systematic risk exposures.  Of course, I'm thinking about

         10      1998 and LTCM. 

         11                I guess, following along the lines of the

         12      president's working group on LTCM, I think that additional

         13      measures need to be taken to deal with issues of systematic

         14      risk.  They're very rare, very unlikely to happen, but,

         15      obviously, when they do, they're extremely important.  And

         16      there are additional things that I think the SEC and the

         17      industry can do to ensure that these risks are minimized. 

         18                MR. SCHEIDT:  Thank you. 

         19                MR. ARTABANE:  Thanks.  I would, I guess, agree

         20      with the thought that the Investment Company Act of 1940 is

         21      not the vehicle to regulate hedge funds.  You can hardly run

         22      many of the strategies in a good way.  So I would agree with

         23      that. 

         24                I think, though, that if Dick's view is undertaken

         25      by the Commission and there is regulation of advisors that

          1      you should look to make sure it's efficient and it's not

          2      overlapping, because many hedge funds are already registered

          3      with the CFTC as commodity pool operators, and you don't want

          4      to get into a situation where there's too much regulation. 

          5                Having said that, I think the institutionalization

          6      of the business is moving the standards up generally, and

          7      that type of process that Robert has and that Michael have in

          8      terms of their due diligence and the investor sophistication

          9      is really raising the bar. 

         10                So I don't think it's broken.  They're, obviously,

         11      not to the standard of mutual funds because of the regulation

         12      in mutual funds, and there are going to be some aberrant

         13      issues given the fact that there are 6,000 managers there. 

         14      Some of them may be doing things that are not right.  Some of

         15      them may simply be taking on too much investment risk and

         16      having a fund that's highly illiquid and highly leveraged,

         17      you know, blow up as the markets go against you, but that's

         18      part of the investment in the asset class. 

         19                MR. SCHEIDT:  Thanks.  Steve. 

         20                MR. VINE:  Yeah.  I'd echo what some of the other

         21      panelists have said.  I think we've seen very significant

         22      consolidation in the industry in the past couple of years and

         23      a very significant in-flow of sophisticated institutional

         24      money.  And what that has meant at the high end of the market

         25      is that the firms are tending to look very similar from a

          1      compliance standpoint. 

          2                The firms that are managing large sums of

          3      institutional money can't really be distinguished in terms of

          4      their compliance culture on the basis of whether or not

          5      they're registered with the Commission. 

          6                Having said that, I think Dick Phillips raises a

          7      good point, that it is hard to understand why an investor who

          8      looks more like a retail investor should have a lesser degree

          9      of protection when making a modest or relatively modest

         10      investment in a wrap account versus a small hedge fund. 

         11                I think there really is a need to look at the

         12      investor accreditation thresholds and see whether they need

         13      to be adjusted to take into account that discrepancy. 

         14                MR. DIESCHBOURG:  A lot of good things have been

         15      said, and I do thank the SEC for having the round table,

         16      because I think education not only for the regulators but

         17      also for the press and for the people in the industry it's

         18      important to let it grow. 

         19                And in growing that business, now I see

         20      institutional players had a major impact on making it better,

         21      but the fund-to-fund operators have been a major part of

         22      making this industry better from a due diligence and from a

         23      process standpoint and bringing the standards up in the

         24      business, and these type of things really help that. 

         25                Becoming a registered investment advisor versus a

          1      registered investment company would be a simple process, and

          2      it's something that we good forward with should be done

          3      simply and easily to identify the needs of our industry but

          4      also shouldn't be restrictive enough that it stops the

          5      entrepreneurial spirit of the people that go out there to

          6      create these businesses. 

          7                The men and women that start these firms still need

          8      to have the entrepreneurial edge to go out there and create

          9      these businesses.  So I just throw that out as a closing

         10      thought, and thank you for giving us an opportunity to be

         11      here. 

         12                MR. LIANG:  Well, I think this industry is a new,

         13      growing and very exciting industry.  However, I do see there

         14      are problems.  If there are not, we won't be here today.  And

         15      the problems are -- we heard that from the street and the

         16      problems with the long-term capital manager over-leverage

         17      issues and systematic risk issues and also those non-auditing

         18      issues. 

         19                But the question is are these issues representative

         20      for the whole industry?  If they are, then the question is

         21      very significant.  If the question is no, they're not, and

         22      then we should do some kind of like a benefit cost analysis. 

         23      But leaving this industry alone like this probably will have

         24      liquidity issues and will have innovations for financial

         25      instruments will attract a lot of talented people these are

          1      the benefit.  And the costs are probably going to drive them

          2      away. 

          3                So I think from the SEC's point of view, probably,

          4      you know, this is a rough point here is doing some kind of

          5      benefit cost analysis.  That's my first point. 

          6                And the second point is we should distinguish one

          7      fund from another.  They're all different.  There are 6,000

          8      of them.  They are not the same.  They have different styles,

          9      and they have different sizes, and they have different

         10      organization structures.  So we should treat them

         11      differently. 

         12                For example, for large funds, they probably will

         13      have some kind of large position issues, and currently they

         14      are reporting to two different agencies for large position

         15      reporting.  And for smaller funds, probably they will have

         16      technology issues, and they will have auditing issues.  So

         17      the issues are not the same. 

         18                We cannot say yes or no for the entire industry. 

         19      It probably is more complicated than that.  We probably can

         20      come to the middle of some positions. 

         21                And my last point is we're talking about hedge

         22      funds and the mutual fund industry there's a, kind of,

         23      conflict of interest issues.  I will not say whether hedge

         24      funds should be regulated or not, but I will raise a

         25      question, and this question seems irrelevant to this round

          1      table discussion, but I would raise it anyhow. 

          2                Mutual fund managers' hands and feet and tied too

          3      tight to have enough freedom because we know there are old

          4      securities laws governing mutual funds.  So can we give them

          5      more freedom other than tighten the hedge funds?  I think

          6      that's a relevant issue to this discussion between hedge fund

          7      and mutual funds. 

          8                MR. SCHEIDT:  Okay.  Well, thank you very much,

          9      everyone.  That wraps up the first day of the round table,

         10      and we hope to see you all tomorrow. 

         11                (Applause.)

         12                (Whereupon, the hearing was adjourned at 5:34 p.m.)