SEC’s ability to directly oversee hedge fund advisers is limited to those that are required to register or voluntarily register with SEC as investment advisers. Registered hedge fund advisers are subject to the same disclosure requirements as all other registered investment advisers. These advisers must provide current information to both SEC and investors about their business practices and disciplinary history. Advisers also must maintain required books and records, and are subject to periodic examinations by SEC staff. Meanwhile, hedge funds, like other investors in publicly traded securities, are subject to various regulatory reporting requirements. For example, upon acquiring a 5 percent beneficial ownership position of a particular publicly traded security, a hedge fund may be required to file a report disclosing its holdings with SEC. In December 2004, SEC adopted an amendment to Rule 203(b)(3)-1, which had the effect of requiring certain hedge fund advisers that previously enjoyed the private adviser exemption from registration to register with SEC as investment advisers. In June 2006, a federal court vacated the 2004 amendment to Rule 203(b)(3)-1. According to SEC, when the rule was in effect (from February 1, 2006, through August 21, 2006), SEC was better able to identify hedge fund advisers. In August 2006, SEC estimated that 2,534 advisers that sponsored at least one hedge fund were registered with the agency. Since August 2006, SEC’s ability to identify an adviser that manages a hedge fund has been further limited due to changes in filing requirements and to advisers that chose to retain registered status. As of April 2007, 488, or about 19 percent of the 2,534 advisers, had withdrawn their registrations. At the same time, 76 new registrants were added and some others changed their filing status, leaving an estimated 1,991 hedge fund advisers registered. While the list of registered hedge fund advisers is not all-inclusive, many of the largest hedge fund advisers—including 49 of the largest 78 U.S. hedge fund advisers—are registered. These 49 hedge fund advisers account for approximately $492 billion of assets under management, or about 33 percent of the estimated $1.5 trillion in hedge fund assets under management in the United States. In an April 2009 speech, Chairman Schapiro stated that there are approximately150 active hedge fund investigations at SEC, some of which include possible Ponzi schemes, misappropriations, and performance smoothing. In a separate speech in April, Chairman Schapiro renewed SEC’s call for greater oversight of hedge funds, including the registration of hedge fund advisers and potentially the hedge funds themselves. SEC uses a risk-based examination approach to select investment advisers for inspections. Under this approach, higher-risk investment advisers are examined every 3 years. One of the variables in determining risk level is the amount of assets under management. SEC officials told us that most hedge funds, even the larger ones, do not meet the dollar threshold to be automatically considered higher-risk. In fiscal year 2006, SEC examined 321 hedge fund advisers and identified issues (such as information disclosure, reporting and filing, personal trading, and asset valuation) that are not exclusive to hedge funds. Also, from 2004 to 2008, SEC oversaw the large internationally active securities firms on a consolidated basis. These securities firms have significant interaction with hedge funds through affiliates previously not overseen by SEC. One aspect of this program was to examine how the securities firms manage various risk exposures, including those from hedge fund-related activities such as providing prime brokerage services and acting as creditors and counterparties. SEC found areas where capital computation methodology and risk management practices can be improved. Similarly, CFTC regulates those hedge fund advisers registered as CPOs or CTAs. CFTC has authorized the National Futures Association (NFA), a self-regulatory organization for the U.S. futures industry, to conduct day- to-day monitoring of registered CPOs and CTAs. In fiscal year 2006, NFA examinations of CPOs included six of the largest U.S. hedge fund advisers. In addition, SEC, CFTC, and bank regulators can use their existing authorities—to establish capital standards and reporting requirements, conduct risk-based examinations, and take enforcement actions—to oversee activities, including those involving hedge funds, of broker- dealers, of futures commission merchants, and of banks, respectively. While none of the regulators we interviewed specifically monitored hedge fund activities on an ongoing basis, generally regulators had increased reviews—by such means as targeted examinations—of systems and policies to mitigate counterparty credit risk at the large regulated entities. For instance, from 2004 to 2007, the Federal Reserve Bank of New York (FRBNY) had conducted various reviews—including horizontal reviews— of credit risk management practices that involved hedge fund-related activities at several large banks. On the basis of the results, FRBNY noted that the banks generally had strengthened practices for managing risk exposures to hedge funds, but the banks could further enhance firmwide risk management systems and practices, including expanded stress testing. The federal government does not specifically limit or monitor private sector pension investment in hedge funds and, while some states do so for public plans, their approaches vary. Although the Employee Retirement and Income Security Act (ERISA) governs the investment practices of private sector pension plans, neither federal law nor regulation specifically limit pension investment in hedge funds or private equity. Instead, ERISA requires that plan fiduciaries apply a “prudent man” standard, including diversifying assets and minimizing the risk of large losses. The prudent man standard does not explicitly prohibit investment in any specific category of investment. The standard focuses on the process for making investment decisions, requiring documentation of the investment decisions, due diligence, and ongoing monitoring of any managers hired to invest plan assets. Plan fiduciaries are expected to meet general standards of prudent investing and no specific restrictions on investments in hedge funds or private equity have been established. The Department of Labor is tasked with helping to ensure plan sponsors meet their fiduciary duties; however, it does not currently provide any guidance specific to pension plan investments in hedge funds or private equity. Conversely, some states specifically regulate and monitor public sector pension investment in hedge funds, but these approaches vary from state to state. While states generally have adopted a “prudent man” standard similar to that in ERISA, some states also explicitly restrict or prohibit pension plan investment in hedge funds or private equity. For instance, in Massachusetts, the agency overseeing public plans will not permit plans with less than $250 million in total assets to invest directly in hedge funds. Some states have detailed lists of authorized investments that exclude hedge funds and/or private equity. Other states may limit investment in certain investment vehicles or trading strategies employed by hedge fund or private equity fund managers. While some guidance exists for hedge fund investors, specific guidance aimed at pension plans could serve as an additional tool for plan fiduciaries when assessing whether and to what degree hedge funds would be a prudent investment. According to several 2006 and 2007 surveys of private and public sector plans, investments in hedge funds are typically a small portion of total plan assets—about 4 to 5 percent on average—but a considerable and growing number of plans invest in them. Updates to the surveys indicated that institutional investors plan to continue to invest in hedge funds. One 2008 survey reported that nearly half of over 200 plans surveyed had hedge funds and hedge-fund-type strategies. This was a large increase when compared to the previous survey when 80 percent of the funds had no hedge fund exposure. Pension plans’ investments in hedge funds n part were a response to stock market declines and disenchantment with traditional investment management in recent years. Officials with most of the plans we contacted indicated that they invested in hedge funds, at least in part, to reduce the volatility of returns. Several pension plan officials told us that they sought to obtain returns greater than the returns of the overall stock market through at least some of their hedge fund investments. Officials of pension plans that we contacted also stated that hedge funds are used to help diversify their overall portfolio and provide a vehicle that will, to some degree, be uncorrelated with the other investments in their portfolio. This reduced correlation was viewed as having a number of benefits, including reduction in overall portfolio volatility and risk. While any plan investment may fail to deliver expected returns over time, hedge fund investments pose investment challenges beyond those posed by traditional investments in stocks and bonds. These include the reliance on the skill of hedge fund managers, who often have broad latitude to engage in complex investment techniques that can involve various financial instruments in various financial markets; use of leverage, which amplifies both potential gains and losses; and higher fees, which require a plan to earn a higher gross return to achieve a higher net return. In addition to investment challenges, hedge funds pose additional challenges, including: (1) limited information on a hedge fund’s underlying assets and valuation (limited transparency); (2) contract provisions which limit an investor’s ability to redeem an investment in a hedge fund for a defined period of time (limited liquidity); and (3) the possibility that a hedge fund’s active or risky trading activity will result in losses due to operational failure such as trading errors or outright fraud (operational risk). Pension plans that invest in hedge funds take various steps to mitigate the risks and challenges posed by hedge fund investing, including developing a specific investment purpose and strategy, negotiating important investment terms, conducting due diligence, and investing through funds of funds. Such steps require greater effort, expertise and expense than required for more traditional investments. As a result, according to plan officials, state and federal regulators, and others, some pension plans, especially smaller plans, may not be equipped to address the various demands of hedge fund investing. Investors, creditors, and counterparties have the power to impose market discipline—rewarding well-managed hedge funds and reducing their exposure to risky, poorly managed hedge funds—during due diligence exercises and through ongoing monitoring. Creditors and counterparties also can impose market discipline through ongoing management of credit terms (such as collateral requirements).