U.S. Funds at War

Mutual funds attack hedge funds over fraudulent publicity issue

Thanks to the recently-passed JOBS Act, U.S. hedge funds and private equity funds will soon be promoting themselves in the media. U.S. mutual funds are terrified at the prospect.

That’s because U.S. mutual funds are subject to very rigid SEC rules regarding what they can and cannot say in their marketing materials and advertisements. The SEC has yet to issue its new rules regarding private fund advertising, which are expected to be finalized in July.

Last month, the Investment Company Institute – which represents the U.S. mutual fund industry – warned the SEC in a bold and forceful comment letter that “private fund advertising is particularly susceptible to fraud . . . [because], unlike mutual funds, private funds often pursue investment strategies that are opaque . . . and invest in securities that are difficult to value or relatively illiquid.”

The ICI reminded the SEC of the 60 years of market experience and adaptive rule-making that led to the legal strictures now limiting mutual fund advertising. It argued that private funds should not be able to claim things in ads about themselves that mutual funds cannot say, such as “predictions of performance, exaggerated claims of investment prowess [and] unwarranted comparisons to competitors or benchmarks.”

For its part, the private fund industry defends a laxer publicity regime for itself than for mutual funds on the fact that its investment vehicles can only be sold to accredited investors, who are presumed to be sufficiently sophisticated to make investment decisions for themselves. In its letter to the SEC, the ICI dismissed that argument by invoking recent hedge fund history to show that accredited investors are just as easily defrauded as the retail investors to whom mutual funds are marketed.

Today, all it takes to be an accredited investor is a $200,000 income or a $1 million net worth (excluding primary residence). The ICI and others think those numbers should be tripled.

The ICI further urges the SEC to impose content restrictions on private fund ads. According to the ICI, if private funds are given free rein in their advertising, the public may not be able to distinguish them from registered funds, which are subject to a plethora of advertising rules, including using a standardized methodology for reporting performance and disclosing the circumstances under which returns were achieved. The ICI recommends that, until such time as the SEC develops a similar performance measurement system for private funds, investment returns should be banned from private fund ads.

Moreover, the ICI wants private fund managers to submit their ads to FINRA for prior review just like mutual funds have to do. FINRA is supposed to make certain that statements made in mutual fund ads meet SEC specifications and are fair, balanced and supportable.

Statistically, the global private fund industry (for most of which U.S. persons are eligible investors) manages approximately $2 trillion in assets and the U.S. mutual fund industry runs around $12 trillion. There are about 10,000 hedge funds in total and about 8,000 U.S. mutual funds (not counting ETFs). Hedge funds and private equity funds are clearly aimed at high-end investors and mutual funds at the general public. Minimum private fund investments are typically in the hundreds of thousands of dollars, if not higher.

To the ICI, having a lot of money does not mean one knows what one’s doing when it comes to investing. Its letter cites sports stars, entertainers and lottery winners as examples of wealthy individuals who may not have any investment sophistication.

If a private fund ad were to make it clear that no investment less than, say, $500,000 or $1 million would be accepted (and the fund’s manager meant it), that would seem to address the problems cited by the ICI, since there really could be no confusion with mutual funds which typically accept investments in any amount and, presumably, investors who can pony up minimum investments of $500,000 or $1 million ought to be able to fend for themselves (so long as they don’t have to borrow the money).

At the end of the day, maybe all that’s necessary to rationalize a two-tiered publicity structure would be to (1) redefine accredited investor for JOBS Act purposes as someone who invests at least $500,000 or $1 million in a private fund and (2) require private fund ads to prominently display the $500,000 or $1 million minimum investment.

Too simple?