Galvin sees wider hedge fund worries

Secretary of State William F. Galvin said yesterday his ongoing probe of the relationship between Swiss bank UBS AG and certain hedge funds stems from broader concerns about the practices of a lightly regulated corner of the financial services industry.

"The bigger issue," Galvin said yesterday, "is, what is to be the role of hedge funds in the financial system? Hedge funds are like the jet stream that affects all the other weather, and can have a disruptive effect at a time when we're saying to most investors . . . 'you're on your own.' "

Correcting earlier reports, Galvin said he has not issued subpoenas to UBS, but rather that bank officials have agreed to provide testimony about the firm's relationship with hedge fund traders who operate out of UBS's Boston office .

Specifically Galvin is trying to determine whether the hedge funds are paying for the office space through higher-than-normal trading fees to UBS, but aren't disclosing the arrangements to their investors. Like other investment banks, UBS leases space in its Boston and New York offices to the hedge fund traders in hopes they will become more significant clients someday.

"It's an unusual relationship, and unusual relationships in the financial-services industry generally portend problems," Galvin said.

A UBS spokeswoman in New York, Rohini Pragasam, said the bank is cooperating with the investigation, but declined to comment on specifics.

Hedge funds are investment vehicles that often give themselves wide latitude in pursuing profits, such as buying and selling derivatives and other sophisticated financial instruments. Mutual funds typically have a straightforward charter to invest in common stocks or bonds, or a mix of both. Unlike the old-fashioned buy-and-hold investment strategy, some hedge funds can pursue profits with furious rounds of trading of financial instruments, which can generate huge fees to brokers who handle those trades.

Because they receive little regulatory oversight, hedge funds are, in theory, limited to certain qualified investors who presumably understand the risks of investing in more exotic instruments --usually wealthy individuals with a net worth of more than $1 million, or institutions such as pension funds.

In exchange for promises of high returns -- and some do deliver spectacular results -- hedge funds have taken in billions of dollars in recent years; they also charge considerably higher fees than mutual funds and other investment advisers.

Galvin said his regulatory oversight over securities operations registered in the state give s him jurisdiction over UBS's local operations. Moreover, as is the case in other states, Galvin's office said that local anti fraud statutes give him power to sue hedge funds if he determines they have cheated or misrepresented themselves to investors.

Members of the hedge fund community are split on what their disclosure obligation to shareholders is in the matter, said Martin Sklar, partner at the New York law firm of Kleinberg, Kaplan, Wolff & Cohen. The firm represents hundreds of hedge fund clients, including some that likely get space from UBS, Sklar said, although he could not say whether any are in Boston.

Recently, as regulators have increased scrutiny of the industry, Sklar said he now includes a disclaimer in fund prospectuses sent to hedge fund shareholders that notes the managers might have arrangements where they steer trades to securities dealers that provide them with office space.

Whatever the arrangements, "I've never had investors come back and make a big deal out of it," Sklar said.

Galvin is a critic of the hedge fund industry, which has been tarred by several hedge fund implosions that hurt shareholders, such as the collapse of Bayou Group in Connecticut , whose leaders in 2005 pleaded guilty to swindling $450 million from investors.

The regulator has brought legal cases against several hedge funds he claimed were improperly soliciting money from unqualified investors. Moreover Galvin has criticized the pension fund for Massachusetts government employees as being too deeply invested in hedge funds, which he described in an interview in March as being "like gambling." (State pension fund officials responded they have chosen hedge fund investments to reduce risk in the investment portfolio).

In recent years hedge funds have become more accessible to investors. First, inflation and rising real-estate values have qualified many people to invest in hedge funds who previously could not. Also, many state and public sector pension funds have invested more money into hedge funds as a way to boost returns, and gain wider investment exposure.

The Securities and Exchange Commission's efforts to require greater disclosure from hedge funds were struck down by a federal appeals court in the District of Columbia in June 2006.

David Friedland, head of a Florida hedge fund firm and president of the Hedge Fund Association, an industry trade group, said a common federal standard would be more helpful than the state actions. But he said Galvin's concern about UBS seemed misplaced since hedge fund advisers usually invest in their own funds so have an incentive to minimize trading costs. Galvin, he said, is "barking up a tree that doesn't have any meat to it."

Ross Kerber can be reached at kerber@globe.com.