U.S. Securities and Exchange Commission chairman Christopher Cox said in Congressional testimony Tuesday that hedge funds don’t make sense for most retail investors, but he urged Congress to take a light touch approach to any regulation of the funds.

In testimony before the U.S. Senate Committee On Banking, Housing And Urban Affairs today, Cox outlined his concerns about increasing retail participation in hedge funds, among other things.

Cox said the SEC’s best estimate is that there are now approximately 8,800 hedge funds, with approximately US$1.2 trillion of assets. It also estimates that 2,000 new hedge funds opened for business last year. And, although hedge funds represent just 5% of all U.S. assets under management, they account for about 30% of all U.S. equity trading volume.

“It is undeniable that in addition to raising questions such as systemic risk and investor protection, hedge funds also provide investors and our national securities markets with tangible benefits,” he said. “They contribute substantially to capital formation, market efficiency, price discovery, and liquidity. By actively participating in derivatives markets, hedge funds can help counterparties reduce or manage their own risks. Some hedge funds provide a way for institutional investors to reduce their exposure to downside risk by allocating a portion of their portfolio to an investment with a low correlation to overall market activity.”

“But given the general lack of public disclosure about the way hedge funds operate, the lack of standards for measuring a fund’s valuation and its performance, the possibilities for undisclosed conflicts of interest, the unusually high fees, and the higher risk that accompanies a hedge fund’s expected higher returns, these are not investments for Mom and Pop. They are generally risky ventures that simply don’t make sense for most retail investors,” he cautioned.

That said, he noted that SEC staff are not aware of significant numbers of truly retail investors investing directly in hedge funds. “In my view, such a development, were it to occur, should be viewed with alarm,” he said. And, in the wake of the Court of Appeals decision which tossed out the SEC’s proposed hedeg fund registration rule, Cox said he intends to recommend to the full Commission that the SEC take formal steps to further limit the marketing and availability of hedge funds to unsophisticated retail investors.

“The concerns about hedge funds that the SEC enunciated when we adopted our hedge fund rule in December 2004 remain the same today. The remarkable pace of hedge fund growth, which we noted at the time, has continued unabated. The potential for retail investors to be harmed by hedge fund risk remains as serious a concern now as then. And the growth in hedge fund fraud that we have seen accompany the growth in hedge funds implicates the very basic responsibility of the SEC to protect investors from fraud, unfair dealing and market manipulation,” he explained.

As for any potential legislation, Cox said it shouldn’t intrude on hedge funds’ businesses. “There should be no interference with the investment strategies or operations of hedge funds, including their use of derivatives trading, leverage, and short selling. Nor should the federal government trammel upon their creativity, their liquidity, or their flexibility. The costs of any regulation should be kept firmly in mind,” he cautioned. “Similarly, there should be no portfolio disclosure provisions. A hedge fund’s ability to keep confidential its trading strategies and portfolio composition should be protected. And hedge funds should be able to continue to charge their clients performance fees, just as they do now.”

“As we move forward, it will be important that we view the whole picture as we work to evaluate both the systemic market risks and the retail investment issues associated with the growing presence of hedge funds in our capital markets. Hedge funds are a significant and growing part of our financial markets that yield not only risks but also many benefits for our economic system.,” he stressed.