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Two Masters Are One Too Many for Fund Firms

Investment firms that manage mutual fund and hedge fund money side-by-side can expect significant new restrictions, if not an outright ban on a practice that invites conflicts and abuse of less sophisticated investors.

Facing intense competition from hedge funds, scores of mutual fund firms have rolled out in-house hedge fund products over the past few years. The operations were a boon to mutual fund shops: They helped fund firms retain top managers who were being pursued by the hedge fund world, and they provided access to a business with fatter profit margins. They also prevented assets from fleeing to greener hedge fund pastures.

There was just one minor problem: These arrangements resulted in "conflicts of interest on steroids," said Robert Plaze, associate director of the Securities and Exchange Commission's Division of Investment Management. As New York Attorney General Eliot Spitzer leads the regulatory pack in investigating abusive fund trading, two firms have been charged with abuses stemming from managing hedge fund and mutual fund money at the same time: AllianceBernstein and Pilgrim Baxter. And industry watchers say there will be more.

Many mutual fund firms manage hedge fund money on the side, including Marsico Funds, Gabelli Asset Management, Firsthand Capital Management, Artisan and Van Eck Global Funds, to name just a few. Indeed, Robert Schulman, chief executive of hedge fund and advisory firm Tremont Capital Management, told a Securities and Exchange panel earlier this year that more than 100 hedge funds in Tremont's database of hedge funds have managers who are directly or indirectly involved in a mutual fund company.

Having mutual fund and hedge fund businesses side-by-side raises several basic conflict-of-interest issues, among them the allocation of IPO shares, trading-execution priorities and disclosure between the two entities -- as well as more nebulous matters such as who gets dibs on the best investment ideas. "Who gets the first buy -- the hedge fund or the mutual fund? It's 10 cents better on the execution for the earlier trade," said Don Cassidy, senior research analyst at Lipper.

In light of the scandal involving mutual funds granting outside hedge funds special access to trade their funds, in-house hedge funds are coming under closer scrutiny. The investigations into abusive trading have centered largely on mutual funds that were striking deals that allowed outside hedge funds, such as Canary Capital Partners, to make improper or illegal trades of their funds' shares. In most instances, Canary or another outside entity got a free pass to trade rapidly in and out of mutual funds in exchange for parking millions of dollars in the mutual fund firm's other offerings -- and the fund firm would collect fees on the parked assets.

Last week, Spitzer's office and the SEC charged PBHG founders Gary Pilgrim and Harold Baxter with fraud for allegedly allowing certain investors to market-time their funds -- including a hedge fund, Appalachian Trails, co-founded by Pilgrim himself. Late last month, Alliance Capital (AC) ousted Gerald Malone, manager of AllianceBernstein's Technology fund, for apparently allowing certain investors to market-time the fund in exchange for investing in the Alliance hedge funds also run by Malone.

"Market-timing" is a blanket term for various ways to make rapid-fire trading within a mutual fund. Among the more common market-timing initiatives is time-zone arbitrage, in which investors aim to take advantage of "stale prices" in a fund's net asset value due to the fact that markets close at different times around the globe. While not technically illegal, improper forms of market-timing skim profits off the top of funds because the heavy trading increases the expenses a fund incurs. If a fund firm allows market-timing that it knows to be detrimental, experts say that's a breach of fiduciary duty that may rise to the level of fraud -- especially if the firm claims to deter such trading activity in its prospectus and then enters into relationships with a select few market-timers in exception to its guidelines. "Late trading," meanwhile, is a clearly illegal practice that involves trading a fund after the 4 p.m. close and getting the pre-4 p.m. share price in violation of forward-pricing rules.
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