Smaller money managers who run both mutual funds and hedge funds are bracing for proposed rules they believe could completely upend the way they do business and make it more expensive.

As the

Securities and Exchange Commission

forges ahead with reforms of the $7 trillion mutual fund industry and threatens to take aim at the $760 billion hedge fund industry, the regulator is again concerned that simultaneous management of hedge funds and mutual funds represents a conflict of interest.

The agency is taking comments on a rule requiring increased disclosure of the side-by-side management of hedge funds and mutual funds through May 21, before it decides exactly what managers who run both types of funds must tell mutual fund investors about their private, largely unregulated investment partnerships.

The SEC proposed the rule after the Senate Banking Committee considered an outright ban on side-by-side management in high-profile hearings this spring. The SEC is now taking the lead on reforms, but any new scandal could renew legislative interest. A ban on individual managers running both types of funds could split duties at asset managers from $730 billion giant

Vanguard

down to the tiniest regional fund companies.

Though the SEC has looked at side-by-side fund management before, under former Chairman Harvey Pitt, the issue returned to the spotlight when

Alliance Capital Management

fired Gerald Malone, manager of the

AllianceBernstein Technology

fund, for allegedly securing an investment in his own hedge fund in exchange for letting an investor market-time his mutual fund.

Other large mutual fund companies such as

Janus Capital

(JNS)

,

T. Rowe Price

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(TROW) - Get Report

,

Evergreen Investment Management

and

Fidelity Investments

prohibit their managers from running hedge funds, but many smaller firms have managers who also run private accounts and hedge funds.

"Obviously, the notoriety at Alliance has made this a front-burner issue," said Jeff Ptak, a mutual fund analyst at Morningstar. "At a minimum, the onus is on mutual fund companies to provide investors with the assurance that their interests are being tended to."

In the last few weeks, SEC Chairman William Donaldson has repeatedly

called for more regulation of hedge funds, saying managers should have to register as investment advisers and provide the agency with more information about their funds. The SEC isn't trying to end side-by-side management, but increased disclosure may indirectly cost investors at smaller asset managers more money by shunting the best managers away from mutual funds and into more lucrative hedge funds. Those largely unregulated funds are closed to all but the richest investors and pay managers a 20% cut of profits, on top of a 2% annual management fee.

For managers, there's a lot at stake -- the average portfolio manager of an equity mutual fund made $325,000 in 2003, according to a survey by Association for Investment Management & Research and Russell Reynolds Associates, which survey salaries every two years.

While there's no reliable data on manager salaries at the approximately 6,800 hedge funds in the U.S., New York consultancy Hedgepros estimates the manager of a $100 million fund could make about $4 million a year.

Michael Malloy, a partner and head of the investment management group at Philadelphia law firm Drinker Biddle & Reath, says the disclosures won't cost mutual fund companies very much in actual dollars but still could hurt smaller investors.

"It's an abstract cost, but an important cost," he said. "The cost of driving some talented managers away is a big cost."

Barry James, executive vice president of James Investment Research, a small asset management firm near Dayton, Ohio, is an exception to Malloy's prediction. The firm concentrates most of its energy on four mutual funds that run about $660 million. A $10 million in-house hedge fund contributes revenue, but is not the firm's main focus, he said.

He said the prospect of increased SEC oversight ended plans for a new hedge fund strategy while it was being tested with managers' money, before it opened to new investors. James said the firm coordinates its hedge fund trades with its mutual funds, and simply doesn't use short positions that could affect mutual fund returns. "We make sure we aren't picking from Peter to pay Paul," he said. "The SEC looked over every trade in that private partnership."

This does create much higher hurdles with upstart firms and really creates a brain drain," he said. "Eventually, that cost is borne by the consumer."

He said many other investment managers will head for hedge funds, because of lower barriers to entry and higher pay.

But Kunal Kapoor, head of mutual fund research at Morningstar, said a careful approach to side-by-side management should allow top talent to invest for the wealthy and the not-so-wealthy alike.

"I think the key is that you have to have safeguards in place so that managers don't end up favoring the hedge fund over the mutual fund," he said. "It's something that's not easy to do, and the potential conflict of interest is certainly apparent."