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.

"There has been a taint associated with a hedge fund product being managed by mutual funds," said Jedd Wider, a partner with New York law firm Orrick Herrington & Sutcliffe. "The reality is the mutual funds that are offering hedge funds will see enhanced scrutiny by not only the SEC but also by the next wave of Spitzer's investigation."

The House of Representatives recently passed a bill to curtail fund-trading abuses that included a measure to bar individuals from managing both hedge fund and mutual fund money. However, some industry critics question whether limiting an individual from managing both sides will be enough to counter the conflicts inherent on a firmwide basis. Either way, they say the measure won't deter Spitzer and others from probing for potential abuses that may have transpired.

The size and scope of the issue is difficult to determine, in part because of the cloistered nature of the hedge fund business. Hedge funds, whose clientele consists primarily of higher net worth individuals and institutional investors, often pursue more complex or risky strategies -- and managers typically earn about 20% of the hedge fund's profits on top of the management fee. However, unlike mutual funds, they are largely unregulated and have to disclose next to nothing of their operations -- making it difficult to track how many mutual fund firms have gotten into the hedge-fund game. Meanwhile, many mutual fund firms prefer not to discuss their hedge fund businesses because of the potential conflicts of interest. (See this article from 2000 that raised some of these concerns.)

"A big part of what made the system work is the separation between the hedge fund and the mutual fund side," said Roy Weitz, who runs the fund-research and commentary Web site Fund Alarm. "What we've seen is that the wall was really quite porous."

Officials at Firsthand Capital Management, a Silicon Valley fund firm that manages both mutual fund and hedge fund money, say the Chinese Wall remains intact. Phil Mosakowski, Firsthand's vice president of marketing, said the firm hasn't allowed its own hedge fund or any other hedge funds to market-time its mutual funds. "We didn't do any special side deals," Mosakowski said.

In getting a piece of the hedge fund business, mutual fund firms are riding an impressive trend. There were more than 7,500 hedge funds managing a combined $650 billion in assets in 2002, up from less than 2,000 hedge funds with less than $100 million in assets in 1990, according to hedge fund Van Hedge Fund Advisors.

The notion of having a hedge fund and mutual fund within one firm shouldn't present an insurmountable oversight challenge. Indeed, in theory at least, preventing market timing or other conflicts should be easier since the compliance departments of both entities are under one roof.

"Before the scandal I would have said the conflicts are manageable," said Mercer Bullard, founder of fund-shareholder advocacy group Fund Democracy. "But the industry and regulators have demonstrated that they aren't."

Orrick Herrington & Sutcliffe's Wider said a number of his firm's clients "satisfy their fiduciary duties on both sides, but the reality is that the regulatory climate changes." Furthermore, "conflicts of interest are conflicts of interest. You can dress them up and try to alleviate them, but there's always a small percentage of gray area," he added.

Several industry watchers suggest that regulators may ultimately insist that firms separate their hedge fund and mutual fund businesses entirely to put an end to all potential conflicts -- going several steps further than the Baker bill's ban on an individual running both hedge and mutual fund money. Some critics, including George Van at Van Hedge Fund Advisors, say such a move would serve only to push more mutual fund managers into the arms of hedge funds. Others, meanwhile, say legislation must take a back seat to other measures to curtail conflicts of interest.

"What we don't have in place today is the technology to make sure that fund manager Susie or Tommy doesn't go off the reservation and treat some customers differently," said Geoff Bobroff of Bobroff Consulting.

Even if the fraudulent activity among firms with hedge funds and mutual funds under one roof remains limited to AllianceBernstein and Pilgrim-Baxter, fund-industry watchers say the inherent conflicts of interest may compel regulators to take a firm stance on separating the businesses. Industry watchers cited several inherent problems.

First and foremost, the performance fee arrangements are so disproportionate -- the average fund expense ratio is about 1.5%, compared with a 20% cut of profits plus the basis management fee for hedge funds -- that it's hard to imagine that hedge fund investors don't get preferential treatment that may undermine mutual fund investors. "Performance fee structure is what troubles us," said the SEC's Plaze.

Another key issue is allocation of shares, such as in initial public offerings. If a money-management firm gets a stake in an IPO, should the majority of the allocation go to the much larger mutual funds or the hedge funds, where profits are greater? Another vital issue is disclosure -- if a hedge fund is privy to the mutual fund's investments, it raises the potential for it to take advantage of that inside information.

Lastly, there is the issue of what Plaze calls "mental energy." How can a compliance department monitor how mental resources are being allocated between the hedge funds and mutual funds? "It's about mind space," said Fund Alarm's Weitz. "How can you prove that somebody didn't give their good ideas to a hedge fund?"
As originally published, this story contained an error. Please see Corrections and Clarifications.

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