Funds on (h)edge over latest craze

Mutual fund companies are walking a tightrope in an attempt to cash in on the latest investment craze – hedge funds.

The path to higher fees and wealthier investors is fraught with potential conflicts of interest because hedge funds are more lucrative to manage than mutual funds.

As a result, some industry experts think fund managers may bias their investment decisions in favor of a hedge fund.

“There is absolutely potential for huge conflicts of interest [when a mutual fund company starts managing hedge funds],” says Amy Hirsch, CEO of Paradigm Consulting LLC in Clifton, N.J.

Ms. Hirsch, whose company is responsible for allocating client assets to alternative investments, says mutual fund companies are moving into hedge funds for the simple reason that they are profitable, and demand from investors is growing.

“This doesn’t mean that hedge funds are not a good business for [mutual fund companies] to be in,” she adds. “But they have to think through all the potential conflicts of interest.”

Front running

Hedge funds typically charge an annual management fee of between 1% and 2%, plus performance fees that range as high as 20% or more.

In contrast, mutual funds typically charge an annual management fee that is usually well below 2% and do not have performance fees. Also, unlike much of the financial services industry, investors aren’t pressuring hedge funds to reduce costs.

In some cases, where the same individual or team manages a hedge fund and a mutual fund, there is potential for “front-running,” where the hedge fund portfolio might purchase shares strategically ahead of a larger share purchase by a mutual fund.

Or as one adviser explains, there could be an instance of a money manager buying a block of shares in an initial public offering that has big opening-day gains.

But the shares don’t have to be allocated to a specific portfolio until the end of the day, when the manager can easily determine where the gains would generate the most fees.

“We would shy away from using mutual funds if the manager also manages hedge funds,” says Robert Levitt, a Boca Raton, Fla., adviser with $130 million of assets under supervision. “But if you are investing in a hedge fund, it could be an advantage [if the manager also manages a mutual fund].”

To further complicate matters, it is often difficult for retail investors to know when their mutual fund manager is also managing hedge funds.

Because of rules restricting such unregistered products as hedge funds from advertising, many fund companies are reluctant to even discuss their hedge funds with anyone who is not an accredited investor.

Boston Partners Asset Management is one of the money management firms that is relatively forthright about its alternativeinvestment business.

But even there, retail investors in the Long/Short Equity Fund – a hedgelike mutual fund – might not be aware that manager Ted Kellogg simultaneously manages two domestic hedge fund portfolios, an offshore hedge fund and separate accounts.

Ms. Hirsch believes that the money management firms have a responsibility to their mutual fund investors to disclose that they are running alternative investments.

But because there are no rules to that effect, it is impossible to accurately calculate how many mutual fund companies are managing hedge funds.

Paul Roye, director of the division of investment management at the Securities and Exchange Commission, said in a speech to financial services industry professionals last month that the dual management roles are closely monitored.

“The differing fee structures create a real risk of favoring a hedge fund over a mutual fund or other accounts when allocating trades,” he said.

Specifically, Mr. Roye mentioned such potential issues as the short-selling of stocks by a hedge fund that are held long by a mutual fund in the same firm. Or, he added, a mutual fund could be used to benefit a hedge fund when long positions are sold after a hedge fund sells the same security short.

“We expect firms to have compliance procedures in place to address these concerns,” he added.

Meanwhile, minding the sticky regulatory details is nothing new to most mutual fund companies.

“We are all over the potential for conflict-of-interest issues,” says Scott Swensen, head of special investments at Zurich Scudder Investments in New York. “We are very conscious of our fiduciary responsibility to our long-only investors.”

While Scudder has been managing private-equity portfolios for seven years, the company entered the hedge fund business about a year ago with a single hedge fund, which is managed by a team that also manages mutual funds.

For all the right reasons, Mr. Swensen says, Scudder has four additional hedge funds in the works.

“Hedge funds are more profitable for the firm, and this is an area where there has been no price pressure,” he says.

growing list

In terms of regulatory oversight, Mr. Swensen says, nothing can compare to the kind of monitoring that is being done at Scudder, by Scudder.

“From day one, the heaviest scrutiny has come from in-house,” he says. “There are a half-dozen people at any given time watching the hedge fund portfolio.”

The growing appeal of hedge fund investing, particularly when the stock market turns bearish, is not lost on the mutual fund industry.

Among the other fund companies that have started hedge funds are Gabelli Asset Management Co. and Aim Funds. And the list is growing rapidly.