What mutual fund investors don't know could hurt them, especially if it's that the manager running their money also operates a hedge fund. Some in the industry believe it's time shareholders be made aware of these potential conflicts of interest.

While side-by-side management of mutual and hedge funds can offer investors in both various economies of scalebetter leveraged research and provide firms a way to retain top-notch talentit can also mean favoritism, unequal trading costs, different trading priorities and disproportionate allocations of securities, even among funds with nearly identical objectives and investment philosophies.

"When you have a perhaps less sophisticated investor in the mutual fund, they need to be made aware of the potential conflicts of interest and the policies firms have in place to mitigate those," said Scott Gibson, an associate professor of finance at the College of William and Mary in Williamsburg, Va. Gibson took care not to criticize the practice, but stressed the need for better transparency. "As of right now, it's not clear to me that information is readily available to investors."

That's because, right now, mutual fund shareholders have to dig deep into their funds' filings to learn what other products their fund manager might handle. Even then, while the mutual fund managers are required to disclose to investors policies protecting against conflicts of interest, hedge funds have no such regulatory requirement. In many cases, even hedge fund shareholders who may be told there are policies guarding against managers' conflicts, cannot obtain the details of those policies, Gibson said.

Hedge funds are unfettered by many of the restrictions that bind mutual funds, for example, soft dollar regulations and those pertaining to cross trades. A hedge fund manager can use brokerage commissions to pay for things a mutual fund cannot, such as utilities, exclusive research or even office space, and execute cross trades, moving securities between accounts among funds not subject to the Investment Act of 1940, far more easily than between mutual funds, especially those harbored in retirement accounts. In both cases, such practices shave transaction costs for hedge fund shareholders, while subjecting mutual fund shareholders to higher fees.

"These are examples of some of the unintended consequences of regulation," said Janaya Moscony, president of Philadelphia-based SEC Compliance Consultants.

For side-by-side shareholders, the repercussions can be significant. In a paper published last December, Gibson and colleagues Gjergji Cici, also of William and Mary, and Rabih Moussawi, of the University of Pennsylvania, reviewed 71 management companies that had, collectively, 457 U.S. equity mutual funds with $448 billion in assets run side-by-side with hedge funds in the decade ending in 2004.

The professors then compared that group of mutual funds to others in comparable classes, styles and size that were run by managers who did not also manage hedge funds.

The analysis showed that, on an annualized basis, those shareholders invested in the first group of mutual funds earned 124.3 basis points less each year than those in mutual funds where managers do not also oversee hedge funds.

In 2004 alone, this disparity, net of fees, cost mutual fund shareholders as much as $5.6 billion, according to the paper.

In a competing paper published last November, three professors who analyzed 155 side-by-side mutual funds representing $123 billion in assets during 2004 found that because the opportunity to manage a hedge fund in addition to a mutual fund attracts talented fund managers, side-by-side mutual funds actually outperformed funds managed by mutual fund-only managers.

Meanwhile, the complementary hedge funds' performance suffered compared to peers in their class, according to the paper, published by Tom Nohel, of Loyola University in Chicago, Z. Jay Wang, of the University of Illinois-Urbana and Lu Zheng of the University of California at Irvine.

While circumstances vary from manager to manager, investors should always be aware that no matter who the practice favors, there is a potential for conflict of interest, said Laura Lutton, a mutual fund analyst who works on assigning mutual fund stewardship grades for Morningstar in Chicago.

"There will always be a temptation not to act in the best interest of all of your clients," Moscony said.

That temptation will only increase as the number of managers who operate side-by-side mutual and hedge funds continues to rise, driven, in part, by the onslaught of institutional money flowing into hedge funds.

In 1989, there were only three side-by-side managers, according to data from Morningstar. In 1999, there were 15. By 2003, there were 64, by 2005 there were 112, and by the end of last year, 124. Because there's a difference in how these managers view their mutual fund shareholders and performance-based, high-fee-paying hedge fund clients, mutual fund shareholders can lose big.

New York-based Alliance Capital, for example, came under scrutiny from the Securities and Exchange Commission in 2003, after the company executed cross trades to move securities expected to perform especially well out of its mutual fund and into its hedge fund.

Baltimore-based Nevis Capital Management learned in 2003 that by giving disproportionately more initial public offerings shares to its hedge fund than to its mutual fund, the firm could not only produce stellar results and attract more hedge fund clients, but also incur the wrath of regulators, who fined the company for its egregious exhibition of favoritism.

"Mutual funds protected by weak [conflict of interest] policies should display consistently poor return gaps and poor reported returns, whereas those protected by strong policies should show little or no underperformance," according to the paper penned by Gibson's team.

The Investment Company Institute has outlined potential conflicts and called on funds to outline policies to guard against them.

Once those have been established, it's equally important to communicate them to shareholders on both sides, Gibson said. "I'm not advocating revealing any proprietary secrets," he said. "Just let the investors know."

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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