Mutual fund complexes branching into hedge funds to woo new customers are facing scrutiny from regulators who fear that traditional mutual fund investors could be harmed as the two different types of funds are offered under one roof, lawyers told Reuters Monday.

"Managers receive better compensation for hedge fund products than mutual fund products, and that creates a conflict on where you send the trades," said Kenneth Gerstein, a partner at law firm Schulte Roth & Zabel. That could entice a manager of both a hedge fund and a mutual fund to work harder for his or her hedge fund clients, fund managers and lawyers said.

The prospect of conflicts has reportedly caught the eye of the Securities and Exchange Commission. Sources familiar with the agency’s ongoing hedge fund industry probe ( see MFMN 03/31/03) said the loosely regulated industry may soon face some restrictions.

Hedge funds, often described as freewheeling investment pools, manage roughly $600 billion. They have traditionally charged their rich clients multi-million dollar minimums, but have recently begun to lure average investors such as teachers and social workers with smaller minimums of as little as $25,000.

By using techniques like selling stocks short and borrowing money, or leveraging, hedge fund managers generally outperform their mutual fund manager cousins, boosting their employers’ bottom line and making their clients happy.

In another possible conflict of interest, a mutual fund manager could buy a stock that the hedge fund manager will sell short, creating a situation where the mutual fund client may see heavy losses while the hedge fund client sees gains.

To avoid these sorts of problems, industry observers are becoming more convinced that some sort of regulations will soon face hedge funds.

"There are clear signals that the SEC has sent, and there has been a clear move toward regulating the industry," said Jedd Wider, a partner at law firm Orrick, Herrington & Sutcliffe.




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