The Fund Industry's Next Crisis?

Say a neighbor pays you to shovel the snow in front of his house. But the neighbor on the other side of your house gives you 10 times as much for the same service, plus a bonus if the sidewalk doesn't have a speck of ice on it. Wouldn't you be inclined to do a better job for the higher paying customer? That's just the tension managers who run both mutual and hedge funds face. Because hedge funds,

Say a neighbor pays you to shovel the snow in front of his house. But the neighbor on the other side of your house gives you 10 times as much for the same service, plus a bonus if the sidewalk doesn't have a speck of ice on it. Wouldn't you be inclined to do a better job for the higher paying customer?

That's just the tension managers who run both mutual and hedge funds face. Because hedge funds, the largely unregulated investment vehicles for institutions or the super rich, charge significantly more than their simpler mutual fund cousins, managing both pots of money is yet another conflict of interest in a long list of potential abuses that mutual funds face today.

“The profit margin is so much higher for running a hedge fund than for a mutual fund, that it influences where managers devote their time and energy,” says Don Phillips, managing director at fund tracker Morningstar.

Open-ended mutual funds charge clients an average expense ratio of 1.5 percent of assets annually. Hedge funds, by comparison, levy an annual management fee of 1 or 2 percent plus collect a portion of the profits, typically 20 percent. A manager could easily make 10 times more in a hedge fund.

No cases of managers skimping on their mutual fund duties in order to dote on their hedge funds have come to light — yet. But few people in the industry deny that the potential for abuse exists.

“It's hard to be committed 100 percent to your retail investors while at the same time running a fund that can be taking positions contrary to the retail fund,” says Ted Siedle of Benchmark Financial Services in Oceanridge, Fla., a firm that investigates money management abuses for pension funds.

The potential conflicts are numerous. The main area of concern is the allocation of stocks and initial public offerings. A big bounce in a stock price translates into much juicier profits for a hedge fund than for a mutual fund. Another is front-running — buying stock with the knowledge that a large transaction is coming that may affect the price.

The issue is more than academic these days as scores of fund companies have rushed to open hedge funds recently. AIM Investments, Invesco and Franklin Templeton offer hedge funds. During the market rout, shareholders were bolting from equities in droves and some firms saw alternative investments that stress absolute returns as a way to generate revenue. They also wanted to keep star managers from jumping to the much more lucrative hedge fund world.

Lately, there's been some retreat from hedge funds on the part of fund complexes. MFS exited the business in 2002, and, in late February, Fidelity said that it would not offer hedge funds, despite losing a few of its best stock pickers to hedge funds. “If a fund company's core business is mutual funds, they don't want to jeopardize that reputation by getting involved in something with a potential conflict of interest,” Phillips of Morningstar says.

But portfolio managers who run both mutual and hedge funds say it's possible to act ethically. “Conflicts of interest are nothing new,” says Patrick Adams, president of the Choice Funds in Denver. “If a money manager has more than one client and more than one fund, that's a conflict of interest.” Adams manages two mutual funds — a long-short and a market neutral fund — registered under the Investment Advisers Act of 1940 plus two limited partnerships with higher minimums and high fees that are available to fewer than 100 investors. The two limited partnerships are virtual clones of the mutual funds.

“The most important thing to look at,” Adams says, “is whether you have appropriate allocation procedures in place.”

When Adams buys a block of stock, he allocates among the funds based on their proportion of assets. The biggest funds receive the biggest allotment and smaller funds less.

As everybody knows by now, trading improprieties have been routine as the recent crop of investigations by New York Attorney General Eliot Spitzer shows. For example, Richard Strong, founder of Strong Capital Management, is being accused of trading in his personal offshore accounts to the detriment of fund shareholders. Before that, Ron Baron, the famed growth investor, ran into trouble for selling AMF Bowling stock from his private accounts to his public mutual fund, Baron Asset. And in 1996, McKenzie Walker Investment Management of Larkspur, Calif., was fined by the SEC for allocating IPOs to its performance-tied accounts, but not to clients who paid a flat fee.

“There's always been a strong message from the SEC that if a manager has a clients with conflicting objectives and conflicting fee arrangements and favors one over the other, that manager can be cited for fraud,” says Barry Barbash, a partner and head of the asset management group with Washington, D.C.-based law firm Shearman & Sterling. Barbash formerly directed the SEC's Division of Investment Management.

Though there are ways to put in safeguards against potential improprieties, says Phillips, mutual funds aren't in a position to plead for investor trust in light of the recent scandals. “Right now the industry doesn't have the public trust,” he says. “It's hard for an investor to say, ‘I trust my fund company to treat mutual funds the same way as hedge funds.’”

They may not have to. A new bill introduced in the Senate Banking Committee is threatening to put a ban on the same individual managing both a conventional mutual fund and a hedge fund. Some companies like American Funds of Los Angeles run both pots of money by erecting a Chinese wall in which portfolios are managed by different people. Other fund families hire outside sub-advisors to run their hedge funds. “Whether perfection is out there in the fund world, is always the question,” says Barbash.

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