WEST PALM BEACH,FL (HEDGECO.NET) – As hedge funds continue on their growth path, increasing numbers of traditional investment managers such as mutual funds are studying for ways to get a piece of theaction by establishing their own hedge funds as well. But many argue that when mutual fund managers run hedge funds as, such condition invariably can create conflicts of interest.
Hedge funds have experienced record busting growth over the past five years, as wealthy persons and institutions poured assets into alternative investment instruments. Hedge funds are for the most part loosely regulated investment products, accepting minimum investments of usually about $1million. Unlike mutual funds, hedge funds usually bet on stock declines, as part of its investment strategy.
In 2003, there are estimates of about 7000 hedge funds managing about $800 billion in investor assets. This figure however, is still well below the roughly $7 trillion invested in mutual funds, but the hedge fund industry is projected to continue to grow in the coming years. This is because many more conservative investors like pension funds and endowments are discovering hedge funds and are increasingly devoting a higher percentage of their portfolios into hedge fund strategies.
With such growth in global hedge fund portfolios, in addition to higher compensation packages for hedge fund managers compared to mutual fund managers, increasing numbers of traditional mutual fund managers are moving over to hedge fund management. Some of those managers are actually forming and managing their own hedge funds as well. [HedgeCo.Net,previous story]
Some affluent mutual fund investors have indicated their interest in investing in hedge fund strategies. Many mutual fund managers are offering hedge funds, so as to accommodate such demands, and to boost profits as well. This strategy may also help mutual funs retain their talented managers, who are increasing moving over to hedge fund arena.
According to Reuters, �Many mutual fund money managers 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�.
When this situation arises, one of the possible areas of conflict is the issue of where these managers may send their trades. According to Kenneth Gerstein, a partner at law firm Schulte Roth & Zabel.�Hedge fund managers receive better compensation for hedge fund products than mutual fund products and that creates a conflict on where you send the trades”.
There is also another potential conflict of interest situation. For example, a mutual fund manager may decide to buy stock which a hedge fund manager sells short, this situation may lead to an outcome where a mutual fund portfolio may experience a loss while on the other hand, the hedge fund portfolio may see gains.
According to Jonathan Bergman who manages $200 million at Palisades Hudson Asset Management Inc., a situation like this could be problematic. Bergman said, “I am not excited about this and I would prefer that mutual fund companies not do it. It will be tough to reconcile the conflicts of interest.” Bergman explains that he invests in hedge fund managers, but his preference is that hedge funds do not run mutual funds simultaneously.
Marc Baltuch, a former Securities and Exchange Commission official, who is now chief of compliance at Zweig-DiMenna, a money-management firm puts it this way, �If you’ve got a mutual fund and another similar account with a 20% performance fee, it inherently raises a conflict of interest, I�ve heard of situations where new issues found their way into performance-based accounts and not others� Baltuch adds.
Situations such as these have led to increased skepticism that mutual fund managers who also run hedge funds could avoid such tempting conflicts. One can also argue that mutual fund managers running hedge funds cannot totally separate such interests, after all, their managers interact with one another, and eat lunch at same places.
Michael Griffin, head of the hedge fund practice at law firm Dorsey & Whitney LLP expressed his concerns. According to him, the SEC is worried that “assets with an incentive fee may be advantaged over others” such scenario may lead to hedge fund managers taking on excessive risk with the hope of hitting a home run for hedge fund portfolios which offer incentive fees.
Mutual funds may be the bigger losers if these trends continue. Recently Bjorn Borgen, former owner of Founders Asset Management, settled a case with the SEC in 2000 for allegedly discriminating against investors with smaller accounts by charging them higher fees than other investors with larger accounts. There is also the issue that Founders trade practices favored larger accounts than smaller ones. Borgen paid $150, 000 in fines to settle with SEC, and also agreed to pay back $500,000 to its clients.
This column in its last editorial argued that hedge funds do not need to be regulated, because for the most part they have kept themselves in check, and transparency has been increased to the point that hedge fund investors can go online to obtain current data on the fund�s activities. However, on the issue of mutual funds operating hedge funds under the same roof, government regulations may indeed be appropriate because such developments can truly lead to conflicts of interest.
Paul Oranika
Editor-in-Chief
HedgeCo.Net
Email: Editor@hedgeco.net
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