Got Conflicts?

When the mutual fund scandals broke in 2003, some of the most notorious villains were so-called side-by-side managers — money managers that ran mutual funds and hedge funds at the same time. In the worst cases, managers rewarded hedge fund clients at the expense of mutual funds. For example, mutual fund Alliance Technology faced SEC penalties for allowing hedge fund clients to market time, trading rapidly in and out of the mutual fund. Appalled at the conflicts of interest, the House of Representatives passed legislation banning mutual fund managers from also running hedge funds.

But the Congressmen may be worried about a non-issue: Instead of fleeing side-by-side managers, investors should embrace them, according to recent academic research. “There is no reason to ban fund managers from running hedge funds,” says Russel Kinnel, Morningstar's director of mutual fund research.

To be sure, side-by-side managers can be tempted to favor their hedge funds because of fee structures. While a hedge fund manager can earn more than 20 percent of profits, a mutual fund manager gets relatively slim rewards, such as 0.75 percent of assets or less. Because of the fee structures, a manager has an incentive to boost hedge fund returns — even at the expense of his mutual fund. To avoid cheating fund shareholders, a manager must be scrupulous. If he gets a hot IPO, the shares must go equally to hedge funds and mutual funds. And a hedge fund manager should not short a stock that his mutual fund owns in a long position.

Multitasking Managers

But if side-by-side managers were still giving in to temptation, then their mutual funds should perform relatively poorly. And that is not the case, says Tom Nohel, an associate professor at Loyola University, who studied performance records along with Z. Jay Wang of the University of Illinois and Lu Zheng of the University of California, Irvine. To look for signs of conflict of interest, the academics examined 155 mutual funds whose managers also ran hedge funds. The researchers found that on a risk-adjusted basis, mutual funds run by side-by-side managers outdid their peer group by 1.5 percent a year. “The side-by-side guys really do better,” says Nohel. “Our results could suggest that the best mutual fund managers may be recruited to run hedge funds.”

Taking a cue from the academics, many fund companies are not defensive about their use of side-by-side managers. Executives argue that if they didn't allow top managers to run multiple funds, star employees would jump ship and spend all their time with hedge funds — a loss for mutual fund investors.

Side-by-side managers may be particularly important for fund companies that rely on subadvisors — freelancers who manage money for many funds and clients. Vanguard Group, a big user of subadvisors, makes no bones about side-by-side managers. By using tough monitoring procedures, Vanguard makes sure that its shareholders get a fair shake. Vanguard subadvisors that also run hedge funds include Edward Owen of Wellington Management, who also manages Vanguard Health Care, the best-performing member of its category for the past decade, and Sam Wilderman of GMO, who manages some of the assets for top-ranked Vanguard Explorer.

Disclosure, Disclosure

Does your fund manager also run a hedge fund? In the past, there was no way to know. But in 2006, new rules required managers to disclose all of the funds and accounts they manage in Statements of Additional Information. The material is available on the SEC's Edgar site. In some cases you can bypass the SEC site and instantly get the data through a Google search. By searching for “Diamond Hill Statement of Additional Information,” you can quickly learn that the boutique fund company's Chuck Bath, portfolio manager of top-performing Diamond Hill Large Cap, also runs hedge fund assets.

In some cases, the disclosures don't use the term “hedge fund,” but they give away the game by noting that the managers run unregistered funds. Another code phrase for a hedge fund is that the advisory fee is “performance based.” Translating the legalese, it is possible to determine that John and Nick Calamos, managers of Calamos Growth fund, also run hedge funds.

Along with announcing who runs hedge funds, the new disclosures show the total assets a manager runs. This is of particular interest for advisors who worry that a manager's returns may drop as his portfolios become bloated. In the past, data on mutual fund assets was readily available from Morningstar and other fund trackers, but it was next to impossible to find out how much a manager oversaw in hedge funds and separate account assets. Now all of these numbers are listed in the Statement of Additional Information. For example. GMO's Wilderman runs $2.9 billion in separate accounts and $4.4 billion in hedge funds. John Calamos manages about $35.6 billion in mutual funds, $11.7 billion in separate accounts and $348 million in hedge funds.

Armed with the new data, advisors can now make more informed decisions about whether a manager's load is becoming too bulky. “When you are trying to decide whether a manager can run more assets, you have to look at everything, including separate accounts and institutional money,” says David Kovacs, senior portfolio manager of Turner Investment Partners, a fund company that is careful about closing funds to new investors when they get too large.

How big is too big? Experts disagree, but Morningstar provides some rough guidance. The fund tracker looked at the median sizes of funds that had closed to new investors. This suggested what levels the managers themselves thought were appropriate. The median size of the closed large-cap funds was $18 billion, while mid-caps closed at $3 billion and small-caps at $800 million. To be sure, there are examples of funds that produced strong performances after they passed the Morningstar average closing levels. For top side-by-side managers the appropriate closing marks could be higher. Any manager that can deliver strong returns from both hedge and mutual funds may be nimble enough to handle an unusually large pool of assets.