Just when things were starting to look up for hedge funds after a rough 2008, a mushrooming insider trading scandal could prompt investors to start pulling money out again.

The trading scheme uncovered at prominent hedge fund firm Galleon Group last month was widened on Thursday to include a number of smaller, less known firms. But it also appears to touch a prominent firm. The government's cooperation agreement with Choo Beng Lee, a former hedge fund trader turned government informant, suggests he engaged in insider trading while working at hedge fund firm SAC Capital, one of the industry's biggest and best-known.

For many hedge fund investors, the biggest fear is that a large, well-known hedge fund might also be involved, several investors and industry lawyer said.

"This could be spreading like a virus," said Michael Hennessy, managing director at Morgan Creek Capital Management, which invests USD 9 billion in hedge funds.

The allegations of an old-fashioned insider trading scheme, coming less than 12 months after Bernard Madoff's monumental, USD 65 billion Ponzi scheme was unearthed, could unnerve many investors.

"This is yet another shockwave that could serve to undermine investor confidence," said Brenda Sharton, a partner at law firm Goodwin Procter.

Pension funds, endowments and the rich, who put billions into loosely regulated and often secretive hedge funds, might be shaken most, however, because this is the first time hedge funds have been involved in such a case, lawyers said.

"Right now no one wants the career risk of being invested in a fund that might be linked to this," said Morgan Creek's Hennessy, adding that many investors are now debating how to react to the growing scandal.

Bad Timing

For the USD 1.5 trillion hedge fund industry, the insider trading scandal could not have come at a worse time -- less than a year after it posted its worst-ever returns, sending many investors racing for the exits.

In the year ended June 30, investors pulled about USD 800 billion out of hedge funds. The tide finally turned in the third quarter, when funds reported inflows of USD 1.1 billion, data from Hedge Fund Research show.

Those numbers, issued in October, encouraged industry consultants to forecast that pension funds and endowments would rekindle their ardour for alternative investments because returns were up and managers were more open.

To attract capital, some normally secretive funds are now talking to investors about their strategies, who else is invested and how they propose to avoid disastrous declines.

"People looked at the performance, they liked it and October's numbers will accentuate that hedge funds can make money when other markets are off," said Thomas Lynch, managing director at Cliffwater LLC, which helps pension funds invest USD 6.5 billion in hedge funds.

"I am not seeing a bailout of hedge funds by any big institutions," he said.

But the fragile trend could be squashed by fears that more embarrassments are lurking and that U.S. authorities could soon link a big-name hedge fund firm to this probe.

On Thursday, traders or fund managers at three relatively small firms -- Spherix Capital, S2 Capital Management and Incremental Capital -- were named, as well as a lawyer at the prominent firm Ropes & Gray.

"What everyone is scared to death about is that a prominent manager could be implicated in this scheme and that would be absolutely devastating for the industry," said one investor who puts USD 5 billion into hedge funds, but is not permitted to speak about the investments publicly.