New York (HedgeCo.Net) – At almost every hedge fund conference, a panel or two will present on the pros and cons of liquid alternatives, but when an industry grows 45% in the twelve months ended October 31st, 2013 to $129.8B in AUM, people tend to notice. Liquid alternatives once again took center stage at the FRA “Establishing a ’40 Act Alternative Fund” on April 1st in New York. While the name implies an audience of hedge fund managers looking to start mutual funds, it was actually made up of investors and gatekeepers seeking more information about the structure, distribution, and strategies that comprise one of the fastest growing areas in registered products.
Specific to the discussions was understanding the types of strategies that can be effectively executed in a mutual fund structure. Regulations impose restrictions on position concentrations and the use of leverage, while liquidity terms dictate that strategies are able to meet daily redemption requests. This typically means a hedge fund, which is not bound by these restrictions, is not always able to recreate its exact existing investment strategy in a ’40 Act product. For instance, if the fund is managing a distressed credit portfolio, the underlying positions would probably be too illiquid for a ’40 Act fund. Still, plenty of funds with qualified strategies are left to weigh the best ways of diversifying their business models and addressing the benefits the ‘40 Act structure provides.
At initial costs nearing $200,000 plus the additional ongoing compliance reporting and increased oversight, creating a ’40 Act fund is not a decision to be taken lightly. One discussion group weighed the benefits of two common structures of choice: a series trust and a proprietary fund. The series trust can be thought of as conglomeration of funds. The structure is owned and managed centrally, usually by large financial industry participants like commercial and investment banks, while each “subsidiary” fund portfolio, or series, is managed by a different investment manager. This keeps the investment manager from having to create a whole new fund structure from scratch, reducing costs and the amount of time necessary to begin taking in investors.
While the series trust is a more “turn key” solution, the proprietary fund, as the name implies, enables a manager customize the structure. The advice of some panel members was to build the fund structure and roster of providers around the specific underlying strategy. One illustration focused the discussion on the use of a tri-party custodial relationship for long/short funds. Where a series trust will most likely have solidified a relationship with a bank custodian, the investment manager starting his proprietary fund can search for custodians that have a broker/dealer arm or relationship that can handle the non-traditional aspects of his portfolio, such as his short positions or derivatives.
As a quick overview of the issue at hand, for a long/short equity mutual fund, the equities fully bought long must be held with a qualified bank custodian or trust company, whereas the fund will need to designate a broker/dealer to custody its short positions, as well as futures and options.
In the case of utilizing a separate custodian and broker/dealer, the speakers noted the potential for confusion when assessing margin collateral. A proprietary fund can search for a custodian that has a tri-party arrangement with a broker/dealer. This can streamline the process of managing what is, in effect, two separate portfolios as if it was one portfolio held with one broker.
Compliance also plays a key role, often above and beyond the regulations set out by the 1940 Act. One panel discussed the likely conflict of interests that arise when hedge fund managers start mutual funds and begin managing two differently priced offerings in a similar strategy. This typically entails clarifying trade allocation and best execution methodology, as well as the investment decision making process. As an example, the panelists walked through the scenario of a portfolio manager’s great stock idea, but with limited capacity. The speakers noted that the manager may be pulled between their hedge fund, where they may be charging 2% management fees and 20% performance fees, vs their mutual fund that typically comes in at just a 2% management fee.
Once the structural adaptations were addressed, participants moved on to the most pressing question: distribution. Hedge fund managers are used to marketing their fund on a very individualized basis by positioning their strategy for a specific investor and touting their operational infrastructure above their competitors. Attendees of this conference left with the notion that promoting an alternative mutual fund shifts the mindset from individualized marketing to distribution platforms. The shortest route to the most end investors is through large wirehouses. Charging upwards of 40 basis points, many of these wirehouses require minimum AUM and length of track record, but even their offerings are becoming crowded. Panelists estimated the number of alternative mutual funds to be over 400 and growing.
Hedge fund managers that aren’t inclined to start their own registered product have another option which removes much of the headache, but also most of the control. Some hedge fund managers are choosing to sub-advise their services to registered mutual funds, who in turn offer them as “multi-manager” alternative products. While this option does not require the set up and distribution efforts, it also means the fund is beholden to their operating partner for everything from compliance to distribution. There are several operators out there and it is probably best to explore all options before jumping into a long term arrangement.
Despite the multiple nuances and complexities compared to operating a hedge fund structure, alternative mutual funds are seeing growing demand as investors push the alternative industry for lower fees and better liquidity terms. While alternative mutual funds are not the end all, with several other options in the market for investors, such as segregated managed account platforms and separately managed accounts, these funds seem to be here to stay and we can expect to see more and more of them in the future.
Director of Business Development