Bear markets are devastating, bull markets a beautiful sight to behold, but nothing gets Wall Street more excited than the dawn of a new financial product that brings with it lucrative client flows. Thus despite the weather, the mood in luncheon conversations during my trip to New York last week was downright giddy. The excitement is over a new frontier for the hedge fund industry: mutual funds. Over the past few years, a combination of industry shifts and regulatory changes has led to a number of alternative investment firms entering the mutual fund market.
If you haven’t yet come across “hedged mutual funds” or “alternative mutual funds”, chances are you probably will soon. This newer breed of mutual fund purports to deliver hedge fund- like exposure, but is available in a mutual fund structure. They are mutual funds that employ investment tactics traditionally only found in hedge funds including the use of leverage, derivatives, and short selling. This is far afield from traditional, ‘long-only’ mutual funds which limit themselves to buying and holding assets, most typically public equities or bonds. The new tactics employed within hedged mutual funds allow mutual fund investors to gain access to a wide range of traditionally exclusive hedge fund strategies including merger arbitrage, convertible arbitrage, long/short equity, macro trading, etc. They also represent a vast expansion in the potential client base for the hedge fund industry, unleashing a new gold rush of sorts for alternative asset managers.
Gold in them thar hills….
In recent years, the hedge fund industry has undergone considerable consolidation, and this process has generated a number of large firms who now have the scale required to manage mutual funds. According to HFRI, out of a total of approximately 10,000 hedge fund firms in existence today, the top 287 hedge funds mange $1.5T in total assets, or around 60% of the industry total. To accommodate large asset growth, many of these firms have had to change their investment approach along the way and abandon many lucrative but capacity constrained opportunities. Untethered to niche, capacity constrained investment styles, with large scale firms to support, and operating in an environment where fee pressures are felt at every level, their focus has often turned to raising even more assets.
At the same time however, growth in the hedge fund industry has slowed from the heydays of past decades. Though last year’s growth was a very respectable 15% according to a recent report from Barclays Strategic Consulting, it was largely driven by performance, not new client flows. In contrast, last year the new alternative mutual fund community (’40 Act funds) brought in 66 cents for every dollar of new assets invested in traditional hedge funds, in spite of the fact that the alternative mutual fund community is 18x smaller than the hedge fund industry. In fact, alternative mutual fund products grew at a neck-breaking 43% last year, turning a lot of heads in the process. Hedge fund, fund of hedge funds, and mutual fund firms are eyeing this nascent but potentially immense opportunity in alternative mutual funds. To put it in perspective, around $13.2T is currently managed in traditional US mutual funds, almost 4.5x as large as the global hedge fund industry today.
Alternative mutual funds offer investors a new way to diversify
Since their early beginnings, regulators have restricted hedge fund investing to “qualified investors” – namely the wealthy and institutional investors. Thus for retail investors, these new products provide a partially open door into the exclusive world of hedge fund investing. The new alternative mutual fund products are generally less interesting to institutional investors, as they can readily access traditional hedge funds and negotiate with hedge fund managers to obtain appropriate liquidity, transparency and fee terms. However some constrained institutional investors (that are smaller in size, need higher liquidity, or have strict fee policies) have also been eying these products as an opportunity to obtain lower fees, higher liquidity, and greater transparency than available in a traditional hedge fund portfolios.
So now that these once exclusive hedge fund products are available for the masses, and at comparatively “low fees” to boot, should we all be rushing to include these in our investment portfolios? Well, not so fast. There are many questions remaining about what exactly these products are meant to deliver and what role in an individual’s portfolio they should play, and most importantly, will they actually work, i.e. will they provide a return profile similar to their non-mutual fund structure ancestors?
How hedge funds work and why they are interesting to institutional investors
Unlike mutual funds, which are highly regulated, hedge funds are ‘unconstrained’ investment vehicles. This allows them to target investment opportunities that may be too illiquid, small, or complex for traditional investment vehicles like mutual funds. By utilizing certain investment tools, techniques and trade structures that are unavailable to traditional mutual funds, hedge funds are able to engineer return streams that look much different than traditional stock or bond allocations and thus offer valuable diversification to investor portfolios.
One of the principle advantages that hedge funds have over traditional funds is their ability to tolerate investments with lower levels of liquidity. By law, mutual funds must provide daily liquidity. There are a number of complex and distressed investments that offer compelling return profiles, but are precluded from mutual funds because they will take a few days, weeks, or even months to sell at a reasonable price. Incentivized with performance fees and with monthly or longer investor liquidity, hedge funds are positioned to reap the benefits in some of these under-served, less liquid markets.
For example, certain distressed mortgage backed securities issued in 2007 and 2008 lost their traditional investor base when they were stripped of their investment grade ratings. As a result they became somewhat illiquid and traded at steep discounts to fundamental value. This provided an attractive entry point for hedge funds who were positioned to manage the lower level of liquidity. As the housing market then recovered, these funds reaped handsome profits.
Another key competitive advantage for hedge funds is the ability to short sell securities (i.e., to take positions that profit if securities go down in price). This allows hedge funds to deliver returns with low correlation to market direction as the managers can use shorting to remove unwanted market exposure in the portfolio. For example, a hedge fund may have a deeply researched view on a particular Brazilian equity. By shorting the Brazilian equity market and buying the equity, they can isolate their investment exposure to profit from their conviction on the particular stock, and hedge out volatile moves in Brazilian equity markets as a whole.
Finally, hedge funds can employ leverage, i.e. they can borrow money to enhance returns in their portfolios. This allows hedge funds to increase risk of positions and portfolios in order to meet their return targets, where appropriate. By targeting off-the-run, complex, less liquid investment opportunities, shorting to remove unwanted market risk exposure, and using leverage to target an appropriate risk level, hedge funds have the potential to generate attractive returns that are uncorrelated to traditional long-only bond and equity asset classes. In fact, many institutional investors have classified hedge funds as a new asset class and invest in hedge funds to help diversify their pension fund, endowment, sovereign wealth, and insurance related portfolios.
Fitting a square peg in a round hole?
Despite the enthusiasm from both mutual fund investors and hedge funds managers for alternative mutual fund products, there remain significant fundamental challenges to including hedge fund strategies within mutual fund structures. The very same drivers that make hedge funds attractive to institutional investors also make them difficult to shoe-horn into a mutual fund structure. There are many restrictions and regulations for running a mutual fund company that are different from a hedge fund including governance structure, reporting requirements, registration requirements, and mandate flexibility. However the restrictions that have the potential to effect returns the most are limits on liquidity (to less than 15% of the fund), leverage (limited to 1.33x NAV), and restrictions on instrument type (certain derivative transactions are not allowed).
These limits have the effect of eliminating many types of hedge fund strategies from consideration for alternative mutual funds. Looking at the existing alternative mutual fund products being offered today, strategies which tend to use more liquid securities and less leverage, such as long/short equity, global macro, and event driven equity, tend to be over-represented compared to the makeup of the traditional hedge fund universe. Meanwhile hedge fund strategies in fixed income are generally under-represented. This makes sense as fixed income hedge funds tend to meet their return objectives either by exploiting deeply distressed special situations in credit (too illiquid) or employing highly leveraged trading structures to exploit small dislocations in liquid bond markets (too levered). Outside of these two approaches, and in today's low interest rate environment, bond markets generally offer lackluster returns.
Another significant challenge has nothing to do with regulation: overcoming capacity constraints. Hedge fund managers scour the universe for market inefficiencies, which tend to occur off the beaten pathways of efficient markets. Many of the best opportunities are often too small to be interesting to market behemoths. However, appropriately sized hedge fund managers are able to spend the time needed to understand the complexities in these smaller opportunities because the fee structure allows for it- they are paid with performance fees, allowing them to generate lucrative revenues even off of a comparatively small capital base.
With no performance fees allowed, and lower management fees, mutual fund businesses are instead geared for scale. Portfolio managers of mutual funds thus seek markets that can tolerate large trade tickets and provide daily liquidity for their much larger portfolios. Thus, applying the same niche, smaller scale and performance-oriented opportunities that hedge fund managers generally pursue within the context of a large alternative mutual fund structure would be like trying to fill a bathtub with a teaspoon, there aren't enough of these opportunities to wet your toes.
Ironically, fees are also a potential issue with alternative mutual funds. Despite the fact that alternative mutual funds boast lower headline fees than standard hedge fund products, costs and fees still have the potential to weigh down returns. This is because pass-through expense policies may be more lenient in the mutual fund format than the hedge fund format and investors may have to pay additional distribution and sales charges. Including management fees, sales charges, distribution fees, short-selling and other expenses, total fees for alternative mutual products can range between 3% and 5% per year.
Finally, perhaps the biggest challenge is for hedge fund manager to overcome the conflicts involved in running both a high fee, unconstrained hedge fund while also running a low fee, constrained mutual fund. The problem is that by offering high quality, low fee versions of their higher fee hedge funds products, hedge fund managers risk cannibalizing their existing client base. This goes beyond the more mechanical problem of making sure trade allocation policies are executed fairly. In principal, a hedge fund manager launching a mutual fund must convince its existing hedge fund investors that the new mutual product is sufficiently different than the hedge fund, and that the hedge fund is worth "paying up" for. Hedge funds have responded by clearly delineating the subset of trades and strategies that will be included in mutual funds. Managers are clearly incentivized to put their most capacity constrained, lucrative ideas in the hedge fund vehicle which may lead to a performance gap over time.
In order to mitigate these constraints and conflicts, generally a few approaches have been taken. At the portfolio level, multi-manager products tend to be disproportionately skewed heavily toward equity and macro strategies. Many hedge fund strategies must be abandoned all together such as relative value and distressed investing. Managers have attempted to mitigate cannibalization by providing a clear articulation of how these products are limited versions of their higher fee products. However, it is important to recognize that these issues can be mitigated but not fully addressed. The reality is that although these portfolios offer some of the features of hedge funds, they cannot possibly fully duplicate the exposure. With liquidity, capacity, and conflict constraints, returns are likely to be affected, leaving the diversification objective as the principal motivation for investment in these products.
Conclusion
In summary, to answer whether or not alternative mutual funds should be included in your portfolio, it's important to be cognizant of the following issues. 1) Alternative mutual funds are not going to be able to exactly replicate the return profile of unconstrained traditional hedge funds. They should not be thought of as an exact hedge fund substitute because the constraints and conflicts inherent in these products have led to significant adjustments in the investment process. 2) Because of these constraints, many of the key sources of return generation for the portfolios are necessarily excluded from consideration. This exclusion may lead to a gap in performance between the traditional hedge funds and alternative mutual fund products. This leaves diversification as a primary rational for including these into a portfolio. Perhaps the most appropriate way to position these products in retail portfolios is a partial substitute for fixed income allocations (i.e. as a diversifier with lower return potential, lower volatility). With bonds and equities both nearing record highs, having another uncorrelated source of potentially positive risk adjusted returns may be valuable to many retail investors.
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