What hedge fund managers need to know before offering ‘40 Act funds

Tue Feb 11, 2014

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Time is of the essence.


   
   

By Tom Florence

Hedge fund managers have built their business on exclusivity, traditionally catering to wealthy investors and institutions. Lately, though, as accessing those fundraising channels has gotten more competitive, hedge funds are exploring - and offering - products for which they have never been associated - mutual funds.

Money invested in alternative mutual funds in the U.S. rose 51 percent through the first ten months of 2013, to $239 billion, according to Morningstar. Experts are forecasting the staggering growth of liquid alternatives to continue for the foreseeable future, with one survey conducted by Citi projecting total assets of $1 trillion by 2017. Understandably, many hedge fund firms are chomping at the bit to capture some of those assets. But enterprising hedge fund managers would be wise to consider the potential pitfalls before entering the '40 Act space and possibly biting off more than they can chew.

Here are some of the things managers must consider before leaping into the world of liquid, registered funds:

Structure

Mutual funds and hedge funds are both pooled investment vehicles, but that's basically their only structural similarity. The most common structure for a hedge fund is the limited partnership, wherein one or more general partners assumes responsibility for running the fund, and the investing limited partners are liable for the money they put into the fund. In this scenario, the fund manager calls all of the shots. For U.S.-based partnerships, there typically isn't a board of directors, and there are no wholesale distributors to worry about.

Mutual funds, on the other hand, are required to have a board of directors. By definition they draw money from a larger pool of investors, so distribution is critical. Hedge fund managers who are used to controlling every aspect of their business might be tempted to manage their own distribution, but that would be a mistake. Successful entrants into the alternative mutual fund business will stick to what they know-managing money - and outsource distribution, broker/dealer functions and other structural aspects to other firms.

Marketing Savvy

Historically, hedge funds have been prohibited from general solicitation to the public at large, and managers differentiated their funds primarily through strategy and performance. This approach -along with an internal sales team, networking and referrals-drove contributions from new investors. But the Jumpstart Our Business Start-ups (JOBS) Act, is changing how hedge funds can promote themselves. Under the Act, hedge funds will now be able to advertise and more directly solicit business, including posting private offering documentation on their websites for public viewing. While it is unlikely that we will soon see managers pitching funds like ShamWows, it is clear that many are getting ready to test the marketing waters.

And therein lies the rub: Excellent money managers may not make excellent marketers - particularly in the direct-to-consumer/advisor marketing done by mutual funds. So, as hedge funds look to expand their brands into the retail arena, a strong strategy - and marketing partner - is advised.

Fees & Fund Cap

Hedge funds tend to be more expensive than mutual funds. The typical hedge fund follows a two-tiered fee structure-a flat management fee, usually 1.5% to 2%, plus a 20% performance fee-while most mutual funds have expense ratios of less than 2%.

The difference in fees should inform the decision of where to cap the fund in terms of assets. In other words, it doesn't make sense to cap a mutual fund at $250 million given its fee structure. Hedge fund managers seeking to offer mutual funds should be prepared to attract $500 million or more in investments to make the fund worth running.

Regulations & Reporting

Another major difference between hedge funds and mutual funds lies in how they are regulated. Hedge funds with less than $150 million under management do not need to register with the Securities Exchange Commission; mutual funds of any size do. Over the years hedge funds have made great strides to improve transparency, but there is still a veil of secrecy over some aspects of their day-to-day management. For instance, there are no pricing requirements for hedge funds, so investors may not be able to gauge the value of their investments at any given time. Moreover, investors are usually required to keep their money in the fund for at least a year.

Mutual funds, by contrast, have daily pricing requirements and are held to strict liquidity standards. By law, mutual fund shareholders must be able to redeem their shares at any time.

Mutual funds are also monitored for diversification and can be no more than 33% levered, per the '40 Act. Hedge fund managers who expect to run a mutual fund like a hedge fund, and who are unprepared to meet the different regulatory standards of mutual funds, could find themselves in hot water both with their investors and the SEC.

Limited Capacity

Most importantly, hedge fund managers seeking to offer alternative mutual funds need to recognize that time is of the essence. The alternative mutual fund space is expanding, but it's quickly becoming a crowded field. The first managed futures funds began trading in 2007. Now, there are more than 140 funds in the managed futures category, according to Morningstar. The more funds there are, the harder it becomes to differentiate oneself. Hedge fund managers who act quickly-and focus on what they know-will be well positioned for success offering alternative mutual funds.

Tom Florence is the chief executive of 361 Capital, a $550 million Denver-based investment firm specializing in liquid alternative investments.