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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.

English: The corner of Wall Street and Broadway, showing the limestone facade of One Wall Street in the background. (Photo credit: Wikipedia)

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).