Aug 15 2011 | 11:31am ET

Joe Barrato is CEO of Arrow Funds, a firm managing over $750 million across five alternative mutual fund strategies. Barrato co-founded the company five years ago with Jake Griffith and a third partner who has since left the firm. All three had been employed at Rydex Investments where they were instrumental in helping that company move into alternative fund strategies. FINalternatives recently spoke with Barrato about the challenges—and benefits—of offering hedge fund strategies in a ’40 Act wrapper.

Can you tell me about Arrow Funds?

We are five years old. The original founders were former Rydex Funds employees…the original product development team there. We helped them get into the ETF business and developed buy-and-hold strategies, including alternatives and hedge fund replication strategies. When we left to start [Arrow], the thought process for us—and it came from our experience of building products—was that we wanted to build packaged solutions that investment advisors could incorporate into their existing portfolios to either enhance returns or mitigate risk in a portfolio, which is not very far off what hedge funds try to do for client portfolios.

We have five funds, we have over $750 million under management among the five products, we have an investment team and we have right now employed in the company about 23 people with the possibility for us to expand to about 37 in the next two years, depending on our growth and government policy.

How common is it to find mutual funds employing alternative strategies?

In the mutual fund space, even going back 10 years ago, alternative strategies—[and] I’ll define alternatives as commodities, inverse leverage or anything that was defined by Morningstar as in the alternative universe—represented 1% of all mutual fund assets, which wasn’t a lot. If you fast-forward that to today and you factor in all of the products that are out there in the ETF space—commodities, inverse leverage—it’s about 4% of all assets. If you understand what endowments are doing, what bank trustee departments are doing for some of their higher-end clients or even [what] family offices are doing, their allocations to alternatives and real assets represent anywhere from 15 to 40% of those clients’ portfolios. And the reason for that is that it creates a natural hedge and it creates a nice offset to, not only what’s happening in the equity markets in certain periods, but also the bond markets.

What strategies do you offer?

We have five products. We have our Balanced Fund that will be out for five years next month, and we’re very proud of that—the Balanced Fund is a fund of funds that trades exchange-traded products. It has five tactical disciplines built into it: sector rotation, style rotation, fixed-income rotation, alternative rotation and international rotation. And it’s rotating among a universe of ETFs using relative strength as a mechanism and each of those five components can be underweighted and overweighted against each other…which is one of the reasons why it does very well.

We came out with an aggressive relative strength fund called the Tactical Fund, between the two of those funds we have $550 million.

We have three alternative funds, we have an Alternative Solutions Fund, which is a mutual fund that has three hedge fund wrappers inside… managed futures, fixed-income arb and hedged equity. What the strategy does is it targets risk to give you exposure to those three hedge fund strategies.

Then we have two other strategies, we have a managed futures fund [that] is basically tied to an index that was developed by Victor Sperandeo, known as Trader Vic. Trader Vic has developed a couple of managed futures indices. This managed futures strategy blends commodities and currencies and it goes long and short in those universes. It’s probably one of the top-performing managed futures strategies over the last year [one-year returns of 8.8%, Fund Class A] and when you compare it to some of the managed futures funds managed by CTAs—and when we’re talking about systematic, broadly traded CTA strategies—it’s outperformed some of the best CTA strategies as well, over the last year.

We recently came out with a very unique commodity strategy. We launched that in December. It’s a long-only commodity strategy but instead of buying commodity contracts in the near term, it goes and buys contracts in the 12-18 month range. So we’re buying long-dated commodity futures and that commodity index that we’re tied to, the Longview Extended Commodity Index (LEX), it is one of the best-performing commodity indexes in the last 5-10 years. And since we’ve launched the product it has outperformed the GSCI Index funds, the Dow Jones Commodity Index products and the Deutsche Bank Indexes.

Suppose I’m an institutional investor and I want exposure to managed futures—what are the benefits to getting that exposure through a mutual fund?

First and foremost, when we look at managed futures today, what you’re really looking for is an instrument that’s going to give you non-correlation to traditional assets like equities and fixed-income instruments. When we built our first non-correlating strategy to the markets, we were really looking for a way to give the investor a way to get exposure. In a hedge fund or a managed futures fund, they try to seek positive returns in any market environment and CTA strategies do the same thing and essentially we’re trying to do that as well. Standard mutual funds just try to give you relative returns but we’re doing the same thing, so you’re not really losing anything there…The trading activity is both long and short, we’re doing that as well. We’re doing low correlation to the equity and bond markets and we’re doing low market risk—so those are the things that we have in common.

What are some of the differences? Well, one major difference is daily liquidity. I think if you look at what’s happened to hedge fund managers, the really, really good hedge fund managers are not losing their clients but those that are sub-par or those that had issues—there was a lot of redemption activity—that caused problems. It actually became a calling card for a lot of smart firms like family offices, even endowments—they wanted liquidity. That is a huge differentiator, mutual funds give you that liquidity where a CTA or hedge fund wrapper offers limited liquidity.

We only charge an asset-based fee, where CTAs and hedge funds typically charge performance and asset-based fees as well—the typical 2 and 20 structure is what you hear…If you look at the…universe of mutual funds that are out there, [fees] can be below 1 [%] to as high as 3 [%]. I don’t want you to think that they’re all low, there are various extremes…but you don’t have incentive fees built into it…

In alternative mutual funds or managed futures funds, you’re open to all investors, where in hedge funds and CTAs, you have qualified investors. They’re highly regulated in a mutual fund structure, there’s very little regulation on the hedge fund/CTA side—and that’s changing, there’s more scrutiny coming and I think what you’re also seeing is a lot of hedge fund managers, they’re looking to convert their hedge fund into a mutual fund wrapper because they know that scrutiny potentially is coming down the road. That’s a very interesting phenomenon that I’m watching.

[Mutual funds are] highly transparent…Minimums are lower on a mutual fund structure. Typically our investors can get in for as little as $1,000. You know that hedge funds and CTAs have higher minimums and a lot of it has to do with just being qualified. And then manager risk—I’m not saying we don’t have manager risk. We have one strategy tied to an index, so we really have more strategy risk. You have high manager risk in a hedge fund strategy because you’re relying on the skill of that manager. Rarely do you see strategies that are not dependent on a manager—a manager leaves a hedge fund, that hedge fund’s over. The other thing is incentive fees—you can typically see a fund that falls below incentive fees, it’s in their best interest to shut the fund down and start a new one because they’re never going to meet their high-water marks. You can’t do that in a mutual fund.

Can you basically replicate any alt strategy in a mutual fund wrapper or do some work better than others?

I think you have limitations on what you can do within a ’40 Act wrapper. If you were to talk with our portfolio manager, there’s only a certain amount of leverage that you can employ on both sides, whether you’re going long or short, and the ’40 Act rules kind of put parameters around what you can do. Now, a hedge fund manager that’s going from the environment where he can do anything into a mutual fund environment has to learn how to thrive and survive within those rules. Our portfolio team not only was doing this at previous firms for a number of years, but they actually started building hedge fund wrappers within a mutual fund structure and had to work within those parameters.

We have other challenges…The classic example is trading commodities. A hedge fund issues, typically K-1s, mutual funds 1099s. Now, mutual funds are not at liberty to just buy commodities instruments, they have some limitations on how they can get that exposure. One way they can buy instruments and commodities is they can buy notes. But with notes you have default risk…Hedge funds are just going to buy futures and futures are cheaper and, in some cases, there’s a lot more protection on just buying the futures because it’s between you and the party that you’re buying it from.

Do you see things like UCITS funds as competition?

When the mutual fund industry and the ETF industry only has 4% of their assets in alternatives, we are not competitors. We have got to do a better job at getting that number [to] 15-20%. Because what we’re really not doing is we’re not helping investors truly understand that they need more exposure to these types of instruments as a hedge in their overall portfolio. And until that happens, we’re not competitors, we’re helping each other get the message out and evangelize the need [for] alternative and tactical strategies [in] mainstream America’s portfolios.

Investors need to think more like endowments and what they’ve done over the last decade—two decades, for that matter—where they were 60% equity and 40% bonds to where they are today with their allocations…That’s [what] I think we’re…trying to convey to mainstream America.

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