Alternative investments allow investors to diversify their holdings away from traditional investment strategies, and thereby smooth out and potentially enhance long-term returns. Within the alternatives sphere, there are many investment vehicles available for accessing a wide variety of strategies; and these strategies and vehicles each have their own features that may make them constructive — or destructive — to an investor’s particular objectives.

For example, uncorrelated strategies provide diversification benefits, but redundancy of exposures can weigh on returns. In order for investors and advisors to make wise allocation decisions, they must understand the ins and outs of their investment strategies and vehicles — and how they interrelate. One problem many alternative investors fail to properly appreciate is netting risk that is associated with an investment in multiple investment vehicles that impose performance fees.

Hedge Fund Fees

A lot has been written about the typical hedge fund fees of 2 and 20 — 2% of assets under management (AUM) and 20% of investment gains. There are those who allege these fees are too high, but hedge fund defenders are quick to point out that the 20% performance fees are only assessed on gains, and if a fund fails to turn a profit for its investors, the asset-based fees are somewhat comparable to the net-expense ratios of alternative mutual funds. Investors are willing to pay for performance, and there’s nothing wrong with that. All fine up to this point.

Netting Risk

However, consider what happens when you invest in multiple hedge funds, and one posts gains while the rest suffer losses? For instance, imagine a portfolio of three hedge funds: Fund A, Fund B, and Fund C. If an investor allocated $1 million to each fund, and Fund A posted a $100,000 gain, while Funds B and C each notched $20,000 losses; then the investor would seem to have a $60,000 gain, but the $20,000 (2% of $1 million) asset-based fee charged by each fund would wipe out these gains. Worse yet, the investor would still be required to pay 20% of his $100,000 in gains from Fund A as an incentive fee to the fund’s manager, thereby turning a $60,000 gain (pre-fees) into a $20,000 loss. As a result, the investor ends up with a 0.67% loss on the $3 million investment, while all three fund managers collected a fee.

While simplified for this example, the scenario above is called netting risk, and it occurs when investors invest separately in two or more hedge funds that charge a performance fee. This can occur when investors structure their own portfolio of hedge fund investments, or use what is called a fund of hedge funds.

In response to this issue, hedge fund managers designed what is called multi-strategy hedge funds whereby an investor can gain exposure to multiple alternative investment strategies all in one fund generally managed by different teams at one asset management firm.

In the case of multi-strategy hedge funds, the hedge fund firm, or asset manager, takes on the netting risk and decides how to allocate a single performance fee across multiple teams managing different strategies. This benefits investors by providing diversification of their investment across multiple investment strategies without the investor taking on the netting risk.

While certainly an improved structure, netting risk is still present for those investors who allocate to multiple multi-strategy funds, which would be a prudent decision in order to mitigate manager risk.

Alternative Mutual Funds

The good news is that investors are able to access multiple alternative strategies without bearing netting risk or suffering illiquidity. Alternative mutual funds pursue hedge fund strategies, and multi-alternative funds are the mutual-fund equivalent of fund of hedge funds and multi-strategy funds. What’s more, since alternative mutual funds don’t charge performance fees₁. investing individually in multiple alternative mutual funds is also free of netting risk.

Here are three different types of multi-alternative mutual fund or ETF structures to look for, and their institutional equivalent:

• Fund of Managed Accounts Equivalents — These funds operate similar to an institutional managed account program, whereby one advisor manages an allocation to multiple hedge fund managers who manage separate accounts on behalf of the advisor.
• Fund of Hedge Funds Equivalents — These funds are managed by a single organization, or advisor, who focuses on fund selection and portfolio construction. Each fund allocates assets to other alternative mutual funds and/or ETFs to provide multi-alternative exposure for investors.
• Multi-Strategy Equivalents — These funds are managed by one advisor across multiple alternative investment strategies, all managed by different teams under the umbrella of the advisor’s organization.

Conclusion

Investors interested in gaining exposure to hedge fund strategies can choose between investing in hedge funds or alternative mutual funds and ETFs. While the range of choices today is certainly much greater with hedge funds, investors should be aware that they are exposing themselves to netting risk when allocating to multiple hedge funds. As a result, alternative mutual funds and ETFs should be considered as a way to avoid this risk and potentially mitigate the downside of netting risk.

As the selection of alternative mutual funds and ETFs continues to grow, investors can choose to build their own suite of single strategy funds, or choose several multi-alternative funds, and do this without the concern of being exposed to netting risk.

Footnotes:

1 There are a few exceptions to this which exist in mutual funds that use offshore vehicles or swap structures to invest indirectly in hedge funds or receive the return of hedge funds. In those instances, netting risk is present. As your mutual fund provider about their structure.

Jason Seagraves contributed to this article.