Get Ready, Hedge Fund Mutual Funds Are About To Fundamentally Change The Market

Date: Thursday, December 2, 2010
Author: Sara Grillo, Business Insider

With the large scale shuttering of hedge funds coupled with investor skittishness over fraud, it seems like the migration of hedge funds to a transparent, publicly available mutual fund structure is inevitable. We predict that within the next 3-5 years, the world will see hedge funds abundantly offering public vehicles housing their strategies, a Hedge Fund Version 2.0. These 1940 Act funds will be referred to as “hedge fund mutual funds” in our discourse.

There Exists Sufficient Rationale for Hedge Fund Mutual Funds

Although due diligence is imperative prior to hedge fund allocation, many investors perform only cursory evaluations, or neglect to conduct any form of inspection at all. The persistence of such neglect is astounding in the wake of the multi-billion dollar Madoff crisis. The arduous process of conducting in-house diligence or the onerous costs of outsourcing may be sidelining proper diligence. Even for firms that do perform due diligence, bias can often create suboptimal analysis.

Another preclusive factor is access. The devastation has spurred the lowering of minimums; however most hedge funds will still not accept less than $250k as the initial subscription. The emergence of distribution platforms which allow monies to be pooled and deployed through a “feeder” model presents a way for many smaller investors to circumvent this difficulty. Many such platforms will not charge the investor, but instead accept kickback fees from the hedge funds which are offered through the platform.

There may be a selection bias to these closed architecture solutions. This is akin to a marketing arrangement, and the investment options available through such arrangements may be inherently limited. It could be hypothesized that perhaps listing on a platform would only be attractive to hedge funds which believe that they will not succeed at raising capital on their own.

Although “hedge fund mutual funds” have their drawbacks, for many smaller investment managers, investing directly in a hedge fund does not present an attractive risk/reward ratio. For such entities, registered funds which fall under the guise of the SEC and present public data accessible through Morningstar would be a better bet. Readers may refer to our post entitled, “Just What Exactly is a Hedge Fund Mutual Fund “ from October 7th for elaboration on the pros and cons of utilizing such vehicles.

The Consequences

This development would change the economics of investing in hedge funds. For those which remained traditional hedge funds, performance standards would become elevated. Why would someone pay 2% management and 20% incentive fee for mediocre performance if a lower hassle version of the same strategy were available?

Because mutual funds can not charge a performance fee, perhaps a proliferation of registered vehicles would cause downward pressure on the 20% incentive fees charged by many hedge funds. Similarly, the growth of liquid mutual funds may also cause lockup periods to shorten for traditional funds.

It is also reasonable to imagine that this may enact a strategy bifurcation between hedge fund replication vehicles and traditional funds. Those who stayed true to the model would perhaps need to distinguish themselves more dramatically in order to command higher fees. This could mean more complex strategies, longer lock-ups, higher leverage, or increased opacity for those who remain on the 1940 Act sidelines.