The Mutualization of Hedge Funds: Will it Be Successful?

	Sanborn Kilcollin Partners' Robert Sanborn

Although some organizations have had great success in recent years starting public funds and entering the relevant fundraising channels, firms should think long and hard about the cultural consequences of going this route and whether such an effort is worth their time. I’ve had experience as a partner and portfolio manager in both types of organizations. Each type of fund has its structural advantages. However, before hedge fund firms start marketing all out to a potentially unfamiliar segment of the marketplace, they should first learn about the culture of the mutual fund business.

From an operational standpoint a mutual fund organization has greater staying power once it attains a critical mass of assets and decent five-year track records for its funds. At that point, like Freddy Krueger of the Elm Street movies, it becomes very hard to “kill off,” as the fund will likely be on all relevant wire house platforms and embedded in workplace defined contribution retirement plans, begetting more assets. As those assets grow, so does consistent management fee revenue.

Hedge funds generally have a smaller, more concentrated investor base. Poor performance, a sudden wave of redemptions, the departure of a key person, media and regulatory scrutiny or all of the above represent major business risks. Thus a retail asset pool (or access to permanent capital if the organization is publicly traded) is very attractive for hedge fund principals seeking long-term stability.

But with that stability comes a great cost. Running mutual funds requires substantial back-office and board governance expenses, not to mention the demands of daily liquidity. If the organization is a public company, that is another set of burdens. Not only will mutual funds cost firms more in operational expenditures, but managers again expose themselves to the whims of marketplace sentiment. The reason I co-founded a hedge fund in the first place was to have more-sophisticated investors who would not seek to redeem in a market downturn at precisely the time I wanted to buy. With a daily liquidity format and more regulatory scrutiny, that luxury of patient, locked-up capital is gone.

Still, this industry convergence seems like a natural progression of recent trends. Institutional investors have been demanding, and receiving, more transparency and more-flexible liquidity terms in recent years. As hedge fund firms have built out their infrastructures to keep up, the ability to offer the daily net asset value and liquidity capabilities of a mutual fund makes a transition easier. For those smaller hedge fund firms that wish to launch 40 Act and mutual funds but do not wish to build out expensive infrastructures, a subadvisory agreement with a large distributor can be an appropriate avenue to take.

Ultimately investors might get the desired risk-return exposures with alternative mutual funds, exchange-traded funds and other 40 Act funds. But one aspect of this industry convergence that has not been discussed extensively is organizational culture, especially in marketing and branding.

Mutual and 40 Act funds are sold mainly through public advertising, commission-only wholesalers or rank-and-file financial advisers. On the contrary, institutional salespeople for hedge funds cannot advertise publicly. They patiently slog through six- to 18-month sales cycles with gatekeepers in the hopes of bringing in multimillion-dollar checks from allocators.

As such, marketing teams hone their messages for each audience without alienating the other — hardly an easy task. While retail investors might be attracted to a hedge-fund-branded product, institutions prefer to allocate alongside like-minded peers and can be suspicious of a firm perceived as a retail shop.

Despite these challenges, coexistence can work. Retail investors want more investing options than a traditional long-only stocks and bonds allocation, and hedge funds want more sources of permanent capital. If it means selling to the masses previously shut out of their velvet-roped elite world, so be it.

Robert Sanborn is a managing member and portfolio manager at Sanborn Kilcollin Partners, a long-short equity fund based in Chicago.