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E-MailThe following post comes to us from Citi Fund Services, Inc., and is a summary of an article that first appeared in the Investment Lawyer, which is available here.
For more than half a century, traditional investment funds (mutual funds) and alternative investment funds (hedge funds) occupied separate and distinct segments of the investment market. They employed different investment strategies, were subject to different regulatory standards, and mostly catered to different classes of investors. Increasingly, however, these two types of funds have found themselves converging toward common investing ground.
Recent changes to the capital markets, to investor preferences, and to industry regulations have caused investors to seek out investment products that contain the characteristics of both mutual funds and hedge funds. Investment managers have responded by introducing a new breed of hybrid funds that combine the exotic strategies of hedge funds with the transparency and relative stability of mutual funds. Because mutual funds and hedge funds operate within different logistical and regulatory frameworks, investment managers desiring to operate in this new hybrid space must familiarize themselves with the elements of each.
The Historic Forces of Separation
Regulatory requirements have played an important role in the historic separation of mutual funds and hedge funds. Mutual funds are subject to an extensive and comprehensive system of federal oversight under the Investment Company Act of 1940, as amended (the 1940 Act). This strict regulatory framework includes numerous restrictions and reporting requirements. Hedge funds, on the other hand, have remained largely exempt from federal regulation and, as a result, have been able to employ riskier, more exotic, investment strategies than mutual funds. These differing investment approaches have typically attracted two distinct types of investor. The relatively conservative and predictable investment strategies of mutual funds have made them attractive to smaller-scale retail investors, while the more adventurous strategies of hedge funds have appealed to more sophisticated investors.
The Current Forces of Convergence
The recent financial crisis, the resulting regulatory reforms, and the increased visibility and popularity of hedge funds have all contributed to the current demand for investment vehicles that contain elements of both mutual funds and hedge funds.
Regulation
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) contains provisions that are expected to restrict certain individuals and institutions from investing in hedge funds. In addition, the Dodd-Frank Act will limit the amount of assets certain banks may invest in certain hedge funds. These provisions will likely force banks to seek out “hedge-like” vehicles in which to invest the money they formerly invested in hedge funds.
Investor Preference
As the financial crisis of 2008 unfolded, and the performance of mutual funds began to suffer, retail investors, in search of greater returns, began to explore more sophisticated asset allocation strategies. These investors have increasingly focused on “absolute return” and other investment strategies not typically associated with mutual funds. Responding to this shift, 60 percent of financial advisers surveyed in a recent study reported that they have increased their clients’ exposure to products employing alternative investment strategies, such as hedge funds. As most retail investors are not permitted to invest directly in hedge funds, those investors are increasingly seeking out retail funds that employ “hedge-like” strategies.
Conversely, many hedge fund investors have responded to the financial crisis by seeking out hedge funds with certain characteristics of mutual funds, such as greater liquidity and more conservative investment strategies. Hedge fund managers have responded to this demand by offering an increasing number of hedge funds that employ such strategies.
New Products Resulting from Convergence
Responding to the demand for products that combine elements of mutual fund and hedge fund strategies, opportunistic fund managers have introduced a variety of new hybrid products into the market. Specifically, fund managers have designed various hedge-like mutual funds as well as hedge funds that incorporate mutual fund characteristics.
Hedge-Like Mutual Funds
Fund managers have developed several different types of mutual funds designed to mimic, to the extent permissible under federal securities laws and regulations, strategies typically employed by hedge funds. These include funds utilizing various specific “hedge-like” strategies, including long-short strategies, market-neutral strategies, arbitrage strategies, and merger/arbitrage strategies, among others.
Hybrid Hedge Funds
Many hedge fund managers have responded to their investors’ “flight to safety” by offering hedge funds with conservative strategies that mimic those of mutual funds. One such strategy is known as the “equity long-only strategy,” wherein a hedge fund invests the majority of its assets in common stocks. Hedge funds that utilize this and other conservative “mutual fund-like” strategies dramatically reduce the volatility of their portfolios, thereby satisfying investors who are looking for stability in this uncertain market.
Regulatory and Operational Considerations
There are a number of regulatory and operational considerations associated with registering and selling mutual funds. Hedge funds, on the other hand, require far less regulatory and operational infrastructure. The following is a review of some of the practical considerations that a hedge fund manager should address when crossing over into the mutual fund sector.
Regulatory Considerations
Fund and Adviser Compliance Programs
Rule 38a-1 under the 1940 Act requires mutual funds to create written policies and procedures reasonably designed to detect, prevent, and resolve violations of federal securities laws by the fund. Also, certain hedge fund managers will be required to register with the SEC under the Dodd-Frank Act, and will thus be subject to the compliance provisions of the Investment Advisers Act of 1940, as amended.
Board Governance
The corporate governance of mutual funds is dictated by the 1940 Act and, where applicable, individual state laws. Mutual fund boards of directors must comply with various provisions of the 1940 Act dealing with, among other things, independence, oversight and accountability.
ERISA
Depending on the nature of a hedge fund’s investors, the fund’s adviser may be subject to the Employee Retirement Income Security Act of 1974. This would require the fund manager to register as an investment adviser, maintain a fidelity bond, and be held to certain fiduciary standards.
Other Regulatory Considerations
The Sarbanes-Oxley Act of 2002 imposes various requirements on mutual funds, including the creation and implementation of controls and procedures regarding the disclosure of certain fund information. Additionally, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 imposes certain duties on mutual funds.
Operational Considerations
Portfolio Compliance
Various regulations require the mutual fund managers to create comprehensive monitoring and reporting programs to address these requirements.
Liquidity and Valuation
Mutual funds must also comply with regulations limiting the amount of illiquid securities a mutual fund may hold as well as those governing the calculation of a mutual fund’s net asset value.
Custody
The 1940 Act contains provisions regarding the custody of mutual fund assets, regulating such activities as recordkeeping and the segregation of assets, as well as imposing various reporting requirements.
Distribution, Marketing and Advertising
Mutual funds market themselves to the public through prospectuses, brochures and advertisements, the content of which is subject to strict regulatory requirements.
Conclusion – The Road Ahead
Reacting to the market turmoil and the corresponding negative performance of retail funds, consumers of mutual funds have increasingly sought the growth potential associated with the exotic strategies employed by hedge funds. The current climate of economic uncertainty and increased regulatory scrutiny, on the other hand, has caused many hedge fund investors to seek out investments that embrace some of the stable and transparent attributes of mutual funds. Fund managers have responded to these demands by developing hybrid funds that combine the attributes of hedge and mutual funds. The result has been a distinct convergence of, or blurring of the line between the two types of funds.
