12/08/2009 Author: Michael S Fischer

The tools of the trade

As hedge funds looks to cater to the increased security demands of wary investors, many are turning to mutual fund strategies as a way to diversify their offerings and provide another tool to attract investment

With last year’s transparency issues still making investors uneasy and Capitol Hill now abuzz with the dread ‘R’ word, increasing numbers of hedge fund managers are looking at the once-disdained mutual fund space. If certain quarters now regard alpha as a dark investment art, these mutual vehicles could be a source of comfort for rattled investors and a way to replenish empty coffers.
Recent activity in this space has been brisk. The second quarter alone saw a flurry of announcements by US hedge fund firms of new alternative mutual fund products, both single strategy and multi-manager or multi-strategy vehicles. In the UK, too, announcements of new products this year have come from the likes of Liontrust, with its European Absolute Return fund, and Odey Asset Management’s CF Odey UK Absolute Return fund. In July, GLG rolled out a long-only UK equity fund, which mirrors the firm’s three-year-old Dublin-domiciled GLG Select Equity fund.
“We’re seeing filings by mutual funds that at least purport to follow hedge fund-like strategies increase, and that increase has accelerated,” says Mitchell Nichter, a San Francisco-based partner in the law firm of Paul, Hastings, Janofsky & Walter. “The acceleration of filings is at least in part due to a desire to provide a product that may have some of the attributes of a hedge fund investment, yet at the same time have protections afforded to registered mutual funds under the Investment Company Act of 1940.” Nichter says many of these filings have come from hedge fund managers looking to mutual funds to diversify their asset bases, and also to attract new assets from wary investors.
A big part of what’s happening in the industry was driven by last year’s economic deterioration and debacle, believes Robert Worthington, president of Hatteras Funds, an alternatives fund of hedge funds (FoHF) shop in Raleigh, North Carolina. He says that even his firm’s most sophisticated clients who had used alternatives for many years panicked in 2008 and started to demand solutions that were valued daily and offered daily liquidity. “Liquidity is obviously paramount right now,” he says.
In June, Hatteras Funds acquired Alternative Investment Partners in Harrison, New York, a provider of two open-end mutual funds that use a multi-manager approach to hedge alternative investment strategies: the Alpha Hedge Strategies Fund, which holds the bulk of assets under management, and the Beta Hedge Strategies Fund.  
If some managers are turning to mutual products as something of a retreat to safer ground, others see them more as a key part of future development, and a way of gaining a competitive edge. “I felt I wanted to do something that was radical and different from the hedge fund perspective,” says Robert Kaimowitz, founder of Bull Path Capital Management in New York. In June, Kaimowitz converted one of his firm’s long/short hedge funds into a mutual fund, the Bull Path Long/Short Fund, which focuses on US midcap stocks. “I wanted to be competitive,” he says. “In the mutual fund, the fee structure is better for the client, you’ve got daily NAV and pretty much liquidity; you have assets held in a trust bank, so the principal is protected.” And, he adds, he is open to the $3trn that is marked for  long-only investment.
“It’s been a long time coming, and the effects of the bear market on investors and the industry itself is what’s driving the recent rash,” says Frederick Lake, co-chairman and treasurer of Lake Partners, a 20-year-old consulting firm in Greenwich, Connecticut. According to Lake, an incipient trend of mutual funds using hedge fund techniques gained momentum in August 1997, when Congress repealed the “short-short rule”, which had limited the amount of short-term trading, including short-selling, a mutual fund could do to 30% of a fund’s income. (Mutual funds still have to maintain liquid assets equivalent to the value of the shares sold short.)
“Once this rule went away, US mutual funds could trade more rapidly and effectively in response to markets, but also it led to the creation of dedicated long/short and hedged mutual funds in 1998,” says Lake.
A hedge fund manager that wants to register a mutual fund needs to ensure it has the compliance and operational infrastructure in place to manage that product efficiently and effectively. It must also come to terms with the fact that, in general, hedge fund managers don’t live with the constraints of the Investment Company Act on a day-to-day basis.
“These [the Investment Company Act] constraints are fairly pervasive and will restrict or at least direct how the hedge fund manager will manage and administer its new product,” says Nichter. “You have a product that’s going to require the manager to use different muscles to manage effectively.”
The mutual fund manager operates under numerous restrictions that don’t apply to hedge funds. For example, a mutual fund may not invest more than 15% of its total assets in illiquid securities. Leverage restrictions apply. A registered fund can borrow directly only from a bank, and has to maintain a 300% asset coverage. Mutual funds have to value daily and provide daily redemptions. Their boards have to consist of at least a majority of independent directors. Finally, mutual funds are very limited in being able to charge investment fees.

With even experienced investors still gun-shy, some more savvy managers are happy to jump through these more onerous regulatory hoops. However, others see it as a way of fostering industry neophytes – bagging allocators who are too green or too tiny to contemplate a ‘real’ hedge fund. In fact, even before the recent upsurge in demand for hedged mutual fund products, some investors were calling for vehicles that smaller investors could access. Nakoma Capital Management’s institutional advisor clientele “expressed an interest in a vehicle that could be used for all their clients, not just larger accredited investors,” says John Mueller, director of marketing at the Madison, Wisconsin hedge fund firm. It responded in December 2006 with the Nakoma Absolute Return Fund, which employs a fundamentally based expectations approach to stock selection, according to Mueller.
Nichter, the San Francisco attorney, expects to see more of these products come onto the market. “Whether the new product development in this area will continue at this pace or accelerate to a great extent is going to depend on what happens in the financial markets, and from the hedge fund manager’s side how difficult it continues to be to raise assets using the more traditional non-registered hedge fund structure,” he says. “And how successful these products are over the longer term.”