By Jerry Szilagyi
Hedge fund conversions—mutual funds that were once hedge funds—are a response to investor demand for better portfolio management tools. For years, investors needed options beyond traditional long-only, buy-and-hold strategies. Demand for alternative strategies has become even more pronounced recently in an environment where years of easy monetary policy across the globe has likely diminished the potential effectiveness of the traditional 60/40 stock/bond portfolio to weather periods of equity market turmoil. With both the equity and fixed income markets near all-time highs, investors are concerned about the risk in traditional portfolios.
Investors started reacting to this risk by allocating a larger portion of their portfolio to alternative strategies that have the potential to generate uncorrelated streams of risk and return. Until recently, the primary way for investors to access a wide spectrum of alternative strategies was through hedge funds and other investments primarily limited to accredited investors. The rise of liquid alternative mutual funds resulted from a push to make these sophisticated strategies available to all investors.
In supplying investors with liquid alternative products, the investment industry responded in a few different ways. Some mutual fund firms launched new funds and hired managers with varying levels of alternative investing experience to manage the strategies. Occasionally, traditional managers were simply asked to run alternative strategies or provide support on alternative strategies. Alternative-focused investment firms also launched new mutual funds that implemented strategies which leveraged their expertise, but, in many cases, the new mutual funds were “watered down” versions of their existing hedge fund strategies. A more unique approach was to seek out proven hedge funds that could be run in the same manner in mutual fund format and then convert those hedge funds into mutual funds keeping the strategy and portfolio management team intact. This process has come to be known as a hedge fund conversion.
How do hedge fund conversions work?
There are a number of requirements that must be met to be able to convert a hedge fund into a liquid alternative mutual fund.
Strategy Compatibility. First, the hedge fund strategy must be compatible with the more stringent regulatory requirements for mutual funds. The U.S. Securities and Exchange Commission requires the fund to certify that the mutual fund’s investment objective and investment strategy will be the same as the hedge fund in all material respects and that the hedge fund was managed in a manner that complies with the investment guidelines and restrictions of the mutual fund. This means that hedge funds that use strategies not compatible with mutual fund regulations, such as excessive leverage or illiquid securities, are not eligible for conversion.
Audited Financials. The SEC requires that at least the last two most recent fiscal years audited financials of the hedge fund be included in the mutual fund’s registration statements. In addition, the audited financials must be presented in mutual fund (S-X compliant) format.
The Mechanics. A conversion of a hedge fund into a liquid alternative mutual fund is technically done through a merger and reorganization. A new mutual fund that is substantially identical to the hedge fund is set up and registered. The hedge fund then contributes all of its portfolio securities to the mutual fund in exchange for shares of the mutual fund. The hedge fund then distributes the mutual fund shares to its shareholders on a pro rata basis. The end result is that the mutual fund holds the exact same portfolio as the hedge fund and the hedge fund shareholders own the same percentage of the mutual fund that they held in the hedge fund.
What are the benefits of investing in hedge fund conversions?
Accessibility and Lower Minimum Investment. While hedge funds typically have high minimum investment requirements and are limited to accredited investors, liquid alternative mutual funds are widely available and usually possess low minimum investment hurdles.
Daily Liquidity. Unlike hedge funds, which typically limit when and how much investors can redeem, liquid alternative mutual funds offer daily liquidity without limits.
More Regulatory Oversight. Compared to hedge fund investors, mutual fund investors benefit from the increased regulatory oversight requirements.
Lower Fees. A traditional hedge fund structure is “two and twenty”—2 percent management fee plus a 20 percent performance fee. Most hedge funds converted into mutual funds offer the same strategy with no performance fee and a management fee that is less than 2 percent.
More Transparency. Liquid alternative mutual funds list prices and investment returns daily and publish their full portfolio holdings quarterly. Hedge funds typically only provide monthly returns and generally don’t provide investors with full transparency into the portfolio holdings.
What are some downsides of the hedge fund conversion process?
Compatibility. Certain hedge fund strategies, such as those with illiquid investments or excess leverage, are not compatible with mutual fund regulations and can’t be converted.
Fee Pressure. Mutual funds, and investment products in general, are regularly subject to fee pressure. Even though the hedge fund managers have already eliminated the performance fee and may have even reduced the management fee during the conversion process, they will find industry pressure to continue to reduce fees. Investors reviewing the historical performance must remember that the investment returns are net of fees, including the impact of the performance fee on the hedge fund. In many cases, managers have earned their fees in hedge funds that are good candidates for conversion.
Managing Investor Expectations. Many converted hedge funds bring over a long and successful track record. Investors may tend to focus too much on strategy gains and not so much on strategy risk. In the current market environment where equities have rallied with limited volatility, a minor drawdown or returns that trail equities may frustrate investors. Managers must educate their investors on the risk and return profile of the strategy and remind investors that the current equity market environment is not representative of what we should expect in the long term.
Hedge fund conversions offer a potential solution to address the growing demand for proven alternative strategies in a mutual fund format. Unlike startup liquid alternative mutual funds, which may have unproven strategies or new managers, hedge fund conversions give investors a lot more information with which to make informed investment decisions. Investors can review the historical track record of the converted fund including how it performed in various market conditions. Like any investment vehicle, these converted funds come with both their risks and opportunities and need to be carefully evaluated by potential investors to determine how they fit in the investor’s portfolio.
Jerry Szilagyi is the CEO of Catalyst Funds.