It’s no secret that investors have been disappointed by the first wave of alternative mutual funds that populated the market in recent years. Many traditional hedge fund providers and traditional mutual fund firms struggled to deliver diversified portfolios with low correlations between return drivers. These funds ultimately were characterized not by their successful performance and positive investor reviews, but by their high fees and mediocre product quality.
While this first showing has fallen short of expectations, it does create a prime opportunity for a second wave of alternative mutual fund products to enter the scene. These products will be focused on installing emerging and established managers—those that can deliver higher-quality outcomes to meet clients’ investment objectives.
This fast-growing segment of the mutual fund business initially produced two kinds of funds. Many strategies in the first wave focused on manager access and delivered modified versions of hedge fund strategies, resulting in products that sometimes under-delivered. Managers took the product they already offered in a private structure, and launched it as a 1940 Investment Company Act–registered mutual fund, selling it through a brand name asset manager.
It was not uncommon for managers to use an offshore blocking entity, a structure that allowed them to charge the performance fees typical of hedge funds, as well as additional mutual fund fees. That resulted in a fee burden and a drag on returns. While investors got marquee names in their portfolios, they did not enjoy the same performance as private investors because they ultimately were investing in either a different fee structure or in a strategy that had been altered by the manager, or both. With these challenges it was, of course, difficult for investors to experience high-quality returns.
The second type of fund in this wave was simply a poor-quality product. Managers that had faced difficulties with their private structures opted to try their hand at alternative mutual funds. This also did not lead to successful outcomes. In the end, neither advisors nor investors got what they expected. They got either returns that had very low correlation to risk betas and no performance, or they got some return and a lot of correlation, standard deviation, and risk—without diversification. Fortunately, the walls of this first phase have started to break down.
In its place is emerging a second wave of alternatives defined by lower correlations and a higher, risk-adjusted return. This movement is about attracting and retaining subadvisers that are not only high-quality, but are really pulling from their core competencies and crafting funds around their skill sets. The alternative mutual fund product may not be an exact replication of what was launched in the private structure, but it should harness the subadvisers’ core expertise, and rely on the same process and team. The best subadvisers have already ensured that their process is integrated, consistent, and intellectually honest. Higher-quality subadvisers are more likely to produce returns similar to those in their private structures.
Some managers will not meet these standards due to capacity constraints. During the due diligence process, managers should carefully review execution and trading processes, along with the existing alternative mutual fund structure to ensure integrity and fairness. Searching for that quality subadviser means the choices will be more limited, but the result will be a better-quality product at a better price for the end user.
Advisors, and investors to some extent, are becoming much more educated about what to expect with alternative mutual funds, and consequently, are also becoming increasingly skeptical and suspicious. They have seen how these products can fail to meet their expectations regarding correlation and diversification. The market is demanding more transparency on fee structures, and fees, as a result, have become much more competitive than they were several years ago.
Regulators are also playing a role in transforming these products. There has been significant flow increase into alternative mutual funds, with their assets under management rising 63 percent, from $158 billion to $258 billion, in the 12 months ending in October 2013, according to the Securities and Exchange Commission. Not surprisingly, reports have surfaced that the SEC has already begun an expected examination of these product providers, probing liquidity, leverage, and valuation issues.
In this next phase, the multi-manager, multi-strategy products will serve clients who want a one-stop shop for their portfolios and smaller advisors who want one set of exposures, but would like someone else to manage those exposures. The second wave will be characterized by an explosion in quantity as well as quality. That will allow larger advisors to build their own alternative portfolios, customizing them based on client needs and objectives. Advisors soon will have the ability to craft the exact exposures they want for clients.
Advisors should prepare for higher quality, higher quantity, and more transparency. But they also need to play the role of advocate and educator for investors, helping them understand how products should and should not be used in portfolios, and helping them set realistic expectations for how they will perform in different market environments.
John Culbertson is Managing Director and Chief Investment Officer of Context Asset Management