Hedge managers get into the fund business. Should they?

If you read today's Wall Street Journal, you would have seen Shefali Anand's Fund Track article about a hedge-fund subsidiary of Legg Mason launching its first mutual fund to be followed by more. The article also points out that this is part of a small but growing trend of hedge managers getting into the mutual fund business. Is this a good idea for hedge fund firms? Let's take a look at the opportunities and difficulties so you can make the call.

Opportunities:

• Public track record. Research firms such as Morningstar and Lipper make it easy for asset managers to build a public profile that is easily tracked and measured. That's not the case with hedge products.
• Communication: Hedge fund firms can not openly communicate their strategies to the public. In a mutual fund format, firms can easily talk with investors through the media, in public settings, etc.
• Business diversification: There is a lot of negative attention these days to hedge funds. So it makes sense for firms to develop hedge type mutual fund products to diversify their product lines, revenue streams, and customer base.
• New market: Since hedge firms are managing money anyway, they can use a similar investment process to sell to new audiences such as retail investors and financial advisors
• Leverage mutual fund distribution infrastructure: Platforms such as Schwab, Fidelity, TD Ameritrade, Pershing and others exist to offer mutual funds to retail customers and all types of financial advisors. In addition, news publications such as the Wall Street Journal and Barrons write about mutual funds every issue for access to all types of investors. Finally, Lipper and Morningstar data is picked up in newspapers and magazines and websites for easy promotion. So if you have a mutual fund product, it is possible to get publicity on a regular basis. And this publicity can help grow your private accounts as well.
• Recent performance: Firms may be taking advantage of the fact that the market is down significantly but funds with shorting and other techniques may have better relative performance.
• Focus on security selection: There are many firms that will do all of the back office, compliance, accounting, etc. work so the portfolio manager can focus on picking stocks and marketing.

Difficulties:

• High costs: It costs about $100,000 to launch a mutual fund.
• Lower fees: Fund managers make only 1-1.5% of AUM, much lower than what hedge managers make.
• Rising costs: As assets drop and regulation is increased, costs are increasing making it more difficult for smaller firms to compete. More are lizuidating, selling or being adopted during this environment.
• Competitive industry: There are 10,000 funds out there. Many have serious distribution and a strong brand so it is difficult for new entrants to compete and attract investors.
• Need for marketing to new audiences: If you want to grow your fund, you will have to focus your marketing efforts on audiences such as retail and advisor that you don’t currently have.
• Strategy limitations: You may not be able to use all of your hedging techniques as in a traditional hedge fund because of mutual fund regulations.