Attention hedge fund managers:Should you launch a mutual fund?

by Katie Bird

In response to the heightened regulations facing hedge fund managers and their funds, some are exploring the idea of launching an alternative mutual fund. This option would provide new sources of capital and answer retail investors’ demands for innovative strategies and uncorrelated returns. However, hedge fund managers can’t simply snap their fingers and begin offering an alternative fund—there are several challenges and risks involved that are somewhat foreign to the hedge fund world.

Jennifer Banzaca of The Hedge Fund Law Report released a two-part article series which discusses the basics of alternative funds, including common investment styles, possible drawbacks and why and how hedge fund managers can enter the alternative arena. This first installment is titled “How Can Hedge Fund Managers Organize and Operate Alternative Mutual Funds to Access Retail Capital?” Subscription only.

Banzaca’s piece explains that there is no cookie-cutter alternative fund; there are several strategies that would be considered alternative. These include managed futures, hedge fund strategies and long/short funds. Basically, anything that doesn’t fit neatly in Morningstar’s style box would earn the alternative label. Banzaca turned to SunStar’s senior vice president and partner, Dan Sondhelm, among other experts, for his take on alternative strategies. He says, “They are all designed to zig when the market zags. They are all designed to have low correlation to the markets. That is why they have done so well and why investors have flocked to these types of mutual funds in recent years.”

He also weighed in on the restrictions of hedge fund advertising, which makes a mutual fund appealing in that it “allows you to tell your story no matter what, and you may get a drift-over effect to the rest of your business.”

Marketing is just one piece to launching an alternative fund, which is the topic for Banzaca’s follow-up piece. She discusses costs and fees, distribution strategies and investment restrictions associated with these funds in “How Can Hedge Fund Managers Organize and Operate Alternative Mutual Funds to Access Retail Capital.” Subscription only.

One key difference is in the fund’ distribution; whereas hedge funds are typically distributed by the manager, alternative mutual funds are mostly distributed by registered broker-dealers. As Sondhelm points out, there is much to be decided once you actually choose your distribution platform: “Do you hire a salesperson? Do you work with the media? Do you leverage technology or advertising? What role does the portfolio manager want to play in the marketing of the fund?”

Another upfront hurdle is fees: legal fees, operating fees and manager fees. Running a fund is not cheap, Sondhelm notes, and some managers may need to subsidize the costs of launching and operating the fund until sufficient assets are raised. Additionally, managers need to be aware of investing restrictions, since not all hedge fund strategies are allowed in the mutual fund world. For example, short selling or derivatives transactions may be restricted for an alternative fund.

However, Banzaca states “One of the biggest conflicts of interest for hedge fund managers managing an alternative mutual fund and a hedge fund employing the same investment strategy side-by-side is the allocation of investment opportunities among the funds.” Basically, there is some concern regarding disproportionate investment allocations given the performance-based compensation associated with hedge funds. She points out that disclosing this conflict of interest in prospectus materials is important so investors are aware.

Deciding to launch an alternative mutual fund is no simple task. While it has advantages, it presents new challenges for hedge fund managers.