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Hedge funds zoom in on mutual funds

Firms seek to diversify client roster and profit from the moves to defined contribution plans

042913 callin
Sabrina Callin says most investors in PIMCO’s fund are institutions.

Hedge fund managers are looking to the mutual fund industry for their next source of growth.

With the relentless shift to defined contribution plans from defined benefit plans, hedge fund managers are looking to DC plans to diversify their client base.

“I think this is a spectacular opportunity. The 40 Act (the Investment Company Act of 1940, which regulates mutual funds) has real, tangible benefits for retail investors, and you will see some world-class hedge funds entering the liquid alternatives space,” said Neil Siegel, managing director and head of New York-based Neuberger Berman Group LLC's global marketing and product development.

Evan Mizrachy, the San Francisco-based head of retail alternatives for BlackRock (BLK) Alternative Investments, agreed, saying: “There's such a strong greenfield opportunity right now. Retail investors, including defined contribution plan investors, don't have enough alternatives in their portfolios. At the same time, institutional investors have enough hedge funds and mostly will be doing manager upgrades.”

BlackRock's three hedge fund mutual funds had combined assets of $1.6 billion as of March 31, a mere blip within the firm's $3.9 trillion of assets under management. Neuberger Berman managed $219 million in its single hedged mutual fund as of the same date, a drop in that firm's $205 billion in assets.

Still, investment consultants are not convinced that liquid versions of hedge funds are a good fit for defined contribution plans or for smaller defined benefit plans, endowments and foundations.

The requirement for daily liquidity tends to limit the hedge fund manager's investment universe, potentially diluting performance, consultants said. High fees further reduce performance.

Aggregate assets invested in hedge fund mutual funds didn't total even 1% of the $13.1 trillion in U.S. mutual fund assets as of Dec. 31, according to Investment Company Institute data. But sources aren't daunted by that.

Assets in hedge fund strategy mutual funds grow 140%

CategoryNet assets
as of Dec. 31,
Net assets
as of Dec. 31,
Bear market$3,013.93$6,790.97
Long/short equity$13,713.90$25,756.75
Managed futures$244.10$8,570.23
Market neutral$8,434.06$19,529.75
Trading-inverse commodities$40.97$12.11
Trading-inverse debt$694.58$433.94
Source: Morningstar Inc.

The growth of hedge fund mutual funds, also known as liquid alternative funds, has been strong: Assets invested in these funds grew 140% to $90.3 billion in the five years ended Dec. 31, according to analysis provided by Morningstar Inc.

The number of liquid alternative mutual funds more than doubled to 838 as of Dec. 31, from 343 at the end of 2007.

“Ninety percent of the mutual fund world is marketing hedged mutual funds. We started doing this before it was cool,” said Michael Aronstein, president, portfolio manager and chief investment officer of Marketfield Asset Management LLC., New York.

Ranked by P&I

Using Morningstar's list of hedge fund mutual funds as of Dec. 31 and incorporating each fund's assets under management as of April 16 from Bloomberg and company data, Pensions & Investments ranked both the largest funds and largest money managers by assets.

Largest hedge fund strategy mutual funds and managers

Largest managers by firmwide assets
1 PIMCO Funds $49,800
2 Natixis Funds $9,851
3 New York Life/Mainstay Funds $7,811
4 AQR Funds $6,877
5 Westchester Capital/The Merger Fund $4,464
6 Absolute Investment Advisors $4,262
7 John Hancock Funds $4,246
8 GMO Funds $3,845
9 J.P. Morgan Funds $3,112
10 Water Island Capital/The Arbitrage Fund $2,981
Largest hedge fund strategy mutual funds
RankMutual fundAssets
1MainStay Marketfield Fund 1$7,811
2Gateway Fund A$7,752
3PIMCO Emerging Markets Currency A$6,801
4PIMCO StockPlus AR Short 1$6,186
5The Merger Fund$4,464
6Absolute Strategies Fund 1 $3,888
7GMO Alpha Only Fund 3$3,845
8AQR Managed Futures Strategy Fund 1$3,151
9The Arbitrage Fund R$2,931
10Calamos Market Neutral Inc. Fund A$2,667
Source: Bloomberg LP, Morningstar, company information

The MainStay Marketfield Fund I was the largest hedge fund mutual fund in P&I's ranking, with $7.8 billion under management, according to Bloomberg.

Marketfield Asset has subadvised for New York Life Investment Management the MainStay Marketfield fund, with Mr. Aronstein as lead portfolio manager, since 2007.

The largest manager of hedged mutual fund assets on P&I's list was Pacific Investment Management Co. LLC, Newport Beach, Calif., with $49.8 billion in its nine funds as of March 31, according to PIMCO data.

PIMCO launched its first hedged mutual fund a decade ago; most investors are institutional, said Sabrina C. Callin, managing director. Ms. Callin declined to identify any investors.

The genesis of PIMCO's liquid alternative funds was to “assist investors in diversifying and re-risking their portfolios. We've been proactive about educating investors about how heavily dominated their portfolios are by equity risk — and then creating solutions,” Ms. Callin said.

The oldest hedged mutual fund in Morningstar's database, the $4.5 billion Merger Fund, also appeals to institutional investors because of its 23-year track record and institutional approach, said Jody Harris-Stern, director of business development of the fund's manager, Westchester Capital Management LLC, Valhalla, N.Y. Ms. Stern said the merger arbitrage fund has a growing institutional clientele although she can't break it out easily.

“Merger arbitrage is a strategy that people can understand. They can read about our deals in the newspaper. The approach is all about the risk management, offering low correlation to major markets and low volatility,” Ms. Harris-Stern said.

Strange bedfellows

Hedge fund and mutual fund management companies that would have been strangers in the past now are working together to combine hedge fund management and retail distribution, said Daniel Celeghin, a partner at consultant Casey, Quirk & Associates LLC, Darien, Conn.

One such partnership is between Arden Asset Management LLC and Fidelity Investments, Boston.

Fidelity hired Arden in early December to manage a hedge fund of funds slotted into Fidelity's portfolio advisory services for mass affluent investors commonly defined as retail investors with between $100,000 and $1 million of liquid assets. The initial allocation from Fidelity's model portfolio totaled $700 million.

Arden's move into mutual funds was defensive: “We had been bulking up on U.S. and non-U.S. defined benefit plans for years. But from 2005 onward, data points kept coming in about our Fortune 100 or Fortune 500 investors that were freezing their defined benefit plans,” said Averell Mortimer, CEO of the New York-based firm.

Arden manages about $7 billion in total and awaits approval from the Securities and Exchange Commission for two hedged mutual funds that are clones of the Fidelity strategy.

The SEC approved Blackstone Alternative Asset Management's registration of the institutional hedge funds-of-funds manager's first mutual fund on April 2.

“Running mutual funds is very different from running hedge funds. There are different mechanics and you really have to figure out what your comparative advantage is. For Blackstone, it's our investment process,” said J. Tomilson Hill, president and CEO of Blackstone Alternative Asset Management, New York.

Mr. Hill declined to provide specifics about the launch and distribution of the Blackstone Alternative Multi-Manager Fund. BAAM managed $48 billion as of March 31.

As popular as hedge fund mutual funds might become with retail investors, investment consultants remain unconvinced of their efficacy for defined contribution plans and other institutional investors.

“The challenge is to get a real hedge fund strategy into a non-accredited, daily valued mutual fund for 401(k) investors,” said Robert “Bob” DiMeo, managing director and senior consultant, DiMeo Schneider & Associates LLC, Chicago.

“We just can't get over the investment restrictions which tend to scrub out the hedge fund investment advantages and the higher fees. The hurdles remain pretty high for institutions when it comes to using hedge fund mutual funds,” Mr. DiMeo said.

“Offering hedge funds in a mutual fund means that you have to emphasize the most liquid strategies, and there's a heavy emphasis on managed futures, commodities and long/short equity approaches. Given the wide basket of hedge fund strategies available in the market, you're getting a pretty narrow slice at a pretty high price,” said Matthew E. Stroud, head of strategies-Americas at Towers Watson Investment Services, New York.

This article originally appeared in the April 29, 2013 print issue as, "Hedge funds zoom in on mutual funds".