Hedge fund managers shy away from mutual funds

Huge growth in alternative investment mutual funds is fueling a big market for subadvisory hires for hedge fund managers.

What's catching the attention of many smaller hedge fund managers, and to a lesser extent big fund complexes, is steady growth of multi- and single-manager hedge fund strategy mutual funds. Assets managed in these funds jumped 54% to $139.3 billion in the year ended Dec. 31 and increased 292% from year-end 2007, according to Morningstar Inc., Chicago.

As hungry as many hedge fund companies are to swell their coffers — 68% of hedge fund managers said increasing assets is their firm's top priority, according to a February InfoVest21 LLC survey — 94% said they don't offer their own hedge fund strategy mutual fund now.

While just 17% of respondents told the New York-based hedge fund researcher they are subadvisers for mutual funds registered under the Investment Company Act of 1940, 27% said they intend to become one in the next 12 months and an additional 11% said it's a possibility.

Hedge fund managers that are willing to adapt their strategies to the more constrained requirements of a mutual fund overwhelmingly prefer the subadvisory route into mutual funds for reasons of efficiency, cost, complexity and compliance, said specialist hedge fund attorney Steven B. Nadel, partner in the New York office of Seward & Kissel LLP.

But many large, institutionally oriented managers aren't entertaining offers by their hedge funds-of-funds investors or mutual fund companies to manage a sleeve of a hedge fund strategy mutual fund that's under construction, said sources.

Executives at a number of well-known institutional hedge fund companies, who asked not to be identified, said they have been approached by a steady stream of would-be hedge fund strategy mutual fund managers but declined, partly because they don't need or want more assets. They especially do not need retail investor assets, which don't carry the possibility of a 20% or higher performance fee on top of a 2% management fee.

The hedge fund executives said the primary reason for turning down mutual fund subadvisory offers is that their investment approaches simply can't be adapted to a daily-valued, liquid fund vehicle. A lack of confidence in their ability to produce mutual fund returns that are remotelyclose to what their hedge funds can offer also was a factor, the sources said.

Still, institutionally focused hedge funds-of-funds managers such as Arden Asset Management LLC, Aurora Investment Management LLC, Blackstone Alternative Asset Management, Grosvenor Capital Management LLC, K2 Advisors LLC and Rock Creek Group LP have convinced a number of hedge fund firms well-known in institutional circles to manage a sleeve of their existing or soon-to-be-launched mutual funds.

Institutional hedge fund managers subadvising hedge fund strategy mutual funds, according to mutual fund prospectuses and new fund registrations, include big names familiar to pension fund investment executives. Among them: Cerberus Capital Management LP; Chilton Investment Co. LLC; CQS (U.S.) LLC; Graham Capital Management LP; JANA Partners LLC; Peak6 Advisors LLC; P. Schoenfeld Asset Management LLC; D.E. Shaw Group; Two Sigma Advisers LLC; Wellington Management Co. LLP; and York Registered Holdings LP.

For other hedge fund managers, the very factors that give portfolio managers an edge in producing higher uncorrelated returns are the same factors that conforming to a '40 Act mutual fund structure takes away from the manager, said Greg T. Fedorinchik, senior managing director and head of the global client relationship team at hedge funds-of-funds manager Mesirow Advanced Strategies Inc., Chicago. Those factors include illiquidity (monthly, quarterly, yearly or longer redemption terms), breadth of investment possibilities, lack of regulation, lack of transparency, low or no leverage, and lower fees absent a performance component.

“The most attractive hedge fund strategies — distressed debt, corporate debt, illiquid debt — won't work in a mutual fund,” Mr. Fedorinchik said. “Hedge funds' (value-added proposition) to a great extent comes from their illiquidity advantage and complexity. A mutual fund (removes) all of the things that make hedge funds and their returns so attractive,” he added.

Mesirow Advanced Strategies executives analyzed the hedge fund strategy mutual fund model and “decided we weren't in any hurry to launch one” because of all the constraints, said Mr. Fedorinchik. Most of the firm's 80 underlying hedge fund managers were not interested in subadvising part of a multistrategy hedge fund strategy mutual fund.

Hedge fund strategies that might generally conform more easily to the mutual fund model include long/short equity, systematic global macro, managed futures, relative value and event-driven approaches, observers said.

But with mutual funds' 15% concentration limit for single securities, very limited ability to use derivatives for short positions and leverage capped at 33% of fund assets, long/short equity managers said it's tough to make a decent return, even in a favorable market.

“The more you have to cut from your strategy, theoretically, the higher the chance that your performance will be reduced dramatically over time,” said a portfolio manager from a large long/short equity hedge fund firm who spoke on condition of anonymity.

“We were asked by hedge funds-of-funds clients to consider offering a daily-valued, liquid, transparent version of our approach. After back testing, I don't have confidence that I could produce a return we would want associated with the firm with what I have left to manage the strategy,” said the portfolio manager.

“When you stack up daily liquidity, no performance fee and limited ability to short against higher fees, longer lockups and larger investors, mutual funds are not a good story,” the manager said.

Many hedge fund managers have been similarly cautious about trying their hand at a daily-valued version of their flagship strategy despite the powerful draw of a fast-growing hedge fund mutual fund market.

“Not every hedge fund strategy will fit into a mutual fund,” agreed Marc Wolf, audit partner, based in the Los Angeles office of tax and accounting specialist Rothstein Kass. “The trick is getting the hedge fund strategy restructured so it can meet the lower leverage and concentration levels and the daily mark-to-market requirements of a mutual fund.”