The lukewarm performance of 2008 and Madoff scandal have left many hedge fund investors puzzled. Many have taken interest in hedge fund strategies offered through 1940 Act structures, or “hedge fund mutual funds.” The pros and cons of investing in such products are worthy of discussion.
These products are particularly popular amongst Registered Investment Advisors with small to medium sized accredited clients. Let’s say an RIA has a client with $1MM in assets who meets the qualifications for accredited investor status. The RIA determines that it is suitable to invest 5% of the portfolio into hedge funds. There is little chance that the client could invest directly into a long/short hedge fund with only $50k, but would be able to have access to a mutual fund which follows the same strategy.
It is useful to consider the drawbacks of investing in hedged mutual funds. Certain strategies may become compromised by the regulatory requirements that apply to mutual funds. For example, the 130/30 limitation in ’40 Act funds can put a damper on the manager’s ability to make large short bets in a heavily declining market. Also, couching a hedge fund strategy within a mutual fund may create operational disadvantages. There is likely more outperformance potential for a smaller, lean, efficient hedge fund than a larger fund offering the same exact strategy, because bigger trades generate more market impact.
Although vehicle choice does not admonish all risk, it may be safer to gain access to hedge funds through more established investment companies. Presumably, the mutual fund company would review the operations of any hedge fund, and use an independent custodian. This may have advantages of time and cost. Hiring an operational due diligence consultant to investigate a hedge fund prior to investing can be onerous for many small firms, and may not scale well if only for a one time allocation.
It is questionable if the economics of hedged mutual funds are favourable. Mutual funds can not charge performance fees, so they often jack up the management fee for these vehicles. I have seen expense ratios as high as 4% that you pay just for filling out the ticket. Hedge funds typically charge 1-2% for managing assets, and 20% or so performance fee if the manager exceeds her high water mark. Investors may see it as more favourable to pay a lower management fee and pay more in fees only if the manager succeeds in making them more money.
Transparency is both a benefit and a drawback to this set up. Hedge funds like to keep their trades secret. Conversely, regulators require the fund to disclose its positions every quarter. This may make the more sophisticated managers a bit less likely to want to make themselves mutual funds.
The information contained in this presentation contains confidential information regarding Diamond Oak Capital Advisors, LLC (“Diamond Oak”) and may contain information regarding hedge funds and other investments recommended or otherwise analysed by Diamond Oak. This document is not an offer to sell, nor the solicitation of an offer to purchase, any interest in Diamond Oak or any hedge funds or other investments discussed herein. An investment in any hedge fund or other investment discussed herein may be undertaken only through such fund or investment, may be speculative, and may involve a high degree of risk. An investor in hedge funds could lose all or a substantial amount of his or her investment.
Certain information contained in this presentation has been obtained from sources outside of Diamond Oak and its affiliates. While such information is believed to be reliable for purposes used herein, no representations are made as to the accuracy or completeness thereof and neither Diamond Oak nor its affiliates takes responsibility for such information. Past, pro forma, hypothetical, projected, or suggested performance of any investment or portfolio of investments is not necessarily indicative of future performance.
This document is neither advice nor a recommendation to enter into any transaction with Diamond Oak or any hedge fund or other investment. This presentation and its contents are proprietary information of Diamond Oak and may not be reproduced or otherwise disseminated in whole or in part without Diamond Oak’s consent.
Other expenses are not included in this analysis. Other expenses may include, but are not limited to: legal, accounting, trustee, administrative, marketing and sales, and custodial.
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