Our past writings have emphasised our conviction that with the large scale shuttering of hedge funds, coupled with investor skittishness over fraud, it seems like the migration of hedge funds to a transparent, publicly available mutual fund structure is inevitable. We feel that this is the catalyst that will be critical to attract divested capital back into this space.
To further elaborate, we are witnessing a bifurcation by size, whereby the largest funds are receiving most capital inflows. They are assuming a format less akin to lean, bare bones trading shops; rather, large hedge funds are looking more like traditional fund companies Small and medium sized shops are shuttering, and Fund of Funds are becoming obsolete. An emphasis on transparency and liquidity has become popular. As backlash to the Madoff fraud, Separately Managed Account platforms (SMA’s) became popular with investors; but it seems as if the burdensome operational requirements have taken the wind out of this movement’s sails.
We feel that “hedge fund mutual funds” are the wave of the future. Why would an investor grapple with onerous lockups, high cost of due diligence, fraud risk, and higher fees, if she didn’t have to? We ponder this question. Investors lost confidence in traditional hedge funds in 2008, when many funds failed to generate non-correlated alpha when the market crashed. Similarly, the risk that hedge fund mutual funds fail to adhere to their stated strategy is a real one. We consider the following as the likely countervailing forces may present challenges to the mutual fund format. Our current discourse analyses the possible headwinds that would prevent hedge funds from assuming mutual fund format over time.
- A mutual fund format may simply not be the most suitable for some strategies. The 1940 Act provisions which forbid high uses of leverage (130/30 maximum) may preclude long/short managers from heavily shorting a down market, preventing them from being able to achieve alpha. Because mutual funds price daily, many less liquid strategies such as Regulation D funds would not be optimal for this format.
- Performance may suffer if funds capacity is not managed adeptly. The high legal and operational costs of mutual fund vehicles may possibly create the need for these vehicles to attract large amounts of money. This may be counterproductive; large trades create market impact, which can derail managers from achieving their strategies.
- The risk of self-selection exists, whereby the larger, more successful funds who naturally attract capital would forgo this structure. However, the relationship between size and success is not always inextricably linked. There are several highly skilled managers who prefer to manage smaller, more nimble pools of capital so that they are able to fly under the radar screen.
- We also envision that perhaps there may exist a framing bias in the eyes of investors. The cache of being invested with a mysterious, covert hedge fund conveys a mystique for some. It is possible that high net worth individuals may not hold a retail mutual fund vehicle in the same regard due to its lack of exclusivity.
- Lack of performance standards in the unregulated hedge fund LP structure may indeed have allowed hedge funds to portray themselves as better than they truly are. It would be interesting to witness the changes in performance results that a universal set of reporting standards may enforce. Past research has shown that the minority of mutual fund managers actually outperform the benchmark on a consistent basis. In contrast, it has been an uncommon experience for me to behold a hedge fund track record that seems grossly unappealing. Survivorship bias may prevail within hedge fund indices, due to the short shelf life of these vehicles. It would be interesting to see the effects of performance measurement if hedge funds had to adhere to a universal set of standards.
It seems as if this movement has already begun across the world. In Europe, we see this movement becoming more popular with UCITS funds. If we think about cross border flow, adopting a 1940 Act structure would likely attract capital from abroad. For foreign investors, being able to invest in a registered hedge fund mutual fund would eliminate the cost of performing onsite due diligence by travelling or using a US-based consultant with whom they may not be that familiar.
Despite several possible deterrents, we believe that the industry will move in this direction. We reckon that the best hedge fund strategies for this format would be long/short equity, market neutral, multi-strategy, or even global macro funds. While in the past, we’ve seen the migration of talent out of the mutual fund space, we imagine that hedge fund managers would be hired back by large institutional buy side firms to manage alternative strategies. We feel this movement would be positive for the industry as a whole and we welcome the opportunity to see what the future may behold.
Disclaimer: 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.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.