04/10/2013

Hedge Funds Plodding Into Mutual Funds

Hedge fund companies haven’t rushed into the mutual fund business in the large numbers expected after the financial crisis, but expectations are that the trend will build over the long term.

Only 19 firms recognized mainly as hedge fund managers operate mutual funds — 45 vehicles in all — despite much talk about hedge funds diversifying into the retail market to raise additional capital (see listing on Page 6). After learning the complexities of launching mutual funds, hedge fund firms have opted to take a slow and deliberate approach to the business.

“It sounds even a little on the high end,” said Kevin McDonald, chief executive of Taylor Investment in Greenwich, Conn., referring to the total number of hedge fund managers in mutual funds. “I think we’re in the very, very early innings of what will develop into a large part of the investment-management industry.”

Among hedge fund managers, AQR has by far the greatest presence in the mutual fund business. The Greenwich, Conn., firm manages $9.2 billion in 20 mutual funds, including three launched last month. The firm manages $70 billion overall. No other hedge fund firm operates more than four mutual funds.

Others are tiptoeing into mutual funds. Whitebox Advisors, a Minneapolis firm best known as a convertible-bond arbitrageur, has launched two mutual funds in the past couple of years. It started Whitebox Long/Short Equity Fund in November and Whitebox Tactical Opportunities Fund about a year earlier. Distressed-debt pioneer Avenue Capital began offering Avenue Credit Strategies in June 2012.

AQR has found it easier to adjust to the lower-margin mutual fund business because it already charges lower fees on its hedge funds than many of its rivals. The firm’s iconoclastic chief, Cliff Asness, has long been a critic of what he views as unnecessarily high hedge fund fees.

After the financial crisis, when funds of funds were imploding and disillusioned investors were yanking their money, hedge funds began searching for another source of capital. At the same time, increased regulatory scrutiny fueled hedge fund interest in the retail market.

Some mutual fund companies and large asset managers, such as BlackRock and Kohlberg Kravis Roberts, have rolled out so-called alternative mutual funds, also known as hedge funds-lite. But hedge fund managers have moved more slowly in crossing into the mutual fund arena.

Andrew Redleaf, chief investment officer of Whitebox, believes mutual fund investors are a natural extension of his client base. “We are entrepreneurs. Entrepreneurs get into a business not necessarily because it is new or fashionable but because they think they can do it better than it is being done by existing firms,” he said. “We like to think of ourselves as evangelists for our principles — by moving into mutual funds we are taking those principles to a broader audience.”

But applying hedge fund concepts to a mutual fund format can be an expensive and labor-intensive undertaking. By one attorney’s estimate, the startup costs of a mutual fund can exceed that of a hedge fund by $100,000 to $200,000.

Three staples of hedge fund activity — leveraging, short selling and charging performance fees — are prohibited or rarely employed in the mutual fund arena. And mutual funds must offer investors daily liquidity, which is foreign to most hedge fund managers.

For those reasons, not all hedge fund strategies, particularly many fixed-income arbitrage approaches that require leverage, can be easily translated into a mutual fund product.

Also, a successful mutual fund launch requires distribution networks that are typically more extensive than those of most hedge funds, said Scott Schweighauser, president of Chicago-based Aurora Investment. That’s why Aurora is offering its new product via Natixis Global Asset and why rival Arden Asset Management linked up last year with mutual fund giant Fidelity Investments.

Investors appear to be clamoring for alternative mutual funds, regardless of whether they are run by hedge fund managers, mutual fund companies or private equity firms. Such products have a combined $150 billion under management, according to Morningstar. The total represents only 1.5% of the $10 trillion under management in mutual funds, but Morningstar says the alternative mutual fund category has, on average, attracted $1.3 billion per month in the four years ended January 31, 2013, or more than 7.5% of total net mutual fund inflows during that period.

“I think this thing has legs. I don’t think this is a flash in the pan,” said Ricardo Cortez, president of global distribution at Broadmark Asset Management of Greenbrae, Calif.

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