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When Hedge Funds Convert to Mutual Funds

It’s best to ignore their preconversion histories.

John Rekenthaler, 02/22/2017

Fortune Telling
There goes my chance to join Paul the Octopus, Carnac the Magnificent, and Jim Cramer on the list of the world’s great forecasters. In early January, I started to write a column on how some mutual fund track records might be other than they appear, citing as an example Catalyst/Millburn Hedge Strategy Fund MBXIX. But vacation approached, the topic needed more work, and I set the topic aside.  

Boom! Last week, the fund’s sibling, Catalyst Hedge Futures Strategy Fund HFXAX, dropped 15% in five trading days. Opportunity squandered.

(Then again, this column’s Friday, Feb. 10 subject was “The Perils of Shorting,” Catalyst Hedge Future’s slide began on the very next trading day of Monday, Feb. 13, and the primary reason for its investment losses was ... you guessed it, its short positions.)

There’s a Catch
Ah, well. The point remains. Generally, when a fund looks shockingly good, there’s a back story. And shockingly good understates Catalyst/Millburn Hedge's accomplishments. Since its January 1997 inception, the fund is up an annualized 11.39%, which, thanks to the wonders of compounding--and they truly are wondrous--equates to a 765% cumulative gain. No competitor in the multialternatives fund Morningstar Category remotely comes close. Over that 20-year period, Catalyst/Millburn Hedge has almost quadrupled the cumulative result of the second-place fund.

How could this be, you might ask? How could a fund generate high returns, year after year after year, and yet be unknown? You would expect Catalyst/Millburn Hedge to carry a Morningstar Analyst Rating of Gold. Its portfolio-management team should have claimed a couple of Fund Manager of the Year awards, plus ongoing invitations to the Morningstar Investment Conference. I mean, 765%! For a fund with low volatility! But, nothing. Neither Catalyst/Millburn Hedge nor any other of Catalyst’s alternative funds has ever received significant Morningstar attention.

That is because they only became mutual funds recently. Before then, they were unregistered funds--“hedge funds,” in the common parlance. Hedge funds do not publish their portfolios, and, without such information, there’s no reasonable way of conducting performance attribution: what risks the funds assumed, what went right for management (obviously, a great deal), and what could have gone wrong. Thus, had they been aware of the Catalyst funds’ existence, Morningstar’s research team couldn’t have offered much insight.

(However, Morningstar’s knowledge did not even extend that far. Hedge funds are required to file certain items with the SEC, but the agency does not disclose those to the public. Thus, if the sponsoring fund organization and the investment-database supplier do not find each other, the funds are effectively invisible. Such was the case for Morningstar, which did not have Catalyst's funds in its hedge fund database.)

The problem runs even deeper than not understanding how the Catalyst funds were invested. It also includes not knowing the size of the brood. Perhaps Catalyst launched dozens or even hundreds of funds that were similarly invested, but many funds died along the way, and nearly all the rest were left behind on the conversion date. If so, the remaining mutual funds’ track record would be far from representative. They would be the sweetest of all the cherries, carefully picked.

is vice president of research for Morningstar.

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