• / Free eNewsletters & Magazine
  • / My Account

Related Content

  1. Videos
  2. Articles

All Aboard!

As investors search past hedge funds for more-liquid offerings, the menu of alternative mutual funds expands to the bond world.

Timothy Galbraith, 12/06/2010

Alternative investing has changed dramatically since late 2008: In Morningstar's hedge fund database, hedge funds have netted outflows since 2008, but alternative mutual funds have seen exponential growth. Flows in 2010 through August surpassed 2009's record amount. The only other mutual fund categories that have seen such explosive growth are in fixed income (from investors seeking capital protection).

It's no secret why investors have looked beyond hedge funds and moved toward alternative mutual funds. In the fall of 2008, many hedge fund investors in need of liquidity were prevented from gaining access to their own assets through provisions known as "gates." An astonishing 56% of the largest 25 hedge fund firms engaged in some form of suspension, side-pocketing, or "stressed actions" to manage through the sudden investor demand for capital withdrawals at the end of 2008.(1) At the same time, Bernie Madoff revealed the world's largest Ponzi scheme, made possible by lack of regulation and neglectful hedge fund managers.

Another, lesser-known catalyst will likely solidify the trend toward alternative mutual funds--a change in the definition of what an "accredited investor" is. Because of recent legislation, it is now harder to become an accredited investor. Consequently, it's more challenging to invest in hedge funds and other private placements--a boon for liquid alternatives like mutual funds.

Like hedge funds, it's also no surprise that investors have fled long-only equity mutual funds, primarily for lower-volatility fixed-income offerings. After the S&P 500 Index experienced drawdowns of more than 50% between October 2007 and March 2009 and 15% between late April and early July, investors are re-evaluating their own risk tolerance and long-term reliance on equity returns.

Unfortunately, fixed income is no stranger to risk, especially in the face of an inevitable rise in interest rates. But risk-managed fixed- income offerings in liquid structures are few and far between. Operationally, hedged or long-short fixed-income strategies are more difficult to implement in liquid, regulated formats than similar equity strategies. The opportunity is too large, however, for both hedge fund managers and mutual fund providers to pass up.

Far from being a passing fad, alternative investing's move from private placements to more liquid, regulated formats is here to stay. And far from remaining static, the menu of liquid alternative offerings is sure to expand to the fixed-income world.

Accredited Investor No More
Tucked inside a paragraph of the 848-page Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law July 21, is a new definition of accredited investor. Previously, the accredited investor standard, which was last revised in 1982, meant that an investor had to earn $200,000 during the previous two years with the likelihood of earning the same during the forthcoming year. Investors also could qualify for accredited status by having at least $1 million of net worth, which included all investments and, critically, their home. Now, accredited investors must meet the $1 million net-worth standard excluding the value of their primary residences.

The accredited investor criteria were originally designed to limit access to private investments, which are exempt from the registration and disclosure requirements of the Securities Act of 1933 under Regulation D. These private partnerships can invest in private equity, real estate, commodities, and hedge fund strategies, which typically have limited transparency, intermittent pricing, and episodic liquidity. The logic behind Regulation D is that higher net-worth investors are sophisticated--able to comprehend and withstand the risks associated with these private investments in exchange for potentially greater returns.

©2017 Morningstar Advisor. All right reserved.