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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.

Since 1982, however, a lot has changed. Net worth has increased for many investors, especially as a result of the housing bubble. Between 1989 and 2001, the percentage of millionaires tripled.(2) Although many investors found themselves technically eligible for private investments, their investment proficiency was less than a perfect match for these sophisticated products, which frequently involve complex trading strategies, partnership tax treatment, or esoteric securities such as a collateralized debt obligations.

The Bottom Line
With fewer accredited investors, the real impact of the legislative change will be twofold. First, hedge funds and other private placements that rely on accredited investors for asset growth will have to swim upstream, targeting the larger, institutional market. Second, because not all hedge fund firms will succeed at this, they will adapt their products to the non-accredited retail market.

Typically, hedge funds look to existing investors in search of assets--the old maxim that existing customers are one's best customers is true in the financial-services industry, too. Unfortunately, going back to existing investors in search of additional assets will not work for many hedge funds. While the law is currently silent to grandfathering existing investors, many expect that the SEC will require new money to meet the new, higher net-worth requirement, even if the investor is already a limited partner. Therefore, hedge funds may have no choice but to go "up market" and target the institutional market: endowments, foundations, larger pension plans, etc.

While these large institutional investors are receptive to alternatives, including hedge funds, they are reticent to invest in smaller funds. Smaller funds are disadvantaged because large institutional investors want a robust organizational structure in regard to systems, compliance, finance, risk, and redundancy in investment teams. These characteristics are expensive to maintain and operate, so firms with large asset bases have an edge. Additionally, institutions are hesitant to be proportionally too large of an investor in a fund. Being a large investor compromises the ability to withdraw capital without affecting the entire fund. According to recent surveys, 39% of institutional investors require a minimum fund size of between $100 million and $499 million,(3) and 37% of institutional investors will not invest outside of existing managers.(4) In truth, not every hedge fund can target large institutional clients.

As a result, small hedge fund firms will have to create alternative products that do not require minimum net-worth standards and that will cast a wide net over investable assets--namely, open-end mutual funds. Hedge fund firms can either build and launch their own mutual fund products or serve as subadvisor to a mutual fund. Mutual funds manage $7.1 trillion and serve as the workhorse of investor portfolios in the United States, where 43% of households own them.(5)

Because most mutual funds employ no leverage, own (long) securities, and provide daily valuation and liquidity, many investors are surprised to learn that the mutual fund structure is conducive to some hedge fund strategies. Regulations permit shorting and the use of leverage in open-end mutual funds, albeit subject to some restrictions. (Proceeds from shorting securities must generally be unencumbered, and the funds cannot take on more debt than one third of their assets.) Funds in Morningstar's long-short category, the chief alternative mutual fund subcategory, follow strategies that can take both long and short positions in equity, debt, and other asset classes.

(View the related graphic here.)

For the year to date through August, more than $12 billion flowed to the long-short category, primarily because of the past few years' extreme market conditions. Investors wary of the current market swings are finding solace in the lower volatility profile of the long-short category. The 36-month standard deviation of the long-short category average was less than half that of the S&P 500 Index (7.9% versus 21.3% annualized, respectively). This should not come as any great surprise--portfolios that have both long and short exposure generally run a lower net exposure, which helps create smoother returns. The real surprise is the astounding rate of inbound asset flows and, therefore, the appetite for risk-managed investments, given the short track records of most funds in the category. Of the 119 distinct long-short funds in Morningstar's database, 49 were launched after 2008. These young products lack a track record for 2008, arguably a year in which most investors would want to see the product's robustness.

Bumps in the Road
Despite the high growth rates for alternative mutual funds, we see some potential obstacles. Clearly, not every fund launched will meet its performance objective and gain investor acceptance. Also, market conditions may change. If there is a multiyear rally in the broad stock market, hedged products with lower equity exposure will lag, leaving unprepared investors wanting more. Investor education and suitability remain vital.

But more important, investors are clamoring for fixed-income strategies, which are clearly lacking in the alternative mutual fund arena. Hundreds of billions flowed into long-only fixed-income strategies in 2009 and 2010, yet only a handful of long-short or hedged fixed-income mutual funds exist, scattered between the long-short and bond categories. Long-only bond investors may face substantial risk; interest rates will eventually rise from their current ultralow levels. The exact timing is debatable, but not the long-term direction. The end of the 30-year bull market in interest rates is upon us, and very few products exist to hedge against this rising tide. In addition to hedging risk, fixed-income strategies that can short can also profit from volatility in interest rates and credit instruments related to central bank announcements and disparate growth rates among countries-- another potential benefit to investors.

If the need is obvious, why don't more alternative fixed-income funds exist? The scarcity of these risk-managed funds is primarily a function of the very legislation designed to protect investors from risk. In designing a long-short fixed-income strategy, fund managers must overcome two significant restrictions of the Investment Company Act of 1940: how to create short exposure without creating obligations (debt) or breaching asset coverage levels, and how to gain access to certain markets without violating liquidity parameters. Both of these constraints are intended to protect the investor from extreme events. In practice, though, instruments commonly used to execute fixed-income strategies (futures, repurchase agreements, reverse repos, standby funding commitments, and swaps) are inherently leveraged. And although many fixed-income instruments are relatively liquid, liquidity can dry up for certain types in times of crisis (over-the-counter instruments, for example). Given the realities of how fixed-income markets function and are financed, long-short fixed-income or relative value fixed-income arbitrage managers find limited operating room inside the 1940 Act. As a result, many fixed-income or even less-liquid equity strategies (private equity, for example) are better suited to private placements. Hedge funds are here to stay and rightly so.

But more and more hedge fund firms, as well as large mutual fund shops, will be forced to compete for assets. The industry has been sucked into a self-reinforcing loop: Asset growth rates will attract more companies to launch alternative mutual fund products, the change in the accredited investor standard leaves a class of investors searching for new products, and continued investor wariness feeds into the desire for lower volatility and less-correlated strategies (including fixed income). There are exciting times ahead.

Footnotes:
1. "Hedge Fund Update--Down but Not Out," January 2009, Barclays Capital Prime Services/Asset Management Solutions Group presentation.
2. Kennickell, Arthur B., "A Rolling Tide: Changes in the Distribution of Wealth in the U.S., 1989-2001," Survey of Consumer Finances, Federal Reserve Board.
3. "Emerging Managers in the Spotlight," Preqin, Hedge Fund Investor Spotlight, Vol. 2, Issue 1, January 2010.
4. "The Next 12 Months: Institutional Appetite for Hedge Funds," Preqin Research Report, August 2010.
5. "Chapter 6: Characteristics of Mutual Fund Owners," The Investment Company Institute Fact Book, 2010.

Timothy Galbraith is director of alternative investments with Morningstar Associates.

The opinions above are those of the author noted and are not necessarily those of Morningstar Associates, LLC, are as of the date written, and are subject to change without notice. Morningstar Associates, LLC is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc.

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