When Hedge Funds Convert to Mutual Funds

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 Hedge funds do not publish their portfolios, and, without such information, there’s no reasonable way of conducting performance attribution: what risks the funds assumed, what went right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 predecessor hedge fund's 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 this fund's predecessor hedge fund in its hedge fund database.)

The problem runs even deeper than not understanding how the predecessor hedge fund had invested its capital. It also includes not knowing the size of the brood. Perhaps the firm that ran the predecessor hedge fund 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 hedge fund's track record would be far from representative. They would be the sweetest of all the cherries, carefully picked.

Difficult to Fix Potentially, one could address the problem by asking Catalyst--or any other organization that markets mutual funds that have pre-existing track records--to submit the histories of all pools of assets, dead or alive, that the manager of the predecessor hedge fund has run in a similar fashion. Unfortunately, such a solution is impractical. It requires the hedge fund manager's cooperation, which is not always forthcoming; it demands data that may no longer exist (not every firm retains records of funds that disappeared during the Clinton presidency); and the response cannot be double-checked.

Finally, there's the question of whether the fund's investment strategy has remained constant. Hedge funds, after all, are permitted various techniques that are prohibited by the '40 Act. The SEC does protect against egregious cases by requiring that funds that wish to cite their preconversion histories be managed in a substantially similar fashion as before. However, substantially similar is not quite the same as identical. And once again, there's that matter of proof. For such claims, Morningstar must trust, and it cannot verify. Ronald Reagan would not approve.

Guessing Games Which brings us to Catalyst Hedge Futures Strategy Fund, the fund that lost 15% in a week. Should investors have known that such a drop was possible? There was nothing in the fund's postconversion record. It became a mutual fund in summer 2013 and had performed smoothly since that time. There was also nothing in the fund's preconversion history, save for a one-month period shortly after its late-2005 inception, when the fund fell 18%, albeit over four weeks rather than one. Was that 2006 decline a clue as to what befell the fund 11 years later? Or was it a nonrepeatable event, a product of the fund's small asset base and/or more-aggressive investment strategy?

You got me. I have no idea whatsoever if Catalyst Hedge Futures’ nosedive could have been expected. As Mr. Spock would say, there is insufficient information on which to make an estimate. I also have no idea whether Catalyst/Millburn Hedge should be regarded as the world beater that it appears to be or whether it’s a risky fund dressed in sheep’s clothing. As far as I am concerned, that fund has a three-year track record. And three years is not enough time on which to form expectations.

In short: For funds that once were hedge funds but have now become mutual funds, ignore their preconversion records. I write that reluctantly, because more information generally beats less. However, when the information carries so many unanswered questions, using it amounts to guesswork.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.