On Mutual Funds, Alternative Strategies, and Waterfalls

The retailization of alternative investment strategies is hardly a new idea. It was a decade ago, after all, that 100 Women in Hedge Funds hosted a roundtable on the subject.

Mutual fund managers have been studying this idea for at least that long. To the extent they are in competition with hedge fund managers for the loyalties of an overlapping investor base, mutual fund managers feel at some disadvantage in that (just for example) their investors expect daily liquidity. Accordingly, their regulators monitor their portfolio liquidity issues carefully, where the liquidity of an asset is understood as the ability of the fund management to sell that asset within seven days at a price reasonably related to that carried on the books. Since some strategies require the long term commitment of assets, this may feel like a pair of handcuffs.

Still: it has by now become widely accepted that mutual funds can and often do offer “retail” investors, that is, investors who don’t satisfy the high net worth requirements for investing in hedge funds, access to some of the alternative strategies often associated with hedge funds, such as long/short, market neutral, and event driven strategies.

It was with all this in mind that I spoke recently to John Siciliano, managing director at PricewaterhouseCoopers, who updated me on the state of retailization/convergence from the point of view of the mutual fund firm managements with whom he has conferred of late.

Siciliano, managing director at PriceWaterhouseCoopers tells me that he has been talking “to executives managing long only mutual funds who have become extremely interested in how a ’40 Act mutual fund can pursue alternative strategies.”  Often the idea is to run traditional and alternatives-based mutual funds side-by-side (although that can generate issues of conflict, compliance, and trade allocation.)

Waterfalls

Before the global financial crisis, a certain amount of pressure had seemed to be building on regulators to allow ordinary folk into the hedge fund arena. Charles Schwab developed a “securities lending fully paid program” in 2004, in effect retailizing the lending of securities to short sellers. Indeed, retailization on a variety of fronts seemed so inevitable that some – including Bloomberg’s Chet Currier – saw it as spelling the end of old-fashioned mutual funds. The argument was that between the flashier alternatives on the one hand and boring-but-cheap passive investments on the other, active long only mutual fund managers couldn’t justify their keep. From north of the border, Jonathan Chevreau said much the same.

In the midst of such developments, there have always been those who sought to warn the retail investors against the flashy dangers of alternatives. For example, in the midst of the troubles of 2008 – months before the failiure of Lehman Brothers but after the forced sale of Bear Stearns to JPMorgan Chase – Chuck Jaffe, in a much-noticed piece in MarketWatch, presented a quite negative view of 130/30, saying “early returns don’t seem to justify the hype.”

Less common, though, have been the warnings delivered to the mutual fund managers. Does anyone ever tell them, in the words of TLC, not to go chasing waterfalls? Stick to the long only  rivers and lakes?

They might not listen, because they want to become part of what they see as an oncoming tide. Siciliano told me that the assets under management in the alternative portion of the mutual fund space have tripled “since the middle of ’08, and that is minor compared to how much room it has left to grow.”

Stepping Carefully but Looking Forward

Siciliano hasn’t started singing the TLC tune, he isn’t against the use of such strategies, but he has been telling managers considering such a move that they’ll have to step carefully.  One of the requirements of the ’40 Act statute for any mutual fund, for example, is an independent board of directors, so managers will have to “educate the members of your board to understand the characteristics of the product,” he said. “Also, you must train your distribution team about suitability issues. This is an ongoing obligation, and applies even if distribution occurs through a third party.”

Looking forward, Siciliano reflected that the alternatives portion of the mutual fund space “might well double within five to seven years, and even the way we talk about it, the word ‘alternatives’ in particular, might go by the boards over that period.”

After all, to say that a 130/30 long/short position, or a commodity futures based strategy, is an alternative is to suggest that long-only equity strategies, or those involving sovereign, municipal, and/or corporate bonds, constitute a perennial range of normal. As the alternatives themselves become normalized, look for vocabulary to adjust.

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