Investors of all stripes, burned by severe losses in even the most diversified investment portfolios, have been craving downside protection as they wade back into the markets. Sensing a business opportunity, money management firms have been all too happy to oblige. The net result: Twenty-four new hedge fund–like mutual funds have been launched over the past 18 months.
Many of the new offerings come from traditional mutual fund players like Putnam Investments, Rydex|SGI and Eaton Vance Corp. But a surprising number have also been launched by firms better known for their institutional and hedge fund businesses. In January, for example, AQR Capital Management, which runs $22.5 billion primarily for institutions, introduced a no-load mutual fund called AQR Diversified Arbitrage Fund. In April, Permal Group, a large fund-of-hedge-funds firm and an affiliate of Legg Mason, launched the Legg Mason Partners Permal Tactical Allocation fund. And in June hedge fund manager Bull Path Capital Management converted one of its long-short funds into a mutual fund.
The launches may be a response to new demand, but they also speak volumes about the state of the hedge fund industry, says Nadia Papagiannis, a hedge fund analyst at Morningstar in Chicago. With the HFRI composite index down 19.03 percent in 2008 and this year’s gain of 13.95 percent through August not enough to overcome those losses, many firms are no longer earning their 20 percent incentive fees. Last year, according to Morningstar, hedge funds lost $136.1 billion because of market action and outflows. That leaves many hedge fund managers with much smaller asset bases from which to generate their typical 2 percent management fees. “At this point, running a hedge fund may be less profitable than a mutual fund,” says Papagiannis, who points out that the new hedged mutual fund products command a high average expense ratio of 2.1 percent, although they do not feature an incentive fee.
The new products are certainly striking a chord with investors seeking the added transparency, liquidity and regulatory oversight that a mutual fund provides. “Our core business is institutions and will continue to be — but there’s no doubt institutional investors ran into substantial challenges last year with illiquidity and other issues,” says David Kabiller, co-founder and head of business development at AQR in Greenwich, Connecticut. “We’re doing this in response to those issues as well as demand from financial advisers.”
For Kabiller introducing the AQR Diversified Arbitrage Fund was a good business decision. Last year was tough for his firm, and AQR’s convertible arbitrage strategies lost 30 percent. The firm’s assets have declined from a peak of $38.5 billion in August 2007. Kabiller says that the plan to ramp up AQR’s mutual fund launches has been in the works for two years — and in July the firm introduced three new no-load mutual funds based on its own momentum indexes. “We’ve always wanted to build an asset management firm, not just a hedge fund business,” he says.
Another hedge fund manager who has leapt at the chance to diversify his business is Bull Path Capital founder and CEO Robert Kaimowitz. In June the firm unveiled its newly converted Bull Path mutual fund, which pursues the same hedge fund strategy that delivered average annual returns of 16.5 percent from inception in October 2002 until the end of 2007. Last year the fund was down 23 percent, however, and since Kaimowitz refused to gate his investors, it “became an ATM,” he says, as funds of funds that were locked up elsewhere redeemed to replenish liquidity. Assets fell from $530 million at the beginning of 2008 to less than $100 million today. “We decided we wanted a different type of investor,” says Kaimowitz. “Retail investors buy and keep on buying.”
Some hedge fund strategies are more easily transferable to a mutual fund format than others. Long-short equity funds currently dominate the ranks of alternative-investment mutual funds, and Kaimowitz’s strategy shows why: His firm has never used illiquid securities or leveraged a fund with borrowed capital, “which put us at a disadvantage in the hedge fund world,” he says, but made the transition to running a mutual fund portfolio seamless. In addition to long-short equity, the more readily transferable strategies include equity market neutral, convertible and merger arbitrage and some tactical asset allocation strategies, money managers say.
These days, though, even seemingly complex strategies are being launched as mutual funds. In September 2008, for example, Natixis Global Associates teamed up with AlphaSimplex Group, which runs hedge funds and global tactical asset allocation strategies, to launch the ASG Global Alternatives Fund, a product that seeks to replicate the broad market exposures of the hedge fund universe by investing in long and short positions in futures and forward contracts in the equity, fixed-income, currency and commodities markets. “What we went about creating was a vehicle that provided the diversification properties of hedge funds — with their exposure to currencies, commodities and other asset classes — with the transparency of investing in liquid instruments,” says Andrew Lo, founder of AlphaSimplex and a pioneer in the field of hedge fund replication strategies. This year through August 31, the fund was up 6.3 percent, compared with 8.03 percent for its benchmark HFRI fund-of-funds composite index. Since inception, though, it returned 3.13 percent compared with a 9.19 percent decline in the benchmark.
Sometimes the mutual fund counterparts of existing hedge funds must be managed differently. Highbridge Capital Management, for instance, runs its statistical market-neutral hedge fund strategy with a targeted annualized volatility of 12 to 14 percent. But it manages its mutual fund counterpart with an eye toward keeping volatility at just 4 to 6 percent a year. And though the comparable hedge fund strategy invests in a universe of 5,000 global stocks, the mutual fund sticks to 1,200 U.S. stocks to ensure daily liquidity.
Lo is the first to admit that returns on hedged mutual funds will be lower than on similar hedge fund strategies, given the limits on leverage and the liquidity requirements. “We’re not going to pretend we’re going to get the same returns as the best hedge funds,” he says. “[But] we feel its a good trade-off.”
Still, transitioning from hedge funds to mutual funds isn’t necessarily straightforward for money managers accustomed to the 2-and-20 fee structure. Kaimowitz figures it takes seven years for a mutual fund to achieve the same economies as a successful hedge fund. “You need to have a long-term plan and commit to get into the mutual fund business. Otherwise stay in hedge funds.”
