Pensions and Investments Magazine published a piece today on hedge funds getting into the mutual fund space. The article, “Hedge funds zoom in on mutual funds,” covers a topic we’ve been interested in for years. We thought it worthwhile to look at the trend today versus what we saw in 2008 and 2010.
The impetus for hedge funds to create mutual funds is distribution. According to the P&I article, one manager said “There’s such a strong greenfield opportunity right now. Retail investors, including defined contribution plan investors, don’t have enough alternatives in their portfolios. At the same time, institutional investors have enough hedge funds and mostly will be doing manager upgrades.”
In December 2010, our research report, “Hedged Mutual Funds: Investment Trends and Business Models,” found that “Long/short, market neutral and absolute return strategies are appearing in investment portfolios in a freshly painted wrapper of mutual funds. These funds, many run by traditional mutual fund companies or hedge funds that have repackaged their offerings, are gaining interest in spite of a confusing array of nomenclatures, returns and styles. A doubling of assets over the last 16 months has shown that these funds are attractive to a portion of the market, and both investors and service providers have taken notice.” Our report was based on the public filings of 102 long/short mutual funds.
We also found that hedged mutual fund assets had doubled between June 2009 and December 2010, from US$25.5 billion to over US$50 billion. Small numbers relative to the over US$10 trillion US mutual fund industry, but still interesting.
“This is not the first time in recent years that mutual funds have sought to use leverage as an integral part of their portfolio strategy, nor is it likely to be the last. In 2007 and 2008, 130/30 type funds, or funds that go long 1X0% of their portfolio and short an additional X0%, gained popularity as an alternative to long-only quantitative funds. Managers argued that if a quantitative fund was successful in the long-only space, their models could be extended to overemphasize security prices that were expected to rise and take advantage of prices that were expected to fall, resulting in outperformance compared to industry benchmarks. Through 2008, however, 130/30 funds fell in tandem with equity prices resulting in disappointing returns. Industry predictions of US$2 trillion in assets under management were greatly disappointed.”
In 2008 we looked at this topic from the asset manager perspective in our annual asset manager survey. We found that ” When we asked about custodial providers at the start of our interviews, only one manager cited a prime broker as a custodian. However, in the course of the conversation it frequently emerged that the firm operated a strategy requiring prime brokerage custody in one way or another. There was no resistance to a prime broker as custodian; it was simply that our respondents did not consider custody to naturally include prime brokers. That said, we found that 48% of our respondents were managing a long/short fund and in most cases the prime broker was also the custodian of assets.”
According to one Operations Manager at a US mutual fund complex, “I would love to see convergence happen [between custodians and prime brokers]. Right now, a prime broker is a custodian that doesn’t do everything. The marketplace will evolve as an experiment but it will be slow.”
We have also looked in the past at 130/30 funds and competition between prime brokers and custodians (we will return to the latter topic in 2013). A recurring issue has been the cost of providing leverage in a ’40 Act format, something that some of the custodians may have now figured out. It seems to us that the idea of hedge funds in mutual fund wrappers isn’t as new as P&I is suggesting, but that the market still has some ways to go to determine the right combination of investor-friendly products and mechanics of leverage to make everything come together right.
For more articles on this topic see our LinkedIn Group, Hedged Mutual Funds.