Over the past few years, one of the fastest-growing segments of the registered mutual fund industry has been in the alternatives space, with "alternatives" being something of a catch-all term for funds focusing on non-traditional asset classes or strategies that had previously been the domain of institutional investors and hedge funds. The number of these funds has skyrocketed, driven in large part by strong demand from retail investors and advisors for investment strategies that offer less correlation to the broad equity and bond markets.
As new offerings have made their way to the broader marketplace, many have begun to gather significant assets, posing a new challenge for mutual fund boards and their independent directors. At its most basic level, the question is this: does a director who oversees an alternative strategy fund have different responsibilities than those of a director who oversees a more traditional fund?
From a legal perspective, the answer is no. The fact that many of these funds pursue complex investment strategies does not alter the fundamental role of an independent fund director. A director's responsibility does not arise from a particular investment strategy or the nature of the securities found in the fund's portfolio, but rather derives from legal and fiduciary duties owed to the fund and its shareholders.
To that end, the Mutual Fund Directors Forum recently published a paper entitled Board Oversight of Alternative Investments that seeks to help directors identify the key oversight issues as more alternative approaches enter the mainstream. For a fund board asked to review an alternative fund offering, questions to consider can include:
Does the adviser have the expertise, knowledge, and resources necessary to carry out the intended strategy?
When a fund is still in the "idea" stage, directors should discuss whether the proposed adviser has the skills and tools necessary to manage the fund's strategy, as well as to own and trade in the securities necessary to implement the strategy. For example, the investment strategy may have its own set of unique challenges, including a relatively limited track record, or an investment track record achieved within a private fund vehicle, rather than a registered fund. In addition, holding derivatives and other complex securities may pose operational challenges that directors should be confident the adviser can meet.
Do the service providers have sufficient expertise and resources to service the new alternative fund?
Boards will want to inquire not only about the background and skills of the adviser, but also the anticipated auditors, administrators, fund accountants and attorneys, since specialized funds will likely call for specialized expertise both in running the strategy and in managing all of the back office and legal/compliance functions.
How will the fund's strategies and/or portfolio holdings fit within the regulatory requirements of an open end mutual fund?
Many alternative strategies can be difficult to fit within the regulatory requirements for open-end funds. For example, as our recent paper points out, the 1940 Act requires daily calculation of a fund's net asset value (NAV), limits leverage, requires asset diversification, places limits on concentration in particular issuers, and places restrictions on the amount of illiquid securities that can be held in an open-end fund. All fund boards overseeing funds with alternative strategies need to be aware of these requirements.
For advisers launching registered funds for the first time, these requirements are vastly different from what they have faced managing funds in the private fund space. Such a fund's board will need to assess whether an adviser new to the registered fund space has the policies and procedures necessary to meet these new regulatory requirements. In other contexts, where an established manager is hiring a sub-adviser to run an alternative strategy, boards will also want to consider how the adviser proposes to supervise each sub-adviser, as well as any potential cultural differences arising from the sub-adviser's lack of experience in the registered fund world.
How is a fund's investment strategy intended to work, and is that strategy functioning as expected?
Alternative funds may present challenges in the areas of performance evaluation, peer group and benchmark identification. A fund with a relatively short track record may not have experienced the market cycle in which it would be most effective, making evaluation of whether it is achieving its investment objective difficult. Moreover, identification of peer groups and benchmarks for appropriate comparisons may be difficult because of the wide variety of investment strategies employed even by funds sharing a common investment objective. The last few years have brought significant change and added levels of complexity to many fund products. Retail and institutional investors as well as hedge fund managers have all begun to see real value in offering alternative strategies in vehicles that can be made available to a wide audience. As always, engaged and informed fund boards will continue to play an invaluable role in representing the interests of fund shareholders. The questions above, as well as the additional topics discussed in our recent paper, can serve as a helpful starting point for the increasing number of directors tasked with overseeing these funds.
Susan Ferris Wyderko is the president & CEO of The Mutual Fund Directors Forum, a nonprofit membership organization for investment company directors.