In order to achieve greater flexibility and improve efficiencies, one of the first open-end mutual funds to wholly embrace hedge fund-like investment strategies will be seeking a face-lift of sorts.

Executives at Alternative Investment Partners (AIP) of White Plains, N.Y., advisor to the $172 million no-load Alpha Hedged Strategies Fund, are asking investors to approve a structural change to the open-end fund, which spreads its assets across 10 investment sub-advisors that employ alternative investment strategies. If shareholders approve, as soon as April 1, the fund will convert to a mutual fund-of-funds, although there will be no visible differences in the operation or expenses of the fund, and the same lineup of sub-advisors will continue to manage assets for the fund.

From its October 2002 inception through now, the Alpha Hedged Strategies Fund has operated as a manager of managers and employed a selection of sub-advisors to each run a piece of the fund's assets through a separate account arrangement.

Alternative Investment Partners now believes the underlying separate account structure could become unwieldy from a tax, accounting and daily operational standpoint across potentially thousands of securities as the fund grows and adds additional sub-advisors, each managing a separate account for the fund. The goal is to continue to diversify the fund's assets across various alternative investment strategies and potentially grow to 40 different managers in the near future, said Lee Schultheis, chief investment strategist and co-founder of AIP.

To more efficiently accomplish this, the fund will be nixing the underlying separate account structure and turning each into a mini, affiliated mutual fund that will only be available for use by AIP. These 10 mini mutual funds will not be registered for public use or investments. Each will, at least initially, be managed by a single sub-advisor in the same way that the separate account had been managed. The Alpha Hedged Strategies Fund will then invest in varying percentages in each of the 10 mini mutual funds created.

Easing the Number Crunch

With 30 or 40 managers managing through a separate account structure, "you've got a tax nightmare," Schultheis said. For example, in adhering to their own investment style and discipline, one manager may have purchased a security while another has shortly thereafter sold that same security. That creates a wash sale, he explained. Moreover, across up to 40 managers, each holding 120 securities positions or more, calculating the daily net asset value (NAV) on the total fund can be cumbersome and may push the limit on getting that NAV calculation into the Nasdaq quotation system by its 5:40 p.m. deadline, he added.

Under the new fund-of-funds structure, each sub-fund will have its own NAV calculated by fund accountants earlier in the day. In turn, those NAVs will be used to calculate Alpha Hedged Strategies Fund's own daily price.

The new fund-of-funds structure also facilitates AIP's desire to launch additional mutual funds, each of which will combine the same underlying hedge fund-like investment strategies but in different amounts to match the risk profile and objective of each new fund.

"This [new fund-of-funds structure] is a way of taking the separate accounts and making them the elemental building blocks to implement more mixes," Schultheis said.

Building For Expansion

Alternative Investment Partners already has a registered sister fund, a beta fund, waiting in the wings, which it expects to launch in the spring. The new structure will allow AIP to create this beta fund, as well as an unlimited number of others, without having to go back to each of its 10 current sub-advisors to ask each to establish a second separate account with its own overhead expenses just for this fund, Schultheis said.

In the future, AIP envisions launching up to five funds and tapping the strategies of as many as 50 to 100 managers. At the present time, AIP is gearing up to add two new investment sub-advisors, each focusing on the distressed securities, event-driven and special situations areas.

In addition, down the road, as additional investment disciplines are added to AIP's roster of strategies, at least some of these mini mutual funds may feature combinations of two or three strategies as opposed to just one strategy and sub-advisor per fund, Schultheis added.

Odd Man Out

The formation of AIP's new mutual fund-of-fund structure is a bit odd. Many players salivating at the chance to offer an alternative investments product have launched hedge fund-of-funds products that cater to the wealthy and themselves invest in a variety of selected hedge funds. AIP's configuration is unusual in that it seeks to offer the same transparency, daily pricing and daily redemptions of an open-end mutual fund.

Within the mutual fund universe, there are many open-end mutual funds-of-funds. But most fund companies, including Vanguard Group, and T. Rowe Price, allocate assets across a selection of their own proprietary mutual funds that are also separately offered to the public as stand-alone funds. In some cases, fund advisors also offer funds-of-funds that allocate assets across a selection of third-party, non-proprietary funds in an attempt to combine superior funds. And there are several well-known funds that operate as multi-managed funds, parceling out a percentage of the fund's assets to each of several best-of-breed managers, each with a different investment strategy.

But, this mutual fund-of-funds structure has a drawback or two. According to Schultheis, costs will be 30% to 40% higher, based upon current asset levels, under the new fund-of-funds format. In addition, transparency may become an issue, industry watchers cautioned.

Vanishing Transparency?

Under the existing format, AIP has reported all of the underlying sub-advisors' long and short securities holdings in reports to fund investors. Under the new format, however, the Alpha Hedged Strategies Fund will only be required to periodically report the percentage allocations to the underlying funds, and not the actual securities that each of the underlying funds is invested in. While the fund's advisor may voluntarily choose to detail the largest securities in each sub-fund's holdings, it also may not.

"AIP can certainly elect to report quarterly the individual security holdings of the underlying funds on a pro-rated basis if we find there is real demand in the marketplace for this level of detail," Schultheis said. But when the fund reaches as many as 30 to 40 managers, "this information will seem like overkill to many," Schultheis predicted.

Moreover, what will remain unchanged is the level of transparency available to AIP. The money manager will still be able to see all trades executed by the sub-advisors, to be certain that each is "managing consistent to their agreed upon style on an ongoing basis." he added.

While AIP has chosen to restructure, executives at competitor Absolute Investment Advisers (AIA) in Hingham, Mass., have been perfectly happy utilizing the separate account structure to run the firm's Absolute Strategies Fund, an alternative strategies fund that, since its July 27, 2005 launch, has amassed $100 million. The fund currently employs 13 sub-advisors.

"I don't see the separate account piece as being very complicated," said Jay Compson, co-founder of AIA and co-portfolio manager of the fund. In addition, the possibility for overlapping of securities among managers can and does exist, but isn't a negative, he added. "It could smooth out tax issues for investors because there are lots of things going on, and one sub-advisor may be selling while another is buying." That could actually mitigate capital gains, he added.

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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