In recent years, driven in part by an increasing desire of retail investors for investment strategies that are not correlated with major market indices, there has been a convergence of hedge fund strategies and mutual funds. Many strategies and products previously available only to sophisticated investors are now being offered in the form of mutual funds. The substantial increase in the number and variety of available alternative funds, coupled with the increased attention to these funds by regulators, suggests renewed focus on key oversight issues surrounding alternative funds.
Some alternative fund strategies and products can be difficult to fit within the unique regulatory requirements that govern open-end funds. While traditional 1940 Act asset managers are familiar with these requirements, advisors with experience in private funds may not be. Further, even complexes with traditional funds may be challenged to adhere to regulatory requirements while investing in new asset classes or pursuing alternative investment strategies. In all cases, directors, CCOs, and fund advisors and sub-advisors will want to work together to develop policies and procedures consistent not only with the regulatory constraints applicable to registered funds, but also with a fund's disclosed investment strategies and objectives.
One challenge facing boards overseeing alternative mutual funds is assessing a mutual fund asset manager's expertise. For example, the asset manager may have either a limited track record with the investments and/or strategy that will be employed by a new alternative fund or the experience may be solely in the private fund context.
All parties involved in running and overseeing an alternative fund also need to consider the asset manager's back-office resources that will be used to support the fund. The fund manager needs the capability to make, confirm, and record trades of investments that may be new to the fund complex. New products may not fit into existing fund record-keeping systems and therefore require manual data entry, which can raise issues of data accuracy.
One available avenue to the expertise necessary to add an alternative fund to the product line-up is hiring a sub-advisor to provide day-to-day management of a fund. However, while these sub-advisors may have extensive experience with alternative investments or strategies in the private fund context, they may have little familiarity with the legal requirements of registered funds. The 1940 Act and its regulations differ in some important ways from regulations governing private funds, including calculation of a daily net asset value, restrictions on illiquid securities, leverage limits, asset diversification, and concentration limits. Exploring how much experience the proposed sub-advisor has with registered funds can help focus on areas of the most significant risk.
Cultural differences are key considerations for fund boards, fund managers, and sub-advisors when an asset manager with experience in the hedge fund universe provides investment advice to a registered fund. For example, board oversight of trading policies is uncommon in the private fund context. Managers of hedge funds may be unaccustomed to a requirement to obtain board approval of trading policies; therefore, fund primary managers and boards will want to inquire as to whether a sub-advisor understands the critical importance of board approval of certain trading policies, and in particular, any necessary pre-approval of changes in those policies.
Soft dollars may be another area of difference when asset managers that primarily manage private funds enter the mutual fund arena. Mutual funds must remain within the safe harbor of Section 28(e) of the Securities Exchange Act of 1934 for soft dollars used to purchase brokerage and research services. Some arguably research-related expenses, such as computer terminals and trading software, explicitly fall outside of the Section 28(e) safe harbor and mutual fund assets may not be used to pay for these items. In contrast, managers of private funds typically merely disclose the use of soft dollars for items falling outside the scope of the safe harbor.
The process required to begin using a new investment vehicle may be another area of difference. In a private fund, a portfolio manager may have the discretion to add a new type of investment to a fund's portfolio at any time. However, depending on the characteristics of the new investment and the established procedures followed by a particular fund complex or fund board, the board may be required to receive notice or approve the use of the new type of investment prior to its introduction into the portfolio.
Retail and institutional shareholders as well as private fund managers have all recognized value in offering hedge fund-like strategies in the registered fund context. Boards, fund managers, and sub-advisors should be aware of regulatory and cultural differences when they begin to offer registered fund products.
Susan Wyderko is president and CEO at Mutual Fund Directors Forum.