While the industry has long been talking about the convergence of alternatives and mutual funds, the growth of liquid alternatives did not pick up steam until the past few years. Simply defined, liquid alternative funds are daily NAV funds that use an investment strategy that provides a source of return differentiated from traditional, long-only equity and bond market exposure. These strategies include the ability to utilize a broad array of financial markets, instruments and derivatives, leverage, and invest both long and/or short.

Cerulli estimates that at the end of 1Q 2013 there was approximately $400 billion1 in assets under management in liquid alternatives strategies, representing roughly 2% of the industry assets. They forecast that in the next 10 years these strategies will represent 14% of total industry assets2. This growth is driven by both supply and demand side factors. Higher fees (compared to traditional mutual funds) coupled with the opportunity to tap into retail investors and the growing defined contribution and IRA markets provide asset managers with a strong incentive to launch retail alternative funds. At the same time, the opportunity for risk diversification and non-traditional sources of yield are driving demand from retail investors and their advisors.

But, launching liquid alternative funds can pose unique operational challenges for both traditional as well as alternative asset managers.

For traditional managers, the compliance and regulatory requirements for a liquid alternative fund are similar to those they face today. However, a trend that we observe is traditional managers favoring multi-manager funds as their vehicle of choice for their initial foray into liquid alternatives. The challenge for a fund sponsor in administering a multi-manager portfolio is managing liquidity, risk and compliance across each sleeve to ensure that the aggregated portfolio complies with the guidelines and limitations for the overall fund. We have developed solutions that allow a manager to aggregate and view portfolios across multiple managers as well as to monitor portfolios for breaches to investment guidelines, providing increased transparency and improved governance for the fund.

An additional challenge for funds that employ shorting or leverage is that the need for a prime broker to manage financing and collateral adds another level of cost and complexity. The BNY Mellon prime custody model provides the ability to hold unencumbered assets of the fund in accounts away from the prime broker reducing counterparty risk. Our collateral capability allows rules-based allocation of collateral from segregated accounts to multiple prime brokers. Integrating our prime custody capability with our fund services allows us to provide investors with greater transparency into the fund.

For hedge fund managers new to the registered fund space, operating a registered liquid alternative fund comes with the challenge of managing custody, liquidity and regulatory requirements. In addition to the prime broker, the fund will need a custodian and a fund administrator who can support regulatory reporting, board material preparation and compliance requirements. This is where an experienced administrator can add value. For example, each fund is required to name a chief compliance officer (CCO) responsible for maintaining detailed policies and procedures for the funds. BNY Mellon has streamlined the process for compliance officers by creating a CCO website that maintains all of the information in a single location.

Another significant change for a hedge fund manager is the need to provide daily liquidity to investors. Assets must now be priced daily versus monthly or quarterly. Part of the challenge is finding sources to properly value securities, especially derivatives, and making sure that appropriate processes and controls are in place. In order to meet these requirements, alternative managers may need to rethink the trading strategies and instruments which they have used to capitalize on certain investment strategies.

Another option for a hedge fund manager launching a registered fund is a turnkey mutual fund solution which streamlines the start-up process. FundVantage and RBB, BNY Mellon's turnkey structures allows the manager to outsource most of the fund oversight, administration, processing and regulatory support and provides an experienced chief compliance officer and an independent Board of Trustees. Creating their liquid alternatives fund within an established fund structure typically allows the manager to bring their fund to market faster and more economically than launching a standalone fund.

As advisors and investors become more comfortable with liquid alternative funds, we expect to see a greater allocation to the asset class. Using a service partner with both hedge and traditional '40 act fund experience to support all of the requirements for liquid alternatives funds in an integrated service model will allow an asset manager to focus on managing the fund in a proven operational model.

1 Includes open ended funds, closed ended funds as well as ETFs and ETNs, but excludes SPDR Gold

2 Cerulli: Alternative Products and Strategies 2013: Identifying Enduring Opportunities in Complex Markets, October 2013

The views expressed within this article are those of the authors only and not those of BNY Mellon or any of its subsidiaries or affiliates.

Hozaifa Arsiwala is a Managing Director in the Asset Servicing Global Product Management group at BNY Mellon.

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