Think a hedge fund can't exist in the open-end mutual fund universe? Think again.

A couple of crafty investment architects have built their own unique versions of hedge-like funds and wrapped them in an open-end mutual fund wrapper, trying to disprove the conventional wisdom that SEC-registered hedge funds only exist in closed-end or interval fund formats.

Alternative Investment Partners of Chappaqua, N.Y., a new investment management company created by two former executives at Kinetics Asset Management of New York [see MFMN 8/26/02], has constructed the AIP Alpha Strategies I Fund. Now in its initial subscription phase, the fund goes live Sept. 23.

A consultant to the fund will select three or four sub-advisors, each of which will employ different, but complementary, hedging techniques including: merger and value arbitrage, long-short investments, market-neutral strategies, as well as investing in distressed securities and derivatives.

Embracing a different approach, this past May, Weston Financial, a registered investment adviser in Wellesley, Mass., launched the $17 million New Century Alternative Strategies Portfolio, the fifth and newest member of the New Century Portfolios fund group, which has $200 million in assets.

The fund's managers don't directly employ hedging techniques, nor have they hired sub-advisors to work their hedge fund magic. Rather, this fund-of-funds invests in almost two dozen other mutual funds, each of which employs a core hedging technique. Investments include such notables as the Calamos Market Neutral Fund, which uses convertible securities arbitrage, Mutual Beacon, which invests in distressed securities, and the Needham Growth Fund, which feasts on a long/short securities strategy.

Of course, whether or not retail and institutional investors are accepting of these hedge funds in mutual fund clothing is yet to be seen.

This wouldn't be the first time a somewhat difficult market segment made its way into the open-end world. When a flurry of floating-rate bank loan funds first debuted in the mid-to-late 1990s, they too were all initially structured as closed-end funds because the syndicated bank loans they invested in were not liquid.

Several years later, as this asset class gained favor, investor interest increased and the supply of bank loans rose, new funds debuted in the open-end universe.

The open-end format made sense for the newer generation of floating-rate funds because most of the funds invested as much as 35% of their assets in highly liquid money market or Treasury securities, said Don Cassidy, senior analyst with Lipper of New York. That easy conversion to cash satisfied even hefty redemptions without forcing the fund manager to sell securities.

But a hedge fund built into an open-end fund format can prove much more difficult, especially where managers are forced to sell securities, he said. Balancing the remaining assets across various hedge fund managers or techniques can destroy the fund's intended hedging equilibrium, Cassidy added.

Nevertheless, these new alternative mutual funds' managers have set their sights on success.

The key to building an open-end hedge fund is to hire sub-advisors that are hedge fund managers but will treat the allocation from the mutual fund as a separate account, said Lee Schultheis, principal and chief investment officer of AIP. "You simply cannot own a hedge fund in an open-end fund," he said.

Schultheis said that he and AIP partner Steve Samson had encountered two types of hedge fund managers as they interviewed potential sub-advisors. Those who presided over hedge fund assets but were not registered investment advisers (RIA) had a much more difficult time understanding the mutual fund concept and what their role would be, he said. Additionally, some were concerned that AIP would send them too much money to manage.

Then there were those who already managed separate accounts under a hedge fund discipline and fully understood what was desired. "That mindset completely jumped the void that needed to be jumped," Schultheis said.

As a RIA itself, Weston already was allocating its wealthy clients' assets to alternative investments as part of its overall financial counseling practice, said Ron Sugameli, principal of the firm and co-manager of the New Century fund. "We were looking for a more active and efficient way to manage these assets," he said.

By creating a no-load mutual fund, Weston was able to lower its clients' costs, since there are no 20% performance fees paid to individual hedge fund managers. In addition, the fund offers transparency and daily liquidity. Moreover, since Weston was already investing in many of these hedged mutual funds, it was entitled to invest in the low-cost institutional share classes of funds, many of which have long since closed their own mutual fund doors and stopped accepting new investors, Sugameli said. "It's in the total mix of these managers that we create added value."

AIP hasn't erected its alternative strategies fund exclusively for high-net-worth investors. While it is targeting the mass affluent, it is also reaching out to bank trust departments that don't want the fiduciary responsibility of selecting good hedge fund managers, as well as pension funds and endowments whose mandate required an approved mutual fund vehicle, Schultheis said.

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