Tapping Retail Demand for Hedge Funds

With several publicly-offered hedge funds now exceeding US$1 billion in assets, the stage is set for more to be launched. Such is the demand for these products that many managers are overcoming long-held objections to them. Indeed, many now view them as a valuable way to diversify their investor bases.

Through the public market, hedge funds are tapping into both retail investors and institutional investors such as smaller pension funds. Retail investors are buying as they seek alternatives to traditional long-only funds. Institutional investors, for their part, increasingly want the protection offered by regulated products after the financial crisis and related scandals.

By launching publicly-offered vehicles, hedge fund managers are not only diversifying their revenue bases but also enhancing the persistency of their assets. For example, closed-end fund offerings provide what is essentially 'permanent capital' and are exchange traded. Even the open-end mutual fund format can deliver a less volatile investor base. These vehicles also open up distribution channels that are only accessible to regulated vehicles (eg, defined contribution pension assets).

For hedge fund managers, entering the regulated space also provides an opportunity to leverage the brand, allowing them to build broader businesses. In this way, they can grow assets in investment strategies beyond those they are known for.

At the same time, deterrents to joining the regulated world are falling. After all, alternatives managers will have to register with the Securities & Exchange Commission (SEC) anyway from the summer of 2011, and many are already augmenting their compliance infrastructure accordingly.

Challenges to Overcome

For many managers, tapping large markets for regulated products without cannibalising the higher-margin non-regulated products is the biggest challenge. Fortunately, many alternative strategies have to be modified before they can be offered as regulated products. The Investment Company Act of 1940, Internal Revenue Code and SEC regulations applicable to regulated funds all effectively impose limitations that force modifications. These include:

  • Leverage restrictions, especially regarding certain derivatives

  • Diversification requirements

  • Liquidity requirements – relating to the portfolio as a whole and to periodic distributions

  • Asset type limitations (eg, physical commodities, operating companies that are pass-through vehicles)

As these constraints restrict managers' investment flexibility, the different product offerings are often clearly differentiated. By the same token, the limitations make some strategies very difficult to carry out in a regulated product environment.

Where it is possible to package strategies as regulated products, the manager will face other challenges such as:

  • Developing new distribution channels, networks and relationships

  • Introducing greater portfolio and organisational transparency

  • Upgrading operations to produce more frequent (and perhaps more robust) net asset values and to monitor compliance with Securities and Exchange Commission and Internal Revenue Services regulations

  • Expanding governance, including managing relationships with a board of directors or trustees

As daunting as they might seem, the already developed infrastructures at third-party service providers such as fund administrators greatly ease the transition. Some even have turnkey solutions that allow managers to launch funds within existing legal structures that already have boards, compliance officers, accounting agents, administrators and custodians. To some degree, many alternative managers have already been addressing these challenges, so they may not be so significant a deterrent to launching a first regulated offering.

Clearly, the entry into the regulated marketplace requires thorough consideration as to product structuring, marketing and management. Even so, the increasing number of extremely successful product offerings from hedge fund managers suggests that more alternative managers will find that the potential rewards of entering the public marketplace outweigh the incremental costs.

This article first appeared in PricewaterhouseCoopers's Asset Management News (March 2011, Page 14). For more information, please visit