Concept Capital’s Jack Seibald (pictured) discusses the risks of ’40 Act liquid alternatives, the potential mismatch between managers and investors, fund investor alienation, and why prime brokers might raise their costs to support the ‘short’ side of these funds.
HW: The rise of the ’40 Act alternative mutual fund has attracted a lot of headlines this year as assets climb north of USD300bn. How do you feel about this?
JS: I’ve been in this business a long time. Every time I see everyone running towards a new product I get concerned. The last big product evolution was ETFs. There’s an ETF now to reflect any kind of market position anyone wants to take, and the perception among many investors and regulators is that if the product is made accessible to the retail market in a less expensive fashion, that’s a good thing.
I think that’s a naïve approach to take. While there are a number of ETFs that are very appropriate investment vehicles, many don’t provide any value other than facilitating short-term trading. Moreover, there are quite a few ETFs that appear to be totally inappropriate for unsophisticated investors as they provide them with an easy way to get involved in strategies or investment products for which they have no understanding, and whose underlying risks they don’t understand. The double and triple levered ones, as well as many commodity ETFs come to mind. To the unsuspecting investor, these may be considered safe because they are traded like a stock, are listed on an exchange, and are inexpensive to execute.
That notion extends into liquid alternatives as far as I’m concerned. We have seen such a significant proliferation of liquid alternatives that it should raise a lot of red flags, particularly because, as SEC registered vehicles, they create an aura of safety. Investors are lulled into believing these funds are okay. After all, they trade like a mutual fund. My concern is that there are a whole host of investors for whom the underlying strategies make absolutely no sense. There’s a real potential mismatch of the risk and potential reward of the fund, and investors’ expectations for such.
HW: Many of these ’40 Act funds, like alternative UCITS in Europe, offer daily or weekly liquidity. This doesn’t translate easily across all types of hedge fund strategies that have, historically, worked on a quarterly liquidity basis to give managers the time needed to implement their strategy.
JS: Right. If a hedge fund manager is used to managing a portfolio in a certain manner that best suits the strategy he employs, how does a decision to offer a liquid alternative of that strategy even begin to make sense? In such a circumstance there’s a potential mismatch between the underlying investment strategy and the manner in which money flows in and out. It’s not just an issue when investors pull money out, it’s an issue when new monies come in. You put a position on in the hedge fund and likewise in the liquid alternative. Due to the way the ’40 Act fund is distributed, if a significant amount of money comes in the next day and the day after, what do you do? Do you put more money into that same position even though the stock price has changed?
Managers need to think hard about whether the strategy they are running makes sense in a liquid alternative structure.
HW: Not all strategies are suitable. An activist manager cannot conceivably run a liquid alternative. They need months – years even – to affect change in the companies they hold positions in. What kinds of strategies are suitable in your opinion?
JS: A long/short equity strategy trading large-cap liquid stocks may be fine, but not, for example, a small-cap value strategy in which the underlying securities don’t necessarily trade that easily. If such a manager also runs a liquid alternative and starts attracting inflows, then what do they do? If they are building positions on the long side in the hedge fund, and then do the same in the liquid alternative, that’s going to drive up the prices of the securities and lead to stronger performance in the hedge fund compared to the liquid alternative.
The reverse is true as well. If money is flowing out of the liquid alternative fund, it risks damaging the performance of the hedge fund because liquidating positions is going to drive down stock prices. So it could be that the ’40 Act outperforms or underperforms the hedge fund based solely on the manner in which money is flowing in and flowing out.
For some strategies there are significant risks of divergence in performance between the hedge fund and the ’40 Act fund that is supposed to be replicating it. One allocator who spoke recently at the Hedgeopolis event in New York said that they would run far away from a manager if he was also running a ’40 Act fund.
HW: The argument made is that a hedge fund manager launching a ’40 Act fund does so on the proviso that it is a completely different fund that cannot be expected to mirror the flagship hedge fund’s performance.
JS: I accept that, but that’s what makes it farcical in my opinion. If you’re going to run a different strategy then you shouldn’t dress it up as some new fangled way to get exposure to hedge funds. If the manager is running a necessarily different version of the hedge fund strategy, that’s fine, but is that liquid alternative really reflective of the hedge fund manager or are they having to make significant compromises in the manner in which they invest the portfolio?
HW: In which case you’re not truly getting full access to that manager’s expertise; you’re getting a watered down version. You also think that it’s the quickest way for a hedge fund manager to lose the audience for their hedge fund(s) because of the friction a ’40 Act fund could generate. How important is this cannibalization issue?
JS: I think it is a legitimate concern. If I’m paying 2/20 fees and that manager decides he’s going to run a liquid alternative which is closely comparable to the hedge fund strategy, then my reaction is obviously going to be ‘Why am I paying these fees when investors in the liquid alternative are paying 1 to 2 per cent?’ Why not just move into that fund offering daily liquidity and save on fees?’
The second issue is, if I’m an investor in a hedge fund where a manager claims he ought to be getting higher fees for his skillset based on a good historical track record, and then launches a ’40 Act with a slightly different strategy, then I would question whether his attention is fully focused on the hedge fund strategy I’m paying significant fees for. Is he looking to just raise assets, book management fees and potentially become less motivated to generate good performance?
HW: This is a danger that some asset allocators have raised; that hedge fund managers are becoming asset gatherers not alpha generators. You have some interesting views on how the institutionalization of the industry has led to this proliferation of liquid alternatives. Could you share them?
JS: I think the liquid alternatives trend may be a reaction to what’s been happening in the hedge fund industry. Twenty years ago, everything was focused on performance. Why? Because the investors were primarily UHNW individuals, family offices, and endowments (which were principally driven by the UHNWs). The goal of both manager and investor was consistent; outsized absolute returns on the assumption of outsized risk; employing leverage, making bets. It was a higher octane, performance-driven environment.
Over the last 10 to 15 years, hedge funds have become more institutional and their very nature has changed. With that, I think there has been, in part, a mismatch of what the original premise was of investing in a hedge fund and the goals of the investor. Pension funds are not looking to take on materially more risk to generate outsized returns. They have a more conservative return objective in mind with hedge funds to help them meet their expected obligations.
This has caused several things to happen: managers with significant institutional investors have grown much larger, are collecting significant amounts from management fees, and frankly have arguably become dis-incentivised to take the risks required to generate those outsized returns.
HW: You could argue that the hedge fund space has become safer, more anodyne.
JS: If a manager receives a USD300mn allocation from an institution, they won’t want to lose that investor so they may be inclined to take less risk and to accepting of generating potentially lower returns.
Offering Memorandums and pitch books for managers used to say that their aims were to generate outsized returns in favourable market conditions and preserve capital in less favourable market conditions. It’s been a long time since I last saw one like that. Now, for the most part, it’s a much more generic pitch about managing risk and capital preservation.
Risk management and preservation of capital has become so central to the theme, it makes one wonder where performance fits in. And with that, why in view of lackluster performance in recent years, the 2/20 fee structure is still on managers’ minds. If the idea is to charge investors performance fees then they should get performance. They shouldn’t get the ‘I’m preserving capital’ thing.
What appears to have gone out the window is the original premise of hedge funds, that is to make outsized returns. Now it’s been replaced with this focus on not losing money. By doing that, managers automatically limit your ability to generate meaningful performance.
HW: This partly explains the genesis of ’40 Act funds: institutional money has led to dampened returns in recent years, which in turn is pushing investors into cheaper liquid alternatives because they don’t want to pay the higher fees.
JS: Look, there are plenty of managers out there running great strategies and generating impressive absolute and risk adjusted returns that their investors are happy to be paying fees for. My guess is that those are the managers who are least inclined to have a ’40 Act fund product.
I’m making generalisations here, but if you have a manager with a track record of generating outsized returns, what incentive would they have to create a liquid alternative structure, where the investor base could be fickle, which won’t allow them to charge a performance fee, and could result in the possible alienation of their fund investors?
HW: We’ve not even touched upon the hard and soft costs of launching one of these vehicles. This is a significant burden for anyone wishing to launch a standalone ’40 Act fund.
JS: The hard costs relate to establishing the ’40 Act fund, operating it on a day-to-day basis and having to pay all the service providers and regulatory fees, not to mention paying a fund sponsor to go out there and sell the fund. If you’re collecting 1.5 per cent in management fees, you’re not keeping much of that unless the assets grow to hundreds of millions or billions.
We hear from managers and service providers that the break-even on a self-managed ’40 Act fund could be anywhere between USD30-100mn, though I suspect that the latter is the more realistic level. So, until you raise that 100mn you are out of pocket a good deal of money. If instead you could raise a tenth of that for the existing hedge fund, that increment helps to spread the hedge fund costs over a larger base, potentially helping performance, and provides the manager potential returns based on management and performance fees.
The other option is to join one of the platforms that run these super structures that allow the manager to create a sub-fund under the auspices of the fund platform; a turnkey solution basically. But that means someone else is also getting a piece of the management fee being charged. And what happens if one of the other ’40 Act funds on the platform blows up? What happens to the other funds on the platform? Does it taint all the other managers? Essentially, the manager is not fully in control.
HW: And what is it that you mean by ‘soft costs’ to the manager?
JS: A ’40 Act fund’s assets are required to be held at a custodian bank, but that custodian cannot hold short positions or derivatives. This requires the fund to enter into a tri-party agreement with the custodian and a prime broker, with regular money movements between the two banks. The prime broker now has the undesirable task of holding only the shorts and the options. What’s the incentive to them doing this? Not much.
They’re not holding the long securities so they can’t lend them out and earn money on the account that way. Rather, they’re in the unenviable position of having to use their balance sheet to support the shorts and options.
The prime broker’s costs are also higher as servicing such accounts is labor intensive. The revenues are lower relative to holding a hedge fund, and my guess is that, moving forward, prime brokers are not going to be willing to hold these accounts unless there’s more in it for them. Maybe they will start charging a custody fee. Maybe they will introduce financing costs that are materially higher than they would normally charge a hedge fund. Given the difficulty it raises for brokers, who only get to see one side of the portfolio, supporting ’40 Act funds could potentially become more of a drag, and thus more expensive for operators.
HW: Finally, how do you see this ’40 Act fund trend developing?
JS: It’s not unreasonable to assume that the liquid alternative evolution is not going to be smooth for the reasons discussed above. The concern I have for the industry is that too many managers get distracted by the idea of potentially raising more assets more quickly and look to liquid alternatives to do that. For managers with strategies and track records of outsized returns, and remain focused on their hedge funds, I suspect the future will be fine as they will continue to attract capital from investors seeking such performance. For some portion of managers who explore the ’40 Act route, things will work out as well. I fear that for a significant number of managers who try it, it won’t.
