Vol. 15, No. 10 • October 2008

      Offering Alternative Investment Strategies in a
     Mutual Fund Structure: Pract...
global macro, long/short, market neutral, fixed                In addition, several fund sponsors have launched
income and...
under the 1940 Act, registered mutual funds can             order to assure that no client accounts are dis-
offer their s...
qualification of income.12 The implementation of            the extent a counterparty cannot fulfill its obliga-
6. Investment managers of mutual funds must be registered                 securities of one issuer (or certain related iss...
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Offering Alternative Investment Strategies in a Mutual Fund ...

  1. 1. Vol. 15, No. 10 • October 2008 Offering Alternative Investment Strategies in a Mutual Fund Structure: Practical Considerations by Dianne M. Sulzbach and Philip T. Masterson I nvestors and their financial advisers continue to search for higher risk-adjusted returns by incorporating non-traditional, non-correlated asset classes into investor portfolios.1 In addition, alternative investment products appeal to investors seek- ing to invest in hedge funds, who may not qualify to invest in them directly. With approximately $12 trillion mutual fund assets in the United States as potential investments in alternative mutual fund strategies, mutual fund sponsors see a significant opportunity in developing investment products that provide exposure to alternative asset classes via hedge- like mutual funds. Nonetheless, offering alternative investment and potentially less liquidity that investors and strategies in a mutual fund structure implicates their financial advisers must evaluate. several compliance, tax, portfolio management, With all alternative investment strategies, fund and operational matters that investment managers sponsors should take additional time to pre- must consider and address. In addition, although pare for the board presentation and proactively alternative mutual funds offer investors potential address likely board questions regarding risk portfolio diversification and return benefits, they management, liquidity and valuation, tax, and generally have high fees and expenses and pose other compliance matters. Managers also should unique risks such as volatility, the use of leverage, utilize a cross functional team from legal, com- pliance, internal audit, tax, and accounting to evaluate all new products, particularly those rely- Dianne M. Sulzbach is an associate in the Investment ing on new investment strategies for the manager Management Practice Group of Morgan, Lewis & Bockius LLP in Washington, DC, and Philip T. and non-traditional investment strategies. Masterson, Esq. is Managing Director, SEI Investment Manager Services. This article is for general informa- Overview of Some Alternative Products tional purposes only and does not constitute legal advice as to any particular set of facts. Copyright © 2008 Mutual funds currently provide investors with Morgan, Lewis & Bockius LLP. All rights reserved. access to several hedge fund strategies—including
  2. 2. global macro, long/short, market neutral, fixed In addition, several fund sponsors have launched income and convertible arbitrage, event driven equity market neutral funds and a few have and emerging market strategies. launched absolute return funds. To achieve their Assets in short extension or long-short prod- respective investment objectives, these funds gen- ucts have grown from minimal assets just a few erally purchase and short equity securities, index years ago to over $100 billion in assets currently futures and even exchange traded funds. As noted, with asset projections in excess of $1 trillion these funds may be net long or short depending within the next 10 years.2 Traditional, long-only on the manager’s view of the market opportunities managers have taken notice of this opportunity and risks. and long-short strategies are one of the most Other sponsors seek to provide investors with prevelant alternative strategies currently offered in exposure to non-traditional asset classes and a mutual fund structure. returns similar to returns from alternative invest- Long-short funds (for example, 130/30 funds)3 ment strategies by tracking indices or investing allow investment managers to use leverage in an directly in a variety of instruments based on pro- effort to create higher risk-adjusted returns.4 In prietary replication methodologies. Replication practice, the investment manager will take long posi- strategies are sometimes referred to as hedge fund tions with 100 percent of the portfolio by purchas- beta strategies. Still other funds invest in underly- ing securities the manager believes will outperform ing funds in seeking to achieve their investment the relevant benchmark. Based on the manager’s objectives. Often times, mutual funds that employ investment process, the manager will then sell short alternative investment strategies rely on derivative securities the manager believes will under-perform investments such as total return swaps and struc- the benchmark. The proceeds generated from these tured notes to implement their strategies. short positions are then used to take additional Discussed below are practical implications man- long positions in securities the manager believes agers should consider when launching alternative will outperform the relevant benchmark. strategies in a mutual fund structure. The concept behind long/short funds is that, through the manager’s investment process, the Compliance and Other manager maximizes its intellectual capital in both Practical Considerations long and short positions in an effort to generate higher risk-adjusted returns when compared to a As noted, offering alternative investment strate- long-only strategy. For example, a 130/30 product gies in a mutual fund structure implicates several allows an investment manager to seek additional compliance, tax, portfolio management, and oper- alpha by investing $130 in attractive positions for ational matters that investment managers must every $100 invested in their product and shorting consider and address. $30 worth of unattractive positions that the man- ager believes will decline in value. 1940 Act and 1933 Act Registration In light of the requirements of Rule 35d-1 (the Names Rule) under the Investment Company Act All mutual funds, including alternative mutual of 1940 (the 1940 Act), managers launching long- funds, must be registered under the 1940 Act and short mutual funds should consider not using must register their shares under the Securities Act “130/30,” “120/20” etc. in the fund name. Managers of 1933 (the 1933 Act). Under the 1940 Act, mutual also should consider whether the Securities and funds must appoint a chief compliance officer, Exchange Commission’s (SEC) recent ban on design and implement a compliance program and short sales in certain financial industry issuers annually test the compliance program. In addition, impairs their ability to effectively manage their as described in more detail below, the 1940 Act long/short funds. In general, managers do not imposes significant compliance requirements on want to lock themselves into a required level mutual funds such as disclosing their proxy votes.6 of short positions but rather determine the level Under the 1933 Act, mutual funds must comply of short positions based on the natural results with specific disclosure obligations and update their of their investment processes. Traditional long- prospectuses annually. Mutual funds also must only managers launching long-short mutual funds make periodic filings with the SEC. also should anticipate fund boards questioning In comparing mutual funds to hedge funds, one the manager’s ability not just to identify short of the key benefits of mutual fund registration candidates but knowing when to open and close is that, unlike private investment funds or hedge short positions.5 funds that rely on exemptions from registration THE INVESTMENT LAWYER 2
  3. 3. under the 1940 Act, registered mutual funds can order to assure that no client accounts are dis- offer their shares to an unlimited number of inves- advantaged (that is, when there are non-pro rata tors. Mutual funds also may publicly offer their allocations). Advisers must also be cognizant that shares whereas hedge funds are prohibited from if a registered fund does not “control” a hedge public offers. An additional benefit of registra- fund in which it invests, as defined under the 1940 tion under the 1940 Act is that registered fund Act, the hedge fund will not be subject to the pro- assets are not deemed “plan assets” under ERISA visions of the 1940 Act. However, a hedge fund and accordingly, ERISA constraints do not apply relying on an exemption from registration under to the management of registered fund assets.7 Section 3(c)(1) of the 1940 Act must ensure that Finally, registered funds that utilize commodity any registered fund does not purchase 10 percent futures can avoid regulatory restrictions applicable or more of the outstanding interests in the hedge to hedge funds and commodity pools.8 fund. Compliance Liquidity and Valuation The compliance considerations for tradi- Under the 1940 Act, mutual funds are obligated tional mutual funds under the 1940 Act are to satisfy investor redemption requests within enhanced for funds with alternative investment seven days of the request.10 As a result, no more strategies. For example, to the extent a fund than 15 percent of a fund’s assets can be illiq- borrows money to amplify returns or invests uid.11 To the extent a fund invests in securities in instruments with imbedded economic lever- that are not exchange traded, the liquidity of such age, the fund’s compliance policies and proce- investments must be considered. In particular, dures may need to be modified. Compliance over-the-counter (OTC) derivatives should be personnel must be trained in the monitoring scrutinized for liquidity purposes. of such investment strategies and instruments In light of the complexity of the instruments and may need to modify their testing programs utilized by alternative investment funds and their accordingly. In addition, fund boards must be increased probability of being deemed illiquid, informed of any modifications to compliance fund valuation procedures may need to be revised procedures resulting from these products prior to reflect these valuation challenges and the fund’s to their approval. operational procedures should be reviewed in light Mutual funds are subject to leverage limitations of the likely increased volume of the fund’s hard- (that is, no more than 33 percent of a fund’s assets to-value holdings. Under Section 2(a)(41) of the may be leveraged).9 The SEC interprets these 1940 Act, fund holdings whose prices are “readily limitations as applying to short sales, options, available” should be priced based upon the market futures, swaps, structured notes and other derivative prices for such holdings. All other holdings must investments, in addition to borrowing. Investment be fair valued in accordance with the 1940 Act strategies that involve leverage require funds to and SEC guidance. An additional compliance either segregate liquid assets at the fund’s custo- concern is adherence to FAS 157, which provides dian or earmark liquid assets on the fund’s books that funds must value their investments at “fair to cover the exposure. Due to the limitations on value,” defined as “the price that would be received the use of leverage through the asset coverage to sell an asset or transfer a liability in an orderly requirement applicable to “senior securities” under transaction between market participants at the Section 18 of the 1940 Act, adherence to leverage measurement date.” Under FAS 157, less liquid requirements must be closely monitored. “Level 3” investments, such as in private equity Side by side management of alternative mutual transactions and customized derivatives, also must funds and hedge funds also is a key compliance be valued. consideration. Advisers must ensure that they have appropriate trade allocation procedures to Tax Considerations address the conflicts of interest that may arise due to the differing trading strategies of the mutual In order to avoid double taxation (that is, fund and the hedge fund product, or because taxation at both the fund level and the share- the adviser receives greater compensation for the holder level), all mutual funds seek to com- management of the hedge fund. Information bar- ply with Subchapter M of the Internal Revenue riers must be established, or alternatively trade Code (IRC). Pursuant to Subchapter M, funds allocation procedures should be implemented in must comply with two tests: diversification and 3 Vol. 15, No. 10 • October 2008
  4. 4. qualification of income.12 The implementation of the extent a counterparty cannot fulfill its obliga- alternative investment strategies must be evaluated tions under the terms of the derivative. against both of these tests. In addition to counterparty default risk, to For example, funds must consider whether they the extent a fund relies on a highly customized have a sufficient number of counterparties so as not derivative to fulfill the fund’s investment objective, to run afoul of the issuer diversification require- the manager and fund board also must consider ments of Subchapter M.13 Similarly, funds must whether there is any significant risk of the fund ensure that their investments, particularly non-tra- failing to achieve its investment objective should ditional investments, generate qualifying income. the counterparty default or terminate the contract Commodity futures and other derivatives whose for any reason.17 Managers must have a clear returns are tied to commodities generally do not understanding of the counterparty’s termination generate qualifying income although funds have rights under the derivative contract and ideally either invested in commodities through a control- have multiple counterparties. led foreign corporation or by the use of structured notes. In either case, to address the documenta- tion requirements of FIN 48, funds generally have Conclusion sought a private letter ruling from the Internal Although alternative mutual fund offerings Revenue Service.14 Regardless, fund counsel and will certainly not, and are not intended to, replace fund auditors must be consulted on these matters. traditional mutual funds, they may serve as a valu- able complement to them for long-term investors Operational Considerations in the context of a well-diversified portfolio. While the lack of a track record for alternative funds To the extent implementation of an alternative may present a concern for some, the possibility investment strategy requires the use of a prime of outsize returns has been sufficient to convince broker, fund’s must consider some practical impli- numerous investors to include them in their port- cations associated with the use of a prime broker.15 folios. Ultimately, it is clear that alternative asset Utilizing both a custodian and a prime broker classes are certainly here to stay in light of their results in additional cash and asset reconciliations potential diversification and return benefits, pro- and investment managers need to ensure the fund’s viding access to asset classes previously unavail- books and records accurately reflect the holdings able to retail investors. with each. Utilizing both a custodian and a prime broker also makes managing cash balances more complicated. Investment managers need to moni- NOTES tor their cash positions, ensure they have sufficient 1. Findings from a Rydex Advisor Benchmarketing survey earlier this year showed that 64 percent of advisers planned funds for their trading activity and efficiently to increase the use of alternatives, citing their absolute returns manage their cash positions so as to avoid the and access to non-correlated assets as the two drivers of client performance drag associated with uninvested cash demand. Financial Advisor Magazine, March 27, 2008. positions. Prime brokerage accounts also accumu- 2. U.S. Institute Executive Summary, “The 130/30 Buzz,” late interest income and interest expense. Interest (February 5–6, 2008): 23–24. income is generated from the cash sweep vehicle at 3. Short extension strategies such as 130/30 funds remain 100 the prime broker and interest expense results from percent net long whereas “long/short” hedge funds may be net the prime broker lending fees or from overdraft long or net short at any given time. Nonetheless, 130/30 and charges at the prime broker. These items need to other extension strategies are referred to as long-short funds in this article. be reflected in the fund’s books and records. 4. Due to the credit crunch, there have been fewer sources of financing for managers of 130/30 funds of late, as well as fewer Counterparty Risk available prime brokers. Nonetheless, Fidelity, JP Morgan, State Street Global Advisors, Martingale, Axa Rosenberg, Munder To the extent any mutual fund, including a fund Capital Management, American Century and BlackRock have that provides exposure to an alternative asset class, launched 130/30 funds, and 16 long/short funds have been invests in OTC derivative investments, the credit launched since December 31, 2006. Since their introduction a few years ago, long-short products, including 130/30 mutual risk of the derivative counterparty must be consid- funds and institutional separate accounts, have gathered about ered.16 While always an important consideration, $100 billion in assets. U.S. Institute Executive Summary, in the post-subprime credit squeeze, counterparty “The 130/30 Buzz,” (February 5–6, 2008): 23–24. credit risk takes on even greater significance. 5. Managers must also comply with margin requirements of Credit risk implicates financial risk for a fund to the federal securities laws. THE INVESTMENT LAWYER 4
  5. 5. 6. Investment managers of mutual funds must be registered securities of one issuer (or certain related issuers). In perform- under the Investment Advisers Act of 1940, which imposes a ing the diversification calculations, the first step is to determine fiduciary duty on investment advisers and requires investment whether the items in the registered investment company’s port- managers to maintain specific books and records among other folio are “securities,” as discussed supra. obligations. 13. Unfortunately, issuer diversification analysis for 1940 Act 7. One of the key drawbacks of mutual fund registration is purposes and IRC purposes does not necessarily result in the that advisory fees cannot be tailored to particular clients. All same conclusion, so funds must evaluate compliance with each investors must pay the same advisory fee. of these requirements separately. 8. Hedge fund managers that use commodity futures must 14. FIN 48 establishes consistent criteria that an individual seek an exemption provided under the Commodity Exchange tax position must satisfy in order for any of the benefit of that Act of 1974 to avoid the need to register with the Commodity position to be recognized in an entity’s financial statements. Futures Trading Commission (the CFTC) or to comply with FIN 48 is intended to increase the comparability of finan- certain rules thereunder. cial statements, but it significantly increases the calculation 9. Short positions, which generate a dividend while out on and documentation requirements for individually identified loan, create an expense item that needs to be recognized on the income tax exposures. books and records of the investment product. When launch- ing a long/short mutual fund, the investment manager needs 15. Prime brokerage account agreements should be reviewed to ensure the funds’ prospectus contains language to the effect by fund counsel and a form of such agreement approved by that dividend expense is not subject to any applicable expense fund boards. In order to permit managers to react to market- limitations the manager has undertaken. place realities and remain nimble should such realities cause a manager to change prime brokers or add a prime broker, the 10. From a practical perspective, mutual fund investors expect, board approval should contemplate changes in prime brokers and the industry practice is to provide, daily liquidity. in between board meetings. 11. An investment is deemed “liquid” if it can be sold within seven days at a price reasonably related to the price reflected in 16. A fund’s evaluation of counterparties also must incorporate the fund’s financial records. the compliance requirements associated with Section 12(d)(3) of the 1940 Act, which prohibits registered investment companies 12. Under the “Qualifying Income” test of IRC § 851(b)(2), from purchasing or otherwise acquiring any security issued by 90 percent of a registered investment company’s gross income or any other interest in the business of any person who is a each taxable year must be derived from “dividends, interest, broker, a dealer, is engaged in the business of underwriting, or payments with respect to securities loans ... and gains from is either an investment adviser of an investment company or an the sale or other disposition of stock or securities (as defined investment adviser registered under the Investment Advisers Act in section 2(a)(36) of the 1940 Act) or foreign currencies, or of 1940. Rule 12d3-1(b) provides that, notwithstanding Section other income (including but not limited to gains from options, 12(d)(3), a registered investment company may acquire any futures, or forward contracts) derived with respect to its busi- security issued by a person that, in its most recent fiscal year, ness of investing in such stock, securities, or currencies.” Under derived more than 15 percent of its gross revenues from securi- the “Diversification” test of Section 851 (b)(3) of the IRC, at the ties related activities, provided that immediately after the acqui- end of each quarter of the taxable year, (i) at least 50 percent of sition of any security, the investment company: (1) may not have the value of a registered investment company’s total assets must invested more than 5 percent of the value of its total assets in the be represented by cash, cash items, US government securities, securities of the issuer; (2) may not own more than five percent the securities of other registered investment companies, and of the outstanding securities of that class of the issuer’s equity other securities, with such other securities of any one issuer securities; and (3) may not own more than 10 percent of the limited to an amount representing no more than five percent outstanding principal amount of the issuer’s debt securities. of the value of the registered investment company’s total assets and 10 percent of the outstanding voting securities of such 17. In addition, to the extent a fund is dependent on a single issuer; and (ii) not more than 25 percent of the value of the reg- counterparty for the asset class exposure, the fund loses leverage istered investment company’s total assets may be invested in the from a fee negotiation perspective. Reprinted from The Investment Lawyer October 2008, Volume 15, Number 10, pages 1, 9-12, with permission from Aspen Publishers, Inc., Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437, www.aspenpublishers.com 5 Vol. 15, No. 10 • October 2008