Large institutional investors, such as pension funds, are not happy with the relatively poor performance of hedge funds in recent years. Despite their high fees — 2 percent management fee plus 20 percent performance fee — traditional hedge fund portfolios sometimes fail to surpass stock market indexes for their clientele.
These hedge funds have decided to target the masses to expand their assets under management, instead of catering to only high net worth individuals and institutions.
This scenario contains risks that may ignite a new financial bubble with an unpleasant ending.
The funds being marketed to the average investor have been termed hedged mutual funds or alternative mutual funds. For as little as $1,000, an investor can participate. These funds employ some of the same strategies as do traditional hedge funds, including the use of leverage, derivatives and short selling.
Goldman Sachs, Fidelity and Wells Fargo have become very active in this space in recent years. Alternative mutual funds now have assets approaching $320 billion, an eightfold increase in eight years, from $40 billion in 2006, according to fund tracker Lipper. At the end of 2012, these assets were $180 billion.
The most recent data indicate new investments in alternative funds are twice that of traditional ones, despite being 18 times smaller, Forbes reported. Total assets in mutual funds now exceed $13 trillion, while those for hedge funds are slightly more than $2 trillion. Three percent of the hedge funds control 60 percent of the hedge fund assets.
However, the alternative mutual fund structure is much more restrictive than the traditional hedge fund is in terms of governance, reporting, registration and mandates to provide investor liquidity and safety. Mutual funds are limited to less risky derivative transactions and less debt leverage to exploit small market dislocations of liquid assets (1.33 times net asset value) and require more liquidity (15 percent or less of the fund may be invested in illiquid assets).
These restrictions may preclude the portfolio manager from exploring market inefficiencies that involve illiquid and high-risk distressed assets and require time-intensive research and execution. As a result, return performance for these investments may be adversely affected.
Total fees for alternative mutual products can range between 3 percent and 5 percent per year, including management fees, sales charges, distribution fees, short-selling and other expenses. While these fees may be less than those in a traditional hedge fund, relative to the potential returns they may be high.
At an Investor Advisor Association Compliance Conference this year, Andrew Bowden, director of the Office of Compliance Inspections and Examinations at the Securities and Exchange Commission, suggested alternative mutual funds
might promote reckless behavior.
Alternative funds permit the financial adviser to invest up to 15 percent of assets in illiquid investments. This represents the cost basis, not market value. As the market value of these illiquid assets rise, the percentage in the portfolio rises. Should the market experience a downturn that triggers redemption of liquid assets, the percentage will increase further. A high level of illiquid assets can contribute to high volatility and loss of liquidity in the markets, thereby harming the clients of the financial adviser.
Further increasing the potential risk, Bowden cited one consultant who estimates alternative fund assets would comprise nearly 16 percent of total fund assets by 2022, up from roughly 3 percent in 2011.
The danger here is that many investors may be lured into an asset class that has high fees relative to performance without adequate liquidity to divest effectively. Strong selling pressures of illiquid investments can precipitate large price declines and wealth erosion, creating a potential financial crisis.
These alternative mutual fund vehicles have inherent risks that need to be explored thoroughly by the investor.
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