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Change = Opportunity: '40 Act Funds Gaining Traction
Thursday, August 8, 2014
Every enterprise strives to sell an existing product into a new marketplace. '40 Act funds have been around for a while and are a good example of this. A blend between hedge fund investing strategies with the structure of a mutual fund, '40 Act funds represent a growing opportunity to tap into the liquid alternative space. It's a more recent trend being fueled by changes in the regulatory and FinTech landscapes and appears to be gaining traction with some of the biggest players in the financial industry.
A ’40 Act fund is a pooled investment vehicle offered by a registered investment company as defined in the 1940 Investment Companies Act (commonly referred to in the United States as the ’40 Act or, in some instances, the Investment Company Act (ICA). The ICA-40 governs the construction and packaging of pooled investment vehicles so that they may be sold to institutional and retail investors in the public markets. All '40 Act funds are registered with the SEC in a process that is different from a typical co-mingled fund (such as a hedge fund). In essence, they allow alternative investments to be purchased by the retail investor, but put much more compliance overhead on the fund manager.
Since '40 Act funds are governed by the SEC, and historically most hedge fund managers were not registered with the SEC as investment advisers, this precluded hedge fund managers from offering these vehicles to their customers. Furthermore, the fee structure of a '40 Act fund typically resembles that of a mutual fund, and therefore offers much lower revenue for the fund manager than the same strategy packaged as a hedge fund. These two hurdles would typically have prevented a hedge fund manager from considering this kind of vehicle
"Now the new wave of entrepreneurs are putting these services in the cloud in scalable, on-demand solutions that allow the mutual fund manager to offer a '40 Act fund at a fraction of the cost than was traditionally expected."
For typical mutual fund managers, there has always been a different hurdle for creating this kind of vehicle for their customer: cost. Mutual fund managers would like to be able to participate in all the profitable activities aggressively pursued by their hedge fund brethren, but with their limited ability to collect fees, they cannot make enough profit to offset the costs of doing so. Mutual funds would love to use leverage, short sell stocks they don't like, and buy derivatives when the common stock market is too thinly traded. However, all these activities create horrific new expense structures that must support the risk management, tax and audit complications that ensue from this approach. Mutual fund managers make all their money on the fees they collect from their customers, and these fees are meager. There simply isn't enough money to compensate for these additional responsibilities and expenses.
So with all these barriers to both the alternative and mutual fund managers, why are things changing? Two reasons.
First, the regulatory space for hedge funds has changed in the last decade. This has forced more and more hedge funds to register as investment advisers (RIA's) with the SEC. With this major hurdle already crossed, the barriers to offering '40 Act funds have become merely a marketing problem.
Second, technology in the FinTech sector is booming, making it more cost effective than ever for a financial services firm to buy all the compliance, risk and tax software that simply wasn't available a few years ago. The old-school solution was to throw bodies at every risk, tax, compliance and operational issue. Now the new wave of entrepreneurs are putting these services in the cloud in scalable, on-demand solutions that allow the mutual fund manager to offer a '40 Act fund at a fraction of the cost than was traditionally expected.
Hedge fund managers are also buying up this new cloud-tech and aspiring to the age-old fund manager's dream: a fund management firm that has no back-office personnel. This, in turn, allows them to focus on the two things they really do wish to spend their time on: investing and marketing. The creativity is in play now to figure out how to offer the hedge funds what they have traditionally managed, re-packaged as '40 Act funds.
One strategy is to offer 'lightweight' versions of their hedge fund products as retail funds. This could mean that they have a high leverage product that is only accessible to their hedge fund clients, but the same strategy is available with less leverage to their retail '40 Act fund clients. By offering both vehicles, they will not cannibalize their existing customer base in the hedge fund space because the only way the high value customer can get access to high leverage is through the high-fee hedge fund vehicle. Only the clients, who are not qualified to invest in the hedge fund, either for reasons of asset limitations or because of handcuffs placed upon them by their governing bodies, would invest in the low-leverage '40 Act fund. These investors, however, represent an entirely new customer base to which they would otherwise not have access.
Hedge Funds typically can only be bought or sold at the end of the month. Some even limit buying and selling to a quarterly or annual basis. This means that a hedge fund might have trouble attracting investors to their products because the investors require (or are required - such as a state pension fund) to limit their investments to those that can be traded daily. However, mutual funds and '40 Act funds are traded daily and a hedge fund manager that opens a '40 Act fund might also be able to attract new customers who in the past were turned off by the limited liquidity of the hedge fund products, but now can invest in that same manager's '40 Act fund that follows the exact same trading strategy.
So with the hedge funds now registered with the SEC and a plethora of new low-cost technologies, both the mutual fund and the hedge fund managers are looking to start up their new '40 Act fund investment vehicles.