Going Mainstream – The current landscape in the ’40 Act space. The following are high-level takeaways from the Barclays Prime Services study on developments and opportunities in the ‘40 Act industry.
Rationale for launching a ’40 Act product
Considerations for hedge fund managers
To put into context the current interest in the ’40 Act market, we first examine the current landscape: what these products are, how big the market is, and who the typical and potential buyers are.
What are ’40 Act alternatives?
A ’40 Act fund is any fund compliant with the US Investment Company Act of 1940. Some of these products are also compliant with the 1933 Act.
For hedge funds, the ’40 Act offers a way for their strategies to be packaged in a mutual fund format and then offered to non-accredited investors. As such, a ’40 Act fund can access retail distribution channels and a previously untapped pool of assets. However, the regulatory requirements for ’40 Act funds are much greater than for offshore hedge funds.
For the purposes of this study, we will focus only on open-ended funds that calculate their net asset value daily, as these are both the most common format and the one most easily accessible to retail investors. The following are some key, high-level regulations for a daily liquidity, open-ended ’40 Act fund:
Size of the ’40 Act industry
The overall ’40 Act industry – that is, all US mutual funds – at $13.2 trillion, is more than five times larger than the entire global hedge fund industry. As Fig.1 shows, alternatives make up just 1% of the overall ’40 Act mutual fund industry, and products where the investment manager is a hedge fund are only approximately one-third of these. ’40 Act products where the investment manager is an hedge fund are split roughly equally three ways, between products set up by asset managers but sub-advised by hedge funds, products set up by funds of hedge funds and sub-advised by hedge funds, and products set up and managed in-house by hedge funds.
The absolute number of managers offering products where the investment manager is an HF is small: just 21 overall have >$100 million of ’40 Act AUM, per our estimates.
Growth of the ’40 Act industry
Unlike the hedge fund industry, which we consider to be a more ‘mature’, slower-growth industry, the ’40 Act space is growing at a considerable pace. As Fig.2 shows, since January 2009, the ’40 Act alternatives industry has grown at a CAGR of 33% (versus 14% for the hedge fund industry), and hedge fund-managed products have been growing at an even faster pace of an 83% CAGR. Moreover, in the last year this gap has widened further (43% for all ’40 Act alternatives versus 15% for the hedge fund industry).
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Furthermore, while performance (rather than flows) has been driving most of the AUM growth in the hedge fund industry, ’40 Act funds continue to receive strong inflows. Currently, hedge funds have 18 times the assets in ’40 Act alternatives and yet have, in the last year, only received 1.5 times the net inflows into ’40 Act alternatives.
The drivers of this growth come from the supply as well as the demand side. Demand at the retail level for alternatives has grown in part due to an increased awareness of alternative strategies, and the role that they can play in portfolio construction, across both retail investors and their advisors. Alternatives are also increasingly perceived as a way to cushion portfolios against downside risks, especially given strong recent performance in fixed income and equities. At the same time, there has been an improvement on the supply side: relatively slow growth in the hedge fund industry and the challenged business models of funds of hedge funds (FoHFs) have encouraged both hedge funds and FoHFs to look at ways of tapping the retail market, and as a result there are more products managed or advised by alternatives specialists and well-known hedge fund managers (rather than traditional long-only asset managers). This, in turn, appears to have led to a general perception that the overall quality of ’40 Act alternatives may be improving. Furthermore, investors and their advisors like the liquidity, transparency and increased regulation of ’40 Act products; many of these investors also do not have access to 2/20 products or dislike the higher minimum investment required.
This combination of increasing investor awareness and appetite, and a perceived improvement in product offering, is likely to ensure that growth of ’40 Act alternatives continues in the future.
What is the distribution, strategy-wise, of ’40 Act hedge fund assets? We decided to try and answer this question and compare the results to the distribution of assets across mainstream strategies in the hedge fund industry. For the purpose of comparing strategy breakdowns, we looked only at ’40 Act products where the investment manager is a hedge fund, as most products managed by traditional asset managers are not truly comparable to hedge funds.
As shown in Fig.3, assets in ’40 Act products managed by hedge funds are skewed toward equity-related strategies (equity long/short, market-neutral and event-driven), accounting for 62% of assets, compared with 50% of offshore hedge fund assets. Funds describing themselves as equity long/short and market-neutral account for 46% of the ’40 Act assets (compared to 26% for the hedge fund industry). However, it is worth noting that many of these products do not correspond exactly to their hedge fund equivalents as they include:
Likewise, many of the funds classified as multi-strategy are either asset allocation products which do not provide exposure to a broad range of hedge fund strategies as provided by a multi-strategy hedge fund manager, or multi-manager products managed by FoHFs. Systematic or quantitative strategies seem particularly suited to the ’40 Act space, as evidenced by their strong representation in the asset base of the industry.
Another notable difference is that some of the largest hedge fund strategies, in particular discretionary global macro and credit/fixed income, appear to be underrepresented in the ’40 Act hedge fund world. The small proportion of assets in stand-alone credit-related strategies is likely as a result of the onerous liquidity requirements of the ’40 Act format; however, the low level of assets in global macro products is surprising, given that the ’40 Act regulations would not seem to impede these strategies.
’40 Act performance
Investor perception of the ’40 Act industry is sometimes that the product offering is inferior to the offshore hedge fund market, and this seems to be at least partially true based on an analysis of historical returns, as shown in Fig.4. The ’40 Act industry (excluding short-biased funds, which are over-represented when compared to the hedge fund industry and skew the aggregate performance) has underperformed the HFRI Fund Weighted Index over the last six years, providing an annualised return of 0.9%, versus 2.3% for the HFRI. However, when one looks at only the products managed or advised by hedge funds – that is, any product where the end investment manager is a hedge fund) – the underperformance is less dramatic, with an annualised return of 1.6% versus 2.3%, and the average drawdown experienced by these funds in 2008 is far less than that felt by the ’40 Act industry overall. As one large asset manager put it, “The retail investor is still getting a good product, although it is not the very best, most expensive, product that hedge funds have to offer.”
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It is also worth noting that the performance of ’40 Act funds also compares favourably with equity long/short hedge funds, which is a valid comparison given the high percentage of equity funds within the ’40 Act hedge fund universe.
The Investment Company Act of 1940 has been around a long time but a confluence of factors has given ’40 Act alternative products, and hedge fund-managed products in particular, critical momentum in recent years.
On the supply side, a number of factors have made this opportunity set more attractive than it has been historically.
At the same time, there has been an increase in demand from retail investors, who would like greater diversification in their portfolios and exposure to hedge fund-like products, and have limited or no access to 2/20 hedge fund products. Most of these investors fall into the high-net-worth (HNW) category and they and their advisors are fairly sophisticated.
For hedge funds that have bad memories of other product extensions that failed, like 130/30 or ‘portable alpha’, it is important to note one key difference, namely that ’40 Act hedge fund products are targeted at a new investor base that has more limited access to 2/20 hedge fund products, whereas those other products tended to be pitched at investors with existing access to hedge funds.