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.

Current landscape

• The Investment Company Act of 1940 offers a way for alternative asset managers to package their strategies within the format of a mutual fund that can be marketed to US retail investors.
• These products have seen strong asset growth in recent years.
• While ’40 Act alternatives are still a small part of the overall US mutual fund industry, their asset base is growing rapidly, especially compared to the growth in the more mature hedge fund industry.
• The performance of ’40 Act products managed or sub-advised by hedge funds has been better than the performance delivered by ’40 Act products overall.

The players

• There are three roles to be played in the ’40 Act market – the investment manager, the product sponsor (responsible for setting up the fund), and the distributor; the combination of these roles played by any industry participant depends on the existing capabilities of the participant and/or their willingness to invest in developing capabilities.
• There are three main types of players in the ’40 Act hedge fund market: hedge funds, funds of hedge funds, and asset managers.
• Depending on their scale and commitment to the ’40 Act market, there are three options available to boutique hedge fund managers to access the space: act as a sub-advisor on a platform, sub-advise their own product or be the investment advisor, sponsor and distributor of their own product.

Rationale for launching a ’40 Act product

• The size of the existing US mutual fund industry and the assets held in the US retail and retirement markets imply a significant opportunity for hedge funds to grow and/or diversify their businesses through ’40 Act products.
• Hedge funds could realise the higher valuation multiples that asset managers and mutual funds tend to have due to their reduced earnings volatility.
• Launching a ’40 Act product sooner than later may allow new entrants to realise a ‘first mover’ advantage.

Considerations for hedge fund managers

• In many cases, hedge funds will need to modify their strategies to comply with ’40 Act regulations and/or make a significant up-front investment to deal with increased infrastructure demands.
• The most material opportunity comes from the retail market, which is a new challenge for most hedge fund managers; as such, finding a distribution partner is usually the best course to take to overcome some of these difficulties.
• Fees in the ’40 Act world are generally much lower than in the hedge fund world and no incentive fees can be charged (except in rare circumstances), although hedge funds can price their ’40 Act offering at a premium to non-hedge fund offerings.
• These factors and others, such as being labelled an ‘asset gatherer’ by some investors, create risk for hedge fund managers that decide to launch a ’40 Act product, thus requiring hedge fund managers to carefully weigh the pros and cons of doing so.

CURRENT LANDSCAPE
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:

Leverage

• A minimum 300% ‘asset coverage’ requirement (i.e., maximum leverage of 1.33x), although this refers only to cash borrowing, not leverage attained through derivatives exposures.

Short-selling

• Short-selling is allowed but has to be done in a tri-party arrangement with assets segregated to cover the positions.

Liquidity

• The fund must honour daily redemption requests.
• NAV must be struck daily.
• Illiquid securities can be no more than 15% of the fund.

Diversification

• At least 50% of the fund’s holdings must be ‘diversified’ – taken to mean no more than 5% of the fund can be invested in securities of any one issuer.

Transparency

• Portfolio holdings schedule needs to be filed with the SEC (and made publicly available) quarterly within 60 days of the end of the quarter.
• Similarly, annual and semi-annual reports need to be filed. A Prospectus and Statement of Additional Information needs to be filed with the SEC and be publicly available, including: detailed information on the portfolio manager/team, with disclosure of the number of funds managed by the portfolio manager/team; and information on the compensation of the portfolio manager/team.

Investment Mandate

• Fundamental investment objectives and strategiesmay not be changed without shareholder approval.

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.

Strategy breakdown
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:

• Long-only equity strategies with an added overlay hedge of index futures or the use of options (e.g., writing covered calls).
• Funds that use broad sector exposures (through ETFs or swaps) instead of single-stock investments.

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.

Why now?
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.

• For hedge funds, it at least partly a response to some of the challenges in the traditional hedge fund business: for example, the pressure on fees and difficulty generating returns and raising assets. At the same time, the unease around the greater regulatory scrutiny and transparency has been somewhat mitigated by the requirement to register with the SEC and the process hedge funds have had to put in place to comply with Form PF/ADV requirements. Having built the reporting infrastructure, most managers see the greater level of regulation in the ’40 Act market as less of a hurdle. Lastly, there is a desire for firms to diversify their business and add differentiated and more stable return streams. This is especially true for the hedge funds that may become capacity-constrained in their mainstream hedge fund business in the future.
• Likewise, for FoHFs, the ’40 Act represents a potential new revenue stream that is additive to their current product offerings, while providing access to an untapped investor base.
• For asset managers, ’40 Act hedge funds also represent a new revenue stream and an entry point into the hedge fund business. It is a way for them to offer new products while leveraging existing distribution infrastructure for incremental revenue.

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.