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Banking and Finance

Hedge Funds Must Ramp Up Infrastructure to Accommodate Liquid Alts

 Pressures have been mounting on hedge fund managers to hedge their own businesses and diversify away from the hedge fund model itself. Lackluster performance, difficult markets, fees that are perceived as too high, scandals and conflicts of interests are just a few of the factors that are leading managers to set up in a new section of the market: Liquid Alternatives.

“Liquid Alternatives” are investment vehicles that feature an alternative strategy but are packaged in a mutual fund, closed end fund or other exchange-traded product, such as an ETF, instead of the traditional hedge fund. These Liquid Alts all have two features in common however: much more regulation as compared to hedge funds, and a far more complex distribution model. As a result, any hedge fund manager seeking to dive into this area must beef up its infrastructure significantly to accommodate the added complexity.

Regulation and Compliance:  Hedge fund managers may go into shock when they see the laundry list of additional regulatory rules and reporting that are applicable to Liquid Alts. For mutual funds specifically (but with other vehicles having similar requirements), the major requirements can be categorized as:

  • Diversification and Concentration:  The fund must declare itself as “diversified” or “non-diversified” and meet applicable requirements for the chosen category. Also, the fund must have a concentration policy.
  • Fund Governance:  The fund must have a board with a majority of independent directors and an audit committee. Meetings are usually quarterly.
  • Financials: semi-annual required, with reports sent to investors and filed with the SEC on public view. All positions are reported and shown.
  • SEC filings: N-Q, N-CSR, N-SAR filings amount to quarterly SEC reporting
  • Compliance program:  written compliance program, with chief compliance officer reporting directly to the board of directors
  • Anti-money laundering program: required

Marketing and Distribution: The collection and payment of a variety of different types of fees and expenses often require sophisticated monitoring. Varying sales loads on different share classes, 12b-1 fees and expenses, and distributor payouts and rebates: the picture gets very complicated, very fast. On the advertising side, the SEC imposes specific requirements on ad content.

Hedge fund managers quickly see that the additional infrastructure required to manage a Liquid Alt is far more complex than the standard hedge fund set-up. While outsourcing of various functions is of course available (usually to a fund administrator), there is still residual monitoring and coordinating that will need to be done in-house and which cannot be outsourced. The decision to hedge away from hedge funds should not be taken lightly.

Read more articles about the hedge fund industry and related legal issues at Hedge Rows, a blog by Judith Gross.

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