Mutual funds are required to provide daily liquidity to investors. While daily liquidity in a vacuum is valuable, this requirement, in the context of hedge fund strategies, severely limits a manager’s ability to execute many strategies effectively.
We believe that only a limited number of strategies can (or should) be implemented in a mutual fund format. Because of daily liquidity requirements, we believe that only a portion of hedge fund strategies can be successfully implemented in a mutual fund structure. The strategies that in theory lend themselves best to a mutual fund format include: managed futures, global macro, and long/short equity strategies oriented towards long-biased, large-cap, and diversified.
For instance, the managed futures market is very liquid, which minimizes most of the liquidity-oriented limitations that are placed on a mutual fund manager. Because a managed futures manager could match large-scale redemptions quickly, we believe gaining exposure to this space in a mutual fund format is acceptable. Wrapping your investment in a hedge fund format may or may not provide better access to this space, but liquidity in and of itself does not limit your ability to access this type of investment efficiently.
Conversely, there are many hedge fund strategies that we believe are not appropriate for a mutual fund structure. Daily liquidity requirements make it extremely difficult, if not impossible, for a manager to successfully implement the following strategies in a mutual fund: event-driven/special situations, distressed credit, multi-strategy, activist investing, fundamental long-short equity (particularly small- and mid-cap oriented funds and more concentrated funds), fixed income relative value strategies, and tail hedges. The inability to access many hedge fund strategies in liquid form can significantly reduce the diversification benefits and the idiosyncratic return/risk drivers that serve as the fundamental rationale for investing in alternatives.
To see how daily liquidity requirements make some strategies unsuitable for a mutual fund structure, we examine distressed credit. Distressed credit managers purchase bonds or other non-investment-grade debt (commonly referred to as “junk bonds”) of companies whose outlook, if not survival, is uncertain. This uncertainty can lead to volatile pricing and poor liquidity for the company’s debt. If a mutual fund manager is a holder of these bonds and subsequently faces large-scale redemption requests, the manager will likely encounter significant pricing pressure in order to liquidate these positions. Specifically, if they attempt to sell an illiquid non-investment-grade security in the open market, the seller must take an offer from a buyer on the other side, which could be significantly below the inherent value of the security. In a traditional hedge fund, a manager has additional time to find a better buyer, whereas a mutual fund manager must take the current offer to meet redemption requests. This “mark-to-market pricing” hurts investors trying to sell their mutual fund investment as well as the investors staying in the fund as they too are subject to the mark-to-market prices (i.e. co-investor risk). December 2015 saw a real-life example of a mutual fund that had its liquidity impaired and had to suspend redemptions. This high-yield mutual fund, a fund that did not even portend to be a distressed credit strategy, “gated” investors and restricted them from getting their money back.
Understanding the strategy limitations inherent in daily liquid structures is critical to portfolio construction, and advisors must be aware of the risks involved when implementing alternative strategies via mutual funds into their clients’ portfolios.
Kenneth Meister is the President and Chief Operating Officer for Evanston Capital Management.
