Advisors may soon see lower fees for liquid alternative asset funds – hedge fund mutual funds – thanks to the push by hedge fund managers to market these plans more aggressively into the defined contribution space, according to panelists at last week's 25th annual Morningstar Investment Conference.

Faced with the contraction of the defined benefit market, which is a large portion of their client base, many hedge fund managers are creating their own hedge fund mutual funds or are signing on as sub-advisors to existing mutual funds in order to penetrate the expanding defined contribution market. The increasing level of competition between these funds will continue to drive down their cost, traditionally some of highest of any asset class, said panelist Dennis Heinke, director of institutional product strategy at Franklin Templeton.

"The hedge fund manager is now having this honest conversation about where he can charge different prices and what’s appropriate" said Heinke. And now that hedge funds with over $100m in assets are required to register with the SEC, he said "all of these things make running a hedge fund more a lot more expensive. It makes it a lot more akin to running a `40 Act' [traditional mutual] fund. So it’s inevitable that we’re in this sea change environment that requires us to bring it to market."

As a result, the number of alternative funds has more than tripled since 2007, to over 350, according to Morningstar. The panelists believe the growth will continue. Given the current growth of defined contribution plans and the stagnant growth rates in both stocks and bonds, the panelists predicted that demand will continue to rise as advisors flock to investments that are not correlated to the larger market.

However, the "40 Act" - the Investment Company Act of 1940 that regulated mutual funds - requires they have daily liquidity, transparency and no carried interest, among other things. This means that hedge fund managers must find ways to keep returns high without access to many of the investments they've traditionally used. This creates a performance "headwind" for many of these funds, said panelist Henry Davis, a managing director and portfolio manager at Arden Asset Management, a hedge fund management company. For investors, however, hedge fund mutual fund expenses are at a large discount to what investors would have had to pay to access the manager in a traditional hedge fund, so Davis thinks the lower performance and lower costs will cancel each other out.

"We’ve done quite a number of excercises to try to quantify what is the trade-off," said Davis. "Time will tell. We think that the amount that you give up versus the amount that you save is pretty comparable."

Davis says that it's a tough transition for many hedge funds, despite the expanding market opportunities.

“The hedge fund managers who have decided to go full-on into the '40 Act' funds,” said Davis, “have essentially had to relinquish their traditional 2 and 20 [fee structure] business. That’s a very difficult decision for firms to make but many of them are grappling with it right now.”

Register or login for access to this item and much more

All On Wall Street content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access