Most following the hedge fund industry are acutely aware that globally, hedge funds have more than $2.2 trillion in assets under management (AUM). This is a staggering sum by any measure and it continues to grow quarter over quarter. However, mutual funds remain the single largest draw for investor dollars, with $30 trillion in AUM world-wide, $15 trillion of which reside in the United States.

This roughly fifteen-fold disparity is the consequence of many factors, not the least of which is the wealth test that potential hedge fund investors must pass to join the club. Although the JOBS Act has liberated hedge funds from the shackles of the ban on general solicitation, it has not eased the membership requirements for participation. As a result, the soup du jour for the majority of retail investors will continue to be mutual funds. However, a substantial number of mutual fund investors are capable of meeting the required criteria for transition to a hedge fund.

The Hedge Fund Mystique

Let’s face it – mutual funds are terribly dull. Moreover, mutual funds do not enjoy the mystique associated with hedge funds. Astute, market savvy mutual fund managers recognize that absent the ban on general solicitation, there is a very real possibility of losing investors to the comparatively provocative world of hedge fund investing. Hedge fund managers should be working aggressively to make that happen—but very few are making the effort.

In contrast, more than a few proactive mutual fund managers have taken steps to recast their fund’s image in a manner that more closely mirrors strategies employed by hedge funds, yet requiring asset minimums as low as $1,000.

For example, mutual funds such as State Street Global Advisors, enabled by the repeal of the so-called short rule, launched a fund with a hedge-sounding name, Global Alpha Edge, which featured a blend of long and short positions, even before the solicitation ban was lifted. Other mutual funds are being offered to investors as “market-neutral”, implying returns in good times and bad. There are also mutual funds offering a “fund of funds” approach.

These imitations, although flattering, should be serving as a clarion call to hedge fund managers. If mutual funds are concerned enough about client retention to mimic hedge fund rivals, then it stands to reason that genuine opportunities exist for hedge funds to capture some percentage of this lucrative retail market … some percentage of $30 trillion.

Efforts Disappoint

To date, there is little evidence that hedge funds are making any serious effort to turn qualifying mutual fund investors into hedge fund investors. The reticence is understandable. The decades-long ban on solicitation has a momentum that is difficult to overcome.  Add to the equation the fact that most hedge fund managers look at the cost/benefit of marketing with the same analytic mindset employed in evaluating an investment and it isn’t helpful that the ROI for marketing costs is a significant unknown in the hedge fund industry.

With trillions of dollars in play, hedge funds must overcome these concerns and forge ahead. The retail market is huge and every effort should be made to tap it.

 

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The removal of restrictions on general solicitation, a consequence of the Jumpstart Our Business Startups (JOBS) Act, has created new opportunities for the U.S. Securities and Exchange Commission (SEC) to probe the depth of hedge fund pockets. The National Examination Program, part of the SEC’s Office of Compliance Inspection and Examinations, has made it clear that the accuracy of performance data used for marketing purposes will be an SEC priority.

Hedge fund firms also need to be cognizant of the SEC’s heightened scrutiny of actual marketing practices as permitted under the new rules arising from the passage of the JOBS Act. Private equity and venture capital firms will be impacted as well.

 

What This Means

Using proprietary risk analytics, the SEC’s enforcement division will be scouting the horizon for firms whose performance claims are inconsistent with published strategies and/or deviate from established benchmarks. These analytics are not dissimilar to those already employed by hedge fund clients to ferret out managers who have manipulated their returns. These indicators include skewed return distributions, bias ratios which detect smoothing, and serial correlations. Any red flags will likely result in enhanced enforcement efforts.

What it Doesn’t Mean

This does not signal any relief from other enforcement efforts, as the SEC will add around 130 new positions to beef up its enforcement division.  As a result, compliance officers will not only need to maintain a vigilant stance, they would do well to review all policies and procedures in place relative to their firm’s marketing efforts and, of course, ensure the accuracy of any and all performance claims made in conjunction with the firm’s retail clients.

As recently as May of this year, an investment advisor and its principals were charged with distributing false performance statistics to potential investors. The SEC also alleges that the CFO altered the opinion of an independent auditing firm to parallel the altered performance statistics.

Other Enforcement Allegations

Under the new rules additional enforcement cases have arisen as a result of:

  • Failing to disclose if, and to what extent, performance results reflect the reinvestment of dividends or interest earnings
  • Reporting gross rates of return that fail to deduct advisory fees
  • Neglecting to report fees and expenses incurred on funds invested in funds
  • Failing to distinguish between model performance results and actual trading results
  • Making inappropriate comparisons of a fund’s return to a benchmark that had significantly different volatility
  • Distributing marketing materials which include performance claims without the review and approval of the Chief Compliance Officer and /or other members of the management team as directed by the firm’s policy and procedure terms

Remarkably, as the last example indicates, the SEC’s enforcement effort extends to ensuring that a firm enforces its own internal policies!

A Proactive Course of Action

  1. Formulate and execute written policies designed to ensure compliance
  2. Employ a qualified compliance officer to administer the firm’s written policies
  3. Ensure that internal reporting systems are auditable and well understood by a majority of the firm’s employees
  4. Establish internal controls to detect anomalies and investigate the cause
  5. Create tolerance reports to compare fund performance to appropriate benchmarks and investigate discrepancies immediately and thoroughly

Making compliance a top priority from the “top” down is an absolute necessity in the current regulatory environment.

 

 

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