With growing concerns about hedge fund returns and structure, interest in hedge fund conversions has spiked. These funds, typically offered in the form of a mutual fund, provide entree to a proven strategy and management team that most investors wouldn’t otherwise have access to. But, just how are these funds converted? And what are the benefits and risks of these products? Here, we offer an in-depth look at the hedge fund conversion processes: the upsides, the downsides and, of course, the tax implications.
Hedge fund conversions are best compared to mergers. In the same way two companies might merge, shareholders, or limited partners in a hedge fund, end up holding the same shares in the mutual fund, with the hedge fund contributing portfolio securities to the mutual fund. At conversion date, all investors in the hedge fund have their investments converted into shares of the mutual fund. If there are any holders in the hedge fund that do not want to be party to the conversion, they must exit the hedge fund ahead of the conversion.
These conversions require a good deal of due diligence and must be registered with the Securities and Exchange Commission. Mutual fund managers interested in converting hedge funds typically look for hedge funds with desirable strategies and excellent performance records that will also be compatible with a mutual fund structure. It’s also critical that the team managing the hedge fund continue managing the mutual fund.
For shareholders, the benefits of hedge fund conversions are many: more accessibility, daily liquidity, more transparency, more regulatory oversight, lower fees, lower minimum investment and access to proven strategies.
The most appealing benefits of these products are that liquid alternative mutual funds usually possess low minimum investment hurdles and are available to people other than accredited investors. Investors are also attracted to the fee structure.
Most hedge funds converted into mutual funds offer the same strategy, with no performance fee and a management fee that is less than 2 percent. (Traditional hedge funds tend to run under the 2 percent management fee, plus a 20 percent performance fee structure). As an added bonus, liquid alternative mutual funds offer daily liquidity and publish returns daily. Another benefit of converted funds is that they can generally be offered in a broader array of investment accounts, such as 401(k) plans.
Like any investment strategy, there are some criticisms of hedge fund conversions. But for every criticism, there’s a strong counter-argument. Investors should understand the risks of investing in these funds, but also understand the whole picture.
Some have claimed that, on average, converted hedge funds’ returns tend to deteriorate post-conversion. While there may be a handful of examples to support this statement, there is a flaw in this analysis — typically related to benchmarking against equities when many conversions have happened during one of the strongest bull markets in history. For example, benchmarking a managed futures strategy to equities from 2007 to 2009 and then from 2009 to 2017 would yield dramatically different results. In the first period, equities struggled and managed futures generated strong, uncorrelated returns, as expected.
During the second period, managed futures maintained uncorrelated returns and equities rallied. It would be illogical to conclude that excess returns eroded after a 2009 conversion simply because the strategy was inappropriately benchmarked to equities.