Implications of Mutual and Private Fund Convergence

Wulf Kaal

Mutual funds are becoming more like hedge funds as a matter of investment strategy while hedge funds are becoming more like mutual funds as a matter of the regulatory framework. The growth of the private fund industry and the proliferation of retail alternative funds in combination with the fundamental regulatory reform of the private fund industry through the Dodd-Frank Act and the JOBS Act make the convergence of mutual and private funds possible. Such convergence has large implications for the evolution of the private fund industry and the growth of the retail alternative fund market.

For most of their history, mutual funds and private funds have operated in different market and regulatory structures. The two asset classes employ different investment strategies, serve largely different classes of investors and have therefore traditionally occupied distinct segments of the investment market. Mutual funds serve mostly retail and institutional investors. They offer risk mitigation by way of diversification, a limited array of investments and strategies, instant liquidity, and daily valuation. They have traditionally been allowed to advertise. Mutual funds and investment advisers to mutual funds are required to register with the SEC and provide regular disclosures including funds’ holdings. By contrast, private investment fund investments have traditionally have been limited to accredited high net worth and institutional investors. Investors in private funds need to be able to fend for themselves, and they are subject to more rigorous verification procedures and contractual requirements. Private investment fund advisers employ a near unlimited array of investments and strategies, and they are subject to redemption restrictions. Unlike mutual fund advisers, private fund advisers are able to avoid registration with the SEC, provided they comply with certain safe harbors under the securities laws. Until 2014, private investment fund advisers could not advertise. Unlike mutual funds, private funds are typically organized as Delaware LLCs or LPs, and they are not subject to an SEC or other requirement that the fund, for example (among many others): has to have an independent board; provide daily valuation of fund positions/holdings; provide daily liquidity to investors; report holdings publicly and to investors on a regular basis; adhere to ’33 Act and ’34 Act disclosure/filing/trading/purchase + sale (etc.) requirements; use transfer agents and underwriters; comply with Subchapter M of the IRC; or refrain from engaging in certain kinds of transactions that encourage undue leverage. Moreover, the size of the investment in trading and operational technology and in experienced portfolio management, trading, reporting, operational, risk management, and other staffing incurred by a mutual fund adviser is materially larger than what a private fund manager must expend to operate its business.

The growth of the private fund industry and the proliferation of retail alternative funds enable the convergence of private and mutual funds. Investment advisers are adjusting their operations to satisfy retail investor demand for alternative investments. Changing demands by institutional investors also had a remarkable impact on the alternative investment industry. The growth of the alternative investment industry reached $2 trillion in assets under management (AUM) by the end of 2013. Since 2005, the alternative investment industry grew twice as fast as the traditional mutual funds industry. Between 2013 and 2015, the private fund industry grew by 26%, increasing from just over 2 trillion dollars AUM in 2013 to 2.7 trillion dollars AUM through 2015.

Retail alternative investments have become increasingly popular over the past twenty years and have become an integral part of institutional investor portfolios. Retail alternative funds, including hedged mutual funds and synthetic hedge funds, combine the structure of a traditional mutual fund (with the attractive liquidity and daily valuation features) with the higher returns and risk mitigation associated with private funds. Their portfolio diversification and comparatively high risk-adjusted returns have made retail alternative investments increasingly popular. Investments in retail alternatives have more than doubled since 2008 and represent over $550 billion in assets. The number of funds offering investors alternative strategies has grown from 181 in 2007 to 402 in 2014.

Retail investors are a core factor for the proliferation of the retail alternative fund market. Starting in the early 2000s, retail investors, traditionally excluded from private fund investments, gained access to hedge-fund-like investments through exchange traded funds (ETFs) and ever more sophisticated publicly available at-home trading tools. Alternative funds offered retail investors access to private fund strategies and higher returns than mutual funds while paying mutual fund fees, thus increasing demand by retail investors. Because of investment managers’ recognition of retail investors’ demand for alternative funds, retail investors gained increasing access to a broader array of alternative investment strategies, further increasing demand for alternative investments. Retail investors are driving the overall demand in the alternative investment sector, seeking more than just the prospect of significant performance but also risk-adjusted and consistent returns that are not correlated to the market.

Regulatory reform also enables convergence of the two industries. The Dodd-Frank Act and JOBS Act streamlined core legal requirements for the private fund industry, aligning them more closely with those applicable to the mutual fund industry and helping the private fund industry transition from a secretive industry to a more open industry supported by a more widely-recognized and influential group of investment managers. More specifically, the registration and disclosure requirements for private investment fund advisers under the Dodd-Frank Act in combination with the removal of advertising restrictions for private fund advisers under the JOBS Act and the equal treatment of mutual and private funds for FSOC’s SIFI designation in effect assimilated legal requirements applicable to mutual and private funds.

The registration and disclosure requirements for private fund advisers under the Dodd-Frank Act illustrate a core point of convergence of the legal regimes applicable to mutual and private funds. While the registration and disclosure requirements for private fund advisers under the Dodd-Frank Act are significantly less onerous than the registration regime applicable to mutual funds, several core overlaps of the two registration regimes illustrate the convergence of mutual and private funds. For the first time in the history of the private fund industry, the Dodd-Frank Act required most advisers to private funds to register with the SEC. By eliminating previous registration exemptions and requiring investment advisers with AUM of more than $150 million to register with the SEC, the Dodd-Frank Act mandated SEC registration and reporting of information that was hitherto considered proprietary and private.

The JOBS Act authorized the SEC to remove a key legal distinction between mutual and private fund – their formerly unequal treatment for purposes of advertising. Before the SEC amended Rule 506 (c) of Regulation D, mutual funds advertised broadly across multiple forms of media while private fund advisers were prohibited from advertising. After more than six decades of private offerings with a ban on general solicitation and general advertising (GSGA) that applied when companies or funds made private securities offerings under Rule 506 of Regulation D, the SEC’s new Rule 506(c), for the first time in the history of the private fund industry, allowed GSGA in a Regulation D offering. The Rule was finalized and published in the Federal Register on June 24, 2013, and became effective on September 23, 2013.

Some legal requirements are only nominally identical for private and mutual funds but in their application largely different. An investment adviser to a registered mutual fund is subject to the same Investment Advisers Act obligations as an investment adviser to a private fund. However, because of the nature of their respective businesses such obligations are far more onerous for mutual fund managers. Similarly, best execution obligations are similar but practically different for private and mutual fund advisers. Whereas the mutual fund manager is exposed to much higher regulatory and litigation risks, the private fund manager incurs minimal time and expense obligations in fulfilling best execution obligations. The registered mutual fund manager has to be able to report daily on the fund’s operating costs and expenses, including trading-related expenses, and therefore invests significantly in – and operates – technology-based systems to collect and track trading-related expense information with a high degree of precision.  By contrast, a private fund manager trying to satisfy best execution obligations does not have to create the same technology-based system, but can elect to periodically and manually review its internal trade processes and select a reasonable sample of trade data for review.

The convergence of mutual and private funds affects the evolution of the private fund industry, making it a more widely recognized industry that is part of mainstream of finance. Convergence of private and mutual funds impacts the market position, recognition, and overall evolution of the private fund industry. While policy makers and commentators have traditionally excluded the private fund industry from mainstream finance (the high profitability of the private fund industry in combination with its penchant for secrecy alienated politicians and regularly triggered calls for increased oversight) the convergence of mutual and private funds helps the private fund industry transition from an industry operating at the fringes of finance to be recognized as part of mainstream finance. Unprecedented changes in the rules and regulations pertaining to the private fund industry under Title IV of the Dodd-Frank Act and the JOBS Act allow increased oversight of the industry and contribute to the increasing recognition of the private fund industry as a fully regulated asset class. These changes established the private fund industry not only in the eyes of investors but also in the eyes of the SEC. Epitomizing the increasing recognition of the private fund industry and its important role in capital formation, in 2013 SEC chairwoman Mary Jo White declared, “Private funds, including hedge funds, play a critical role in capital formation, and are influential participants in the capital markets”.

Convergence of mutual and private funds has a positive effect on the growth of the retail alternative fund market. Merging the regulatory requirements applicable to mutual funds with the formerly more distinct rules applicable to private funds creates incentives for private investment managers to set up retail alternative funds. A higher supply of retail alternative funds, in turn, is likely to further increase investor demand for retail alternative funds. A higher demand for retail alternative funds, in turn, precipitates more sustainable market-driven convergence of the mutual and private fund industries.

The regulatory overhaul of the private fund industry under the Dodd-Frank Act and the JOBS Act creates incentives that support and reinforce convergence. The mandatory investment adviser registration provisions under the Dodd-Frank Act incentivize investment advisers to set up retail alternative funds. Prior to the enactment of the Dodd-Frank Act, the registration of a private fund was a significant disincentive for investment managers to enter into the mutual fund sector. Registered private fund advisers have incentives to also manage mutual funds or set up retail alternative funds because the regulatory burden is minimally higher in comparison with preregistration legal requirements. Moreover, the tightening of accredited investor provisions under the Dodd-Frank Act increases investor demand for retail alternative funds. Investors who no longer qualify for retail alternative fund investments under Dodd-Frank qualified investor standards are likely to seek out hybrid funds. Moreover, limitations to bank investments in the private fund industry, mandated by the Dodd-Frank Act, incentivize retail alternative fund investments for banks. Banks have traditionally been one of the largest investor groups in the private fund industry. Finally, the JOBS Act also creates incentives for investment advisers to set up retail alternative funds. Investment advisers to private funds have better incentives to set up retail alternative funds that allow them to offer features that are attractive to retail investors rather than to advertise under the uncertain new regime (Rule 506(c)) in an effort to attract a now smaller pool of qualified investors that are willing to invest in their private funds.

Given these implications of convergence, it seems possible that the mutual fund industry of the future could be subjected to more risk than the historical averages suggested in the past.  Although mutual funds have historically used little leverage or leverage-creating derivatives and presented little risk, the increasing demand for alternative strategies creates incentives for mutual fund managers to seek ways to simulate leverage. While private and mutual fund convergence is unlikely to cause drastic immediate repercussions for market participants, long-term implications and peripheral effects merit continued monitoring.

The preceding post comes to us from Wulf Kaal, Associate Professor at the University of St. Thomas School of Law.  The post is based on the his bookchapter: Confluence of Private and Mutual Funds, in Elgar Handbook on Mutual Funds (2016), SSRN, which is available here.