Alternative Mutual Funds vs. Hedge Funds

Despite being overlooked by a large segment of the investing community, alternative mutual funds (AMFs) have generated considerable buzz in recent times.

In this article, we explore the opportunities and challenges offered by AMF strategies relative to their more established hedge fund counterparts.

What Is an Alternative Mutual Fund?

Simply put, an AMF is a registered mutual fund that employs investment strategies typically seen in alternative vehicles, including shorting securities, buying and selling options, pairs trading and portfolio hedging using market indices. As the need for more flexible investment vehicles have grown, so too have alternative mutual funds.

It therefore comes as no surprise that the U.S. Securities and Exchange Commission (SEC) issued a bulletin on this growing asset class in February 2017. In that bulletin, regulators outlined the unique characteristics and risks tied to AMF strategies:

• Investment Objectives: While AMFs employ various strategies to reach their goals, all seek to generate above-market returns relative to other mutual funds.

• Investment Style: Unlike traditional mutual funds, AMFs achieve their objectives by investing in non-traditional investments such as start-up companies, global real estate or commodities. These investments often provide greater diversification benefits.

• Strategies: The strategies employed by AMFs are generally more complex than traditional mutual funds. Short-selling, derivatives and market neutral strategies are just some examples of the more complex strategies used in this area.

Alternative mutual funds are also said to provide structural benefits, including regulatory oversight, liquidity, tax simplicity, transparency and competitive fees. Just like hedge funds, alternative mutual funds are governed by the Investment Company Act of 1940.

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Alternative Mutual Funds vs. Hedge Funds

While hedge funds and AMFs employ similar strategies, such as reliance on alternative investments to generate higher returns, they also have important differences. The key differences are broken down below.

Traditional hedge funds employ a quarterly redemption cycle and do not typically disclose their short positions. These funds have a high barrier to entry, with minimum investments usually in the range of $1 million or greater. Typically, their performance fee is 20%. Moreover, hedge funds can take up unlimited leverage. Hedge funds usually require a lock-in period of at least three years where redemption is not possible. Subsequent redemptions are paid out in blocks rather than a full lump sum payment.

AMFs, on the other hand, have daily liquidity standards and provide full holdings transparency on a quarterly basis. One of the biggest benefits of AMFs is the lack of performance fees tied to the assets and the much lower minimum investment requirements. Leverage is also restricted to 250% of the gross exposure. As a mutual fund, AMFs have much easier redemption cycles when compared with hedge funds. Open-ended funds can be redeemed at virtually any time given the relatively smaller amount invested when compared with hedge funds. Examples of AMFs that have outperformed the market this year include the Logan Capital Long/Short Investor (LGNMX), Alger Dynamic Opportunities Z (ADOZX) and the LoCorr Long/Short Commodity Strats I (LCSIX). Some of the more popular alt funds in today’s climate include the Aberdeen Equity Long-Short A (MLSAX), Hancock Horizon Quant Long/Short Investor (HHQAX) and Calamos Market Neutral Income A (CVSIX).

While both types of funds are managed by a professional fund manager, there are important differences. For starters, a mutual fund manager does not hold substantial interest in the working of the fund, whereas a hedge fund manager is mandated to hold a larger share in the respective fund. This is done to ensure a level playing field and prevent the hedge fund manager from making decisions that are detrimental to the fund’s performance.

The differences are broken down in greater detail below:

Despite their unique advantages, alternative mutual funds have seen their demand slowly dry up since 2014. Prior to that, demand had surged over a seven-year period. At the same time, hedge funds have continued to grow, taking in $3.2 trillion by the end of December 2017. What’s more, demand for alternative funds has not grown despite the return of volatility early in 2018. This likely has to do with the fact that U.S. stock and bond markets have continually outperformed in recent years, giving investors less impetus to seek out alternative funds.

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The Bottom Line

The growth of liquid alternative mutual funds is a sign that more portfolios are employing complex strategies to beat the market. Although not without risk, AMFs can provide broad diversification benefits and the ability to generate above-average returns at a time of heightened uncertainty in the global market.

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