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Mutual Funds to Mimic Hedge Strategies: But for Now, Suprime Crisis Could Dampen Convergence

Predictions that the mutual fund industry will embrace elaborate alternative strategies, driven in part by European regulatory changes, may be a bit preliminary, according to some state-side asset management executives.

The argument, advanced by KPMG, TABB Group and a growing number of investment advisors, is that in the wake of the European Union's 2006 Ucits III reform, both European and North American customers will flock to alternative investment vehicles, including those that park money in derivatives and hedge funds.

TABB estimates that 130/30 mutual funds, for instance, will explode at an annual compound growth rate of 141% over the next three years from $140 billion this year to $2 trillion by 2010, whereas traditional actively managed equity mutual funds will only grow by 3% a year.

And Morningstar recently indicated that it is working on developing a tool to reveal derivative holdings in mutual funds.

"It's hard to underestimate what a revolution this is. You ain't seen nothing yet," Guy Monson, chief investment officer at Sarasin Chiswell, which has just launched a suite of mutual funds that employ hedge fund strategies, recently told attendees at an alternative investments conference. A tremendous wave of alternative investment funds will hit the market, Monson said. "We have only scratched the surface of what we are going to see in the next two or three years," he said.

The Ucits III regulatory changes allow European funds to increase their exposure to alternative asset strategies, including leveraging, investing in private equity or illiquid securities, currencies, real estate, options and futures, distressed debt and arbitrage. Proponents of this theory predict a revolution in mutual fund portfolio managers' strategies and say it will quickly spread across the Atlantic.

But not all fund specialists in the U.S. are so certain. "Most people in the U.S. don't understand alternative investments," said Tom Wynn, director of Spectrem Group, a financial services research and consulting firm. He doesn't believe there's a groundswell of interest that could increase enthusiasm for the vehicles.

Working against the adoption of hedge fund investments and other non-mainstream investment choices, Wynn said, is investors' reaction to the subprime crisis. He said the collateralized debt obligation (CDO) debacle will slow down the average U.S. investor's move into alternative investments.

But Wynn didn't say it would never happen. He compared potential adoption rates for hedge fund products with the growth of exchange-traded funds. "As people read more about ETFs, the instruments are becoming more mainstream," Wynn said. He predicted this will eventually happen with alternative investments, as well, but said it will be a longer process than some of their promoters expect.

Another problem for the adoption of hedge fund-like investments, such as 130/30 mutual funds, a common form of long-short fund, is that this strategy, along with many other quant approaches, didn't do well in the third quarter.

But despite these headwinds, the case for increased allocations by North American and European investors into alternative asset classes, has a few supports. Among them is the drop in long-only returns, the desire of mutual funds to go head-to-head with hedge funds and the fact that investors are becoming more familiar with the asset class, even if it is still not quite in the mainstream of investors' focus.

And among asset management executives, expectations about the speed of alternative investments' popularity does vary. It isn't just London-based executives who are on the bandwagon.

"If investors can put their money in pink sheet stocks, why shouldn't they be able to invest in mutual funds that use some hedge fund strategies?" said Adam Sussman, senior analyst at the TABB Group.

Alternative assets are a useful diversification tool, in addition to potentially being a method of juicing returns, Sussman said. If mutual fund investors are going to put their money in private equity, futures, energy and commodities, they will also consider funds that use hedge fund techniques, he added.

The TABB executive also said it may be the case that European deregulation will have an impact on the spread of alternative asset tools across the Atlantic.

"The Financial Services Authority will lead the way" in further liberalization of investment guidelines for investors in the U.K., Sussman said. And when that happens, regulators at the Securities and Exchange Commission will probably take a cue from their British colleagues' action.

Merrill Lynch estimates that $75 billion is currently invested in mutual funds that use alternative strategies, with two-thirds of that money in 130/30 funds. The rest are in market-neutral funds.

But even in Europe, there are likely to be structural impediments to the widespread embrace of alternative asset strategies in mutual fund offerings.

"European investors are conservative," said Jeff Tjornehoj, a senior research analyst at Lipper. "There is lot of the money tied up in money-market and cash and bond investments."

While some European asset management companies are taking good cash flow into their alternative asset products, Tjornehoj said, the system in many European countries of cradle-to-grave welfare makes retail investors less likely to choose more aggressive investment strategies.

Nonetheless, some U.S. mutual fund companies are beginning to roll out 130/30 funds in Europe, but it isn't a major trend, he said. Because 130/30 strategies are quant-based, their growth will also be limited by the market battering that this strategy took during August. He said that although the instrument is structured to offer non-correlation to other parts of the market, the uniformity of the quant strategy can result in less diversification than was intended.

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