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When Hedge Funds Try To Be Mutual Funds

Patrick Morris is a veteran hedge fund manager who has come in from the cold.

Morris ran ultra-sophisticated funds for the ultra-rich based on James Bond-like investing technologies developed by an early "quant," Dr. Robert Hagin of the University of California at Los Angeles. Hagin's approach to markets, as far back as the '60s, was based on feeding relevant market data through an unemotional and systematic filtering process. Not the hunches of portfolio managers.

Now Morris is chief executive of Hagin Investment Management, which has launched a mutual fund designed to bring the filtering process to mainstream investors.

The first instance: the Keystone Market Neutral Mutual Fund, designed to deliver low volatility and a low correlation to market movements, delivered at low cost. Something that should comfort those mainstream investors.

But the fact that Hagin is launching a mutual fund shows that elitism in investing isn't what it used to be.

After years of negative headlines for hedge funds, regulators are getting spunkier and financial advisors more vocal in their demands for hedge-like products that can fit within their transparency regimes.

"The trend toward convergence between the traditional and alternative sectors will accelerate in the future. We would rather be on the leading edge than chasing the wave," says Morris.

Morris is just the latest example of hedge fund managers embracing the masses. Other firms that have recently entered the game include RiverPark Funds and Aristotle Capital Management.

According to Morningstar, which currently tracks roughly 130 alternative mutual funds, $3.4 billion flowed into mutual funds employing currency hedge strategies in 2011, while nearly $3.6 billion flowed into funds using managed futures. Roughly $1.4 billion went into long/short equity funds, nearly $2 billion into market neutral and nearly $4 billion in multi-alternatives. Meanwhile, over $9 billion went into non-traditional bond categories.

Mutual Headaches

However, downgrading from the Aston Martin crowd to the station wagon set isn't easy. There are plenty of operational, legal and strategic headaches involved.

"Converting a hedge fund into a mutual fund raises a number of potential legal issues," says Aisha Hunt, head of the 1940 Act practice at the San Francisco law firm Cole-Frieman Mallon & Hunt LLP.

Headaches, according to Hunt, include tough questions related to product design: Can the strategy work within the liquidity and leverage limits of the Investment Company Act of 1940, as well as the tax constraints of the Internal Revenue Code, such as subchapter M, which limits the amount of underlying actively managed assets? Also, will the adviser or fund have to register with the Commodity Futures Trading Commission as a commodity pool operator, for example, if it has more than 10% of its assets tied to commodity products?

Then there are headaches with organization, registration and implementation. For example, will the mutual fund board be comfortable evaluating the skill of the manager and approving the level of fees? Can the strategy and risks be described in a plain English prospectus?

Fund accountant Bill Kouser, a partner at the Philadelphia firm BBD, LLP, says hedge fund advisors need to address a number of tax issues as well.

For instance, managers have to ensure that the conversion from the hedge fund format to the mutual fund format is accomplished via a tax-free transaction, so that the former limited partners of the hedge fund are not taxed on their share of the unrealized appreciation tied to the hedge fund's investment portfolio.

This means meeting certain technical requirements in the tax regulations for a tax-free transfer. This could involve either getting a letter ruling from the IRS, an expensive and lengthy process, or getting a tax opinion from a fund attorney, which is less expensive but can be less iron-clad.

Managers also have to deal with the costs of audits and regulatory reporting when they transfer to mutual funds.

Hagin built a new infrastructure to meet the needs of the mutual fund world, fine-tuning it by "walking" dollars through-or simulating the operational steps of-the new system to make sure they understood all the ramifications.

That led, for instance, the firm to set up a tri-party agreement for trading. That is to cover the needs for a prime broker for the shorting involved or a custodian to hold stocks for long only investing, plus a fund administrator and a transfer agent.

In comparison, a hedge fund manager can choose to use only a prime broker. The costs and the complexity of trades, of course, increase with the addition of service providers, says Morris.

Managers, he says, also have to keep close watch on all the other expenses as well, some of which they addressed by using a series trust. In a series trust, funds can pool together their resources to address most of their administrative expenses.