Investors’ adventures in 40 Act wonderland

February 06, 2013  

Why is gathering assets proving so hard for some? The US may offer the answer

By Niki Natarajan

"Alice comes upon a mushroom and sitting on it is a blue caterpillar smoking a hookah. The caterpillar questions Alice and she admits to her current identity crisis." — Lewis Carroll’s 1865 novel Alice’s Adventures in Wonderland.

I wonder if perhaps Lewis Carroll’s hookah-smoking caterpillar might not also be referring to the identity crisis currently suffered by the beleaguered funds of hedge funds that are being battered down on fees by underfunded defined benefit pension funds – as well as struggling (for the most part) to raise assets as institutions go direct.

According to a new report from Towers Watson, UK institutional pension fund assets hit an all-time high of $2.7 trillion in 2012 – having grown 5% during the year and more than doubling in the past decade.

The report also found that in the past decade these investors have, on average, increased their exposure to alternative assets to an average of 17% from 3%. Given the sophistication of the US institutional market, it is safe to assume that a similar trend is happening across the Pond. Globally, OECD countries had some $20.1 trillion in pension fund assets in 2011.

"So what is the problem?" the blue caterpillar would probably ask in a short terse tone. The answer lies primarily in zero interest rates – and the subsequent lack of volatility – that has reduced the hedge fund investing industry to the equivalent of the dodo’s Caucus-Race, with everyone running around in a circle and there seemingly being no clear winner in terms of assets or direction.

So why is gathering assets proving so hard for some? If Arden Asset Management’s recent adventure in America’s mutual fund land is more than just a fantasy, then the US may offer the answer.

Instead of tapping the underfunded, shrinking defined benefit pensions market, what about finding a way to mine a rich and relatively untapped source of assets that is actually growing?

Retail investors, or at least the higher net worth stratum that is catered to by the advisory wrap businesses of the mutual fund giants, are still pensioners in waiting. It seems that Arden founder Averell Mortimer and the underlying hedge funds such as Babson, Chilton, CQS and York that have followed him down Alice’s rabbit hole have discovered the curious hall with many locked doors of all sizes – behind which are hidden pots of assets that require alternative thinking to access.

Through one such door, Arden has found the attractive garden and the drink that allows it to shrink (in terms of liquidity) to comply with 40 Act rules – as well as the cake, which will cause it to grow to a tremendous size of $740 million.

Until now, only 30 FoHFs have ventured down the 40 Act rabbit hole but few seem to have found Arden’s garden, judging by the sluggish growth of 14% for the year ending 31 March 2012 (InvestHedge, December 2012).

In the US, which has some $13 trillion in mutual funds that underpin the US savings and defined contribution market, there are very few appropriately constructed mutual funds investing in alternative assets.

Yet despite this lack of product, McKinsey & Company says that retail alternative assets and strategies such as commodities, long/short products and market-neutral strategies have grown by 21% annually since 2005 and now stand at $700 billion.

And with 70 million baby boomers set to retire with insufficient funds in their retirement pots, the likelihood for a percentage of an additional potential $10 trillion or so to also be invested into alternative mutual funds seems like a real possibility as those born from 1948 onwards look for ways to supplement their pensions.

So how can hedge fund investors hoping to taste a slice of the mutual fund pie find the key that will open the right door? "Before crawling away, the caterpillar tells Alice that one side of the mushroom will make her taller and the other side will make her shorter."

Does he mean that a mutual fund may seem small but has the potential to grow large in terms of fees and assets, whereas a defined benefit mandate may start large but not grow or even earn the fees to pay the bills?

When heading off down the rabbit hole, as Alice learned, be careful of what you eat and drink and who you share it with. Finding the right partner is key, because like the Cheshire cat – a cat without a grin but never a grin without a cat – who has ever seen assets without a fund?

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