WHAT'S IN A STRUCTURE? PROS AND CONS OF THE HEDGE FUND, MUTUAL FUND, ETF, AND SMA STRUCTURES
BY KEVIN E. MEIER, CFA
While just about everyone knows the importance of diversification in an investment portfolio, most only apply the concept to systematic and non-systematic risks (market specific risks and company/industry specific risks), allocating capital across different asset classes, strategies, and securities. And while this is indeed vital to risk mitigation, it does little to address non-market related risks, such as fraud or theft, nor any number of other potentially detrimental characteristics of a given instrument. Therefore, it may prove advantageous for investors to examine the structural characteristics of the vehicles in which they invest, and consider diversifying across vehicles to better address these often overlooked issues.
It used to be that, in terms of structure, we would take what we could get; but as time and technology have advanced, so too have our options. The industry is evolving with new strategies and structures that address many more of the concerns of a well-informed investor, while hopefully also offering the potential to fulfill his or her needs. Here, we will look at the pros and cons of a variety of common investment structures that provide investors access to advanced, alternative strategies.*
*Please note, there are many types of investments, vehicles, and structures I will not be addressing herein, and I realize that my audience is sophisticated and may have knowledge of and access to many of them. My expertise, however, lies within the world of public equity and equity derivatives. Therefore, this discussion will be limited to common structures in which one can access strategies within this and other similar spaces.
WHAT'S IN A NAME?
Hedge Funds: Names can be both descriptive and misleading, take the term hedge fund, for example. Hedge funds are indeed funds, i.e. pooled investment vehicles, but they are not necessarily hedged. In fact, other than being funds, they are not necessarily anything specific; rather, the name is more a catch-all label for investment pools that fall outside of other categories. Generally, though, hedge funds are limited partnerships in which the manager is the general partner and investors are limited partners (though it can be an LLC or other corporate entity), and the fund owns and controls the pooled assets while investors own portions of the fund.
We start with hedge funds not because they were the first created, but because they come first to mind when thinking about advanced, alternative strategies. They used to be the only place investors could find such cutting-edge, and truly diversifying investments, and because of their relative difficulty to understand (due to opacity, perceived complexity, and freedom to use any and all assets), they were reserved primarily for institutional investors and the ultra-high-net worth, aka people who could either understand the risks involved or who could withstand taking huge losses, or both.
Regulation: Unlike mutual funds, hedge funds are not subject to some of the regulations that are designed to protect investors. Depending on the amount of assets under management, some hedge fund managers are required to register and/or to file public reports with the SEC. Hedge funds are subject to the same prohibitions against fraud as are other market participants, and their managers owe a fiduciary duty to the funds that they manage, often registered as RIAs.
Transparency: Hedge funds are generally not very transparent in their strategies and holdings (but maybe required to report holdings quarterly, depending on AUM and size of holdings). On the plus side, this opacity protects the manager's strategies and competitive edge. On the other hand, because hedge funds are not required to provide the same level of disclosure as other instruments, it is difficult to fully evaluate the terms of an investment in a hedge fund and to verify representations you receive from the fund manager.
Liquidity: Hedge funds are not generally liquid. They can have significant lock-up periods, and depending on the terms may only offer redemptions according to specific schedules (quarterly, annually, etc.) or during certain windows after a redemption notice has been issued. Further, some funds may impose gates that bar redemptions, often following poor performance. For some managers who invest in liquid assets, this feature may only be a convenience; but having a stable, long-term capital base is imperative for those that invest in illiquid assets.
Fees/Incentives: Many believe that hedge fund fees are exorbitant, charging a combination of management fee (percentage of AUM) and performance fee (percentage of profits). And while fees are contracting on aggregate, critics argue that what you get does not warrant the fees, and that the performance fee, back-stopped by a management fee, might incentivize managers to take on more risk in order to boost performance. Proponents contend that the fee structure attracts the very best management and strategies in the world, and incentivizes investment performance over asset gathering, aligning the interests of manager and investors. To further this alignment, many managers invest their own capital in the funds they manage. And while recently there have been net out-flows in the industry, institutional investors still line up to pay the highest of fees for certain managers whose performance warrants it.
Control: Hedge Funds own and control portfolio assets.
Taxes: As LLPs and LLCs, hedge funds are pass-through vehicles. Gains for investors, then, can be long or short-term, depending on the holding period of each security, and are reported on a K-1 form provided by the fund.
Access: Generally available only to accredited investors, often extremely high minimum investments.
Mutual Funds: Mutual funds are open-end investment companies that pool money from many investors to invest in a variety of securities and asset classes, though most notably stocks and bonds. The mutual fund owns and controls the assets, and each mutual fund share represents an investor’s proportionate ownership of the portfolio and the income it generates. Traditionally providing basic stock and bond strategies to the individual investor, mutual funds have responded to the demand for liquid alternatives, and have vastly broadened their offerings
Regulation: Mutual funds are SEC-registered investment companies and are managed by SEC-registered investment adviser. Because of their availability to the general public, the SEC restricts mutual funds from utilizing certain practices and asset classes it deems inappropriate for average investors (e.g. options and leverage), therefore reducing the efficacy of some alternative strategies in mutual fund form.
Transparency: While better than hedge funds, mutual fund transparency isn't great. They are required to calculate net asset values (NAVs) daily, which is important for performance, but only have to report holdings quarterly, which is not so good for risk mitigation. A quarterly schedule is sufficient for passive strategies, but for active funds, it reveals very little. Strategy is discussed at length within each fund's prospectuses, most often with mind numbing vagueness.
Liquidity: Investors can redeem their shares from the mutual fund company on a daily basis, at the closing NAV. There can be significant early redemption fees meant to dissuade redemptions.
Fees/Incentives: Mutual fund managers charge a management fee as a percentage of assets, which varies depending upon how specialized and/or active the strategy is. The mutual fund, then, passes through other fees, such as administrative and marketing costs in the form of loads, while the broker/dealer imposes transaction fees whenever shares a bought or sold. These fees can certainly drag on performance, and do little to align the interests of managers and investors, nor so they attract top managers. These reasons, as well as poor performance, justify the push for more passive products with lower fees.
There are, however, management companies attempting to better align interests and attract top management by attempting a performance-fee hybrid model; but currently there are few, if any, of those options available.
Control: The mutual fund owns the assets of the portfolio and controls the cash movements, being legally obligated to redeem investors at the next available NAV.
Taxes: For taxable accounts, investors pay taxes on mutual fund distributions, whether the distributions are paid out in cash or reinvested in additional shares. The funds report distributions to shareholders on IRS Form 1099-DIV after the end of each calendar year, and investors pay the full amount for the year regardless of whether or no they received the gains.
Access: Available to the individual investor, and is able to be held in most types of accounts, including tax-exempt and tax-deferred. Many have investment minimums, though they are not usually prohibitive.
ETFs: Like hedge and mutual funds, exchange-traded funds are pooled investment vehicles that can invest different in strategies and asset classes. Unlike mutual funds, however, ETFs do not sell individual shares directly to, or redeem their individual shares directly from, retail investors. Instead, ETF shares are traded throughout the day on stock exchanges. Originally intended to be low cost mutual fund alternatives that mimicked market indexes, ETFs have widened their scope and offer a wide variety of products and strategies.
Regulation: ETFs are SEC-registered investment companies, and their managers are often registered investment advisers
Transparency: One of the hallmarks of the ETF is transparency, reporting their holdings daily. Fees, however, are often not as clear. Like mutual funds, details of complex strategies may be hard to glean from the prospectus.
Liquidity: Perhaps the hallmark of the ETFs, shares are very liquid and can be bought and sold throughout the day on an exchange, but at market prices that may or may not be the same as the NAV of the shares.
Fees/Incentives: Expense ratios vary depending on complexity and activity, and can be somewhat difficult to vet. In general, investors pay a management fee in combination with other admin fees, but cannot charge performance fees. In addition, investors pay commission to their broker when buying and selling shares.
Taxes: ETFs can be held in taxable and non-taxable accounts, and are generally more efficient than mutual funds and the investor is faced with taxable gains after the ETF is sold.
Control: Like the mutual fund, ETFs are investment companies that own and control assets. They do not directly sell or buy interests in them howere, rather shares are purchased on exchanges.
Access: Available to the individual investor, and is able to be held in most types of accounts, including tax-exempt and tax-deferred. Unlike mutual funds, there are generally no or low limits.
SMAs: Separately Managed Accounts are generally managed by a registered investment adviser, but differ from the above mentioned funds in that the assets of investors are not pooled nor become the property of the fund, but remain the property of the investor and held in separate accounts at an independent broker dealer. Strategies can range from vanilla, long-only bond and equity strategies to complex, multi-asset strategies. Because of new found popularity, a number of advisors and broker-dealers are supporting SMA platforms in order to offer these options to investors.
Regulation: Generally, managers are register investment advisers (RIAs) that are held to the fiduciary standard, but strategies and assets are only constrained for certain types of investors.
Liquidity: SMAs can have daily liquidity or may limit liquidity based on strategy and manager. Further, funds may be withdrawn on investor’s own schedule. Investors should consider the specific liquidity feature of the SMA in which they invest.
Fees/Incentives: Fees can be management fees, performance fees, or a combination thereof, usually based on the sophistication of the strategy and the manager’s expertise. Performance fees may only be charged to investors who meet certain income and net worth requirements, but do tend to incentivize performance over asset gathering and can attract better managers. Further, many SMA managers invest in their own strategies, aligning interests with investors.
Taxes: Investors receive 1099 forms, as well as all account documentation and trade confirmations directly from the independent broker dealer. Taxes can be short or long term, depending on holding periods. Some SMA’s can be managed in tax-exempt or preferred accounts, but strategies and securities in such accounts are extremely limited.
Control: Investors retain control of all assets and dictate all cash movements.
Access: Generally accessible to all investors, certain strategies and fee structures may not be appropriate or allowed for all investors. Many SMAs do have investment minimums, but not usually as prohibitive as hedge funds.
Clearly, there is not a single best structure for investors; different structures offer different options, protections and incentives. Intelligent investors would be prudent, then, to examine these different characteristics not just for their own merits, but for how they will fit into the overall portfolio, and consider if structure may be a way to mitigate further risk. We admit to bias as an SMA manager; we very deliberately chose this structure for what it could give our investors in combination with our strategy.