A Fresh Take Needed For Risky Funds

The investment management world used to be simple. Mutual fund managers sold stock and bond investments to the general public subject to stringent regulation, while unregulated hedge fund managers served only the very wealthy with much riskier investment strategies.

But this once-clear distinction is melting away as mutual funds have started to look more like hedge funds, and vice versa. The blurring of the lines has created more choice for retail investors – along with significant challenges for regulators.

The convergence of mutual funds and hedge funds has its roots in consumer demand. In an environment of low returns on traditional asset classes, investors have been willing to consider alternatives to stocks and bonds if they offer the prospect of greater gains.

In response, mutual fund sponsors have developed funds incorporating strategies that, until now, have been used almost exclusively by hedge funds. These strategies often involve leverage, either through borrowing or the extensive use of derivatives, and they frequently emphasize alternative investments such as commodities, real estate and privately placed securities.

At the same time, the sponsors of these “alternative mutual funds,” as they are known, are increasingly likely to be hedge fund managers. Legislation passed in the wake of the financial crisis has subjected these managers to some of the regulations that previously applied only to firms catering to retail investors.

As a result, more hedge funds are willing to consider managing regulated mutual funds that can be sold to the general public. They calculate that the additional regulatory burden will be modest compared with the potential pay-off.

Recent sales of funds with a hedge fund approach give them cause for optimism. Morningstar reports that US investors have moved almost $40bn into alternative and commodity mutual funds over the past two years – while pulling $185bn out of traditional stock funds. Growth in “alternative Ucits”, the European equivalent, has been similarly strong.

Though investors may have embraced these new funds with enthusiasm, regulators have been decidedly more sceptical. In the US, that is partly because existing regulations – which were largely developed in the pre-derivatives era – are a poor fit for the new strategies. For example, the limitations on a fund’s use of leverage never refer to derivatives, by default giving fund managers considerable leeway in their use.

By contrast, regulation in the European Union addresses derivatives explicitly. Funds may use these instruments to create leverage synthetically, provided that their managers have established a process to monitor and manage risk.

But the high level of leverage permitted under these rules – up to three times assets – has raised regulatory eyebrows in prominent EU member states and in some jurisdictions outside Europe, such as Hong Kong, which allow sales of European funds within their borders. These regulators question whether the more aggressive funds are appropriate for the majority of individual investors.

These questions highlight the deficiencies of the current regulatory regime when applied to hedge fund-like mutual funds. This regime is based on two key principles: disclosure of risks to prospective investors and ensuring that funds have the ability to redeem investors upon request. Fund investments have generally been restricted to those consistent with the redemption principle.

As funds have grown more complex, regulators have become keenly aware of the limitations of the disclosure approach. They have tried to make it easier for investors to compare funds by standardizing the information presented in the US “summary prospectus” and the EU’s “key investor information document”, better known as the Kiid.

European regulators have recently gone a step further, by requiring that funds provide a Synthetic Risk and Reward Indicator, ranking funds on a single scale from one (least risky) to seven (most risky). The SRRI is computed from past volatility using a defined formula.

While a laudable effort, the SRRI may be too reductive to provide much insight to investors. An analysis by Lipper found that funds investing in the same segment of the market tended to fall within the same one or two SRRI categories, making it difficult to distinguish funds on the basis of this tool alone.

Therefore, regulators should carefully consider other approaches to mutual funds that are run like hedge funds. These alternative funds might be labelled so that they can be clearly differentiated from traditional mutual funds. And they should be subject to more marketing restrictions if offered to retail investors.

A new model for fund regulation is needed to ensure that product innovation is consistent with investor protection.