Are hedge funds an investment style or a type of account? Mutual fund manager Lee W. Schultheis resolves the question by bringing hedge fund strategies to investors who don't have the capital for a hedge fund account. Many clients should diversify into investments that aren't correlated with traditional asset classes, Schultheis points out, but even accredited investors with enough free cash to meet the minimum investment requirements can find it hard to buy into good hedge funds. Which explains why, five years ago, Schultheis founded Alternative Investment Partners with Trust Advisors LLP, a consulting firm specializing in hedge funds of funds. The firm's two funds--AIP Alpha Hedged Strategies (an absolute return fund) and AIP Beta Hedged Strategies (which has some market exposure)--are designed to perform without influence of the S&P 500 index or market interest rates and to fill the needs of "clients [who] have shifted to the stay-rich mode from the get-rich mode," Schultheis says.
"There's been a demand for more mutual fund products because of the accessible nature, but [funds] that aren't directional and beta-dependent," says Schultheis. The money is managed by hedge fund managers through separate sub-accounts, allowing the AIP funds to function as both open-end mutual funds and multi-strategy, hedge funds of funds. "That was the true void in the market," says Schultheis, who has worked at various mutual fund companies including Chase's Vista funds.
When Alfred Winslow Jones formed the first hedge fund in 1949, he designed its structure to avoid registration with the Investment Company Act of 1940, the very law that governs mutual funds. He invested both long and short to be market-neutral, thus hedging market risk. Modern hedge funds take the liberties further, investing in many different ways, so the term has come to describe the structure more than the investment style. Unlike unregistered funds, open-end mutual funds cannot charge performance fees, must allow redemptions every day, and need to file information on holdings and performance with the SEC. They are allowed to sell short and lever only up to 50 percent of net assets for investment purposes. And they are available to all investors--not only those who meet the $1 million-net-worth accreditation standard.
AIP's funds keep the hedged strategy without the hedge fund structure. To do this, the AIP funds do not invest in hedge funds themselves. Instead, the money is held in separate accounts managed by using techniques similar to those the managers use with their hedge funds. AIP shareholders' money can be invested long and short in marketable securities, but the hedge fund manager cannot use leverage. "We control custody of the assets, and we have every position valued independently," Schultheis says. By keeping the mutual fund money segregated from the hedge fund, the sub-account manager can use her unique investment style--her source of alpha-- and stay well within the provisions of the Investment Company Act of 1940.
Schultheis adds that much of the perceived risk of investing in hedge funds stems from their lack of transparency. Because they are private partnerships with minimal disclosure requirements, it can be difficult to determine who has custody of the assets, how the securities are valued, and how much leverage the fund has at any given time. "You compare that to our structure, which is an open-fund mutual fund," he says. "Our managers, at worst, can be bad alpha managers."
Fees for AIP's funds are 3.99 percent, and total operating expenses are just over 6 percent. That's low for a hedge fund or fund of funds, but expensive for a mutual fund. This can deter investors who are looking at alternative investments for the first time. On the other hand, if the client and his advisor have been looking at hedge funds, they may find it to be a bargain.
Managing the Managers
Schultheis oversees the investment process and makes leverage decisions. The sub-managers cannot use leverage: "We're in total control of that," Schultheis says. "It lets us better control our risk-adjusted returns." When appropriate, Schultheis draws on the funds' lines of credit to allocate more money to certain managers and, if necessary, to meet redemptions.
Because his colleagues have experience with hedge funds of funds, they oversee the sub-portfolio managers and interview prospective additions. "They know who the key principals were in their past life," Schultheis says. Fund managers who work with AIP must be registered with the SEC. Although these managers often have lower than average assets under management, AIP expects them to have a full infrastructure--not working from one-person home offices. The managers must use priceable securities to meet the mutual funds' daily pricing requirements, and they must be interested in handling AIP shareholder money for three to five years.
The AIP staff looks for money managers who are adding value through research and knowledge of unusual markets. Some of these managers exploit arbitrage spreads, while others concentrate on finding pockets of inefficiency. "Replicators, by definition, can't provide alpha--and that's what the high-net-worth individuals want," Schultheis says. "It's tougher and tougher to generate alpha because more money pours into the hedge fund space. The more money you have to deploy, the more difficult it is to work with these pockets of inefficiency. The multi-billion-dollar managers are having more trouble finding alpha."
"We certainly look for an interesting strategy that's fundamental, research driven. We don't like heavy quant models," Schultheis says, because he feels that volatility levels can change and throw those models off. "We look for folks that have a niche, who are doing something a little differently from mainstream hedge fund managers so that they can get their assets deployed without too much competition."
"There are a lot more complex strategies than what we do," Schultheis says. "Every fund that says that it is long-short market-neutral isn't exactly that. We also have a real bias toward finding managers that take a hedged strategy and employ it in global markets. If you are doing merger arbitrage, the spreads in the international market are likely to be better in the domestic space just because you have less competition."
Helping Hedge Fund Managers Market
Despite their reputation for riches, many hedge funds with good managers struggle to get enough money under management to cover operating costs and employee salaries--let alone provide their fund manager with enough take-home pay for mansions in Greenwich and yachts in the Bahamas. The privacy that many hedge fund investors crave comes with a price: The inability to advertise or promote funds except to identified, accredited investors. Even if the fund manager has a track record, restrictions on hedge fund marketing activities mean that it can take a while for investors to become aware of the fund.
"There are 9,000 hedge funds out there, and the top 100 are getting 70 percent of the asset flows," Schultheis says. "The vast majority of them are under $100 million. It's the small, nimble managers that we think will do better. These are exactly the folks who may provide the best risk-adjusted returns in the next two or three years ahead." As they build their businesses, these managers find that handling sub-accounts for AIP lets them show more assets under management and gives them a strong reference, which can help them rank higher in the RFP process. "It's a means to an end," Schultheis says. "Doing business with us for a number of years may accelerate the traction in their hedge fund."
AIP's funds have close to $500 million in assets under management, handled by 19 sub-account managers. The goal is to have 30 to 40 managers working on the funds--which are attracting more investors--in order to improve diversification and non-correlation of assets. "We're in more of an additive phase," Schultheis says.
One challenge for AIP's funds is marketing absolute return. As much as investors understand the value of a steady return over the long haul, emotions can interfere in years when some market sectors post frothy gains. "People have short memories," Schultheis says. "Any one strategy, any one fund is going to have better or worse years. The year that the strategy is out of favor, the client doesn't want it."
But Schultheis is up for the challenge. "I love being an entrepreneur and being a pioneer," he says, and starting the AIP Funds has allowed him to be both. His belief in the funds' business model gives him confidence in the future.. "This type of investment for a client should be a core position in a portfolio, and because it's that way for them, our business should build slow and steady and not experience peaks and valleys," he says.
Ann C. Logue, CFA, has worked as an analyst and is the author of Hedge Funds for Dummies.