The Soapbox: What You Need to Know About Hedge Fund Conversions

Many advisors often ask how to convert hedge funds into mutual funds. These conversion requests can be motivated by several different factors. One reason to convert is to capitalize on potential distribution opportunities available to mutual funds, which can be found on widely known public platforms such as those of Schwab and Fidelity. Many hedge fund advisors often have to turn down significant assets because individual investors don’t have the large minimum investment required to invest in a hedge fund.

In other instances, conversion requests are the result of recent scandals involving non-registered investments, which can spur investors to seek the security of more regulated investments such as mutual funds with hedge fund characteristics.

The rub for advisors is that not all hedge funds can be seamlessly converted into mutual funds. In fact, more often than not specialized investment strategies and structures need to be employed in order to make it happen. For example, a hedge fund that uses significant leverage would have to change its strategy when converting to a mutual fund, because mutual funds are limited as to the amount of leverage allowed.

Mutual funds also are limited in the amount of commodities they can use, since commodities generally don’t qualify as passive income for a mutual fund. Remember, a mutual fund must derive 90% of its income from passive investments under the Internal Revenue Code in order to qualify as a Registered Investment Company, or RIC, which in turn allows the fund to be a pass-through entity for tax purposes. Certain ETNs or ETFs that invest in commodities may qualify as passive income.

At our company, Gemini Fund Services, we have a number of clients that invest in commodities and use leverage. Our task is to help them find the right solution as they navigate this compliance maze. Financial advisors of hedge funds planning to convert into mutual funds should well consider the limitations placed on mutual funds when using leverage or investing in commodities, among other limitations. The key is to coordinate the conversion very closely with an experienced administrator and outside counsel. If an investment strategy has to be adjusted in order to convert, it may impair the mutual fund’s ability to retain its prior hedge fund performance.

Also worth considering is joining a trust of funds. One of our latest hedge fund clients, Bull Path Capital Management, LLC, is entering its new mutual fund into one of our shared trusts, the Northern Lights Fund Trust. By using an existing trust that contains many funds, advisors can achieve economies of scale for expenses, follow an expedited registration process, and gain an experienced board of trustees and officers instantly. While we think highly of our own offerings, we have competitors as well who can help you with the process should you wish to convert.