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Confluence of Mutual and Private Funds
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CONFLUENCE OF MUTUAL AND PRIVATE FUNDS
CONFLUENCE OF MUTUAL AND HEDGE FUNDS
BY
FORTHCOMING IN ELGAR HANDBOOK ON MUTUAL FUNDS (2016)
The growth of the hedge fund industry and the proliferation of retail alternative funds in combination with the fundamental reshaping of the regulatory landscape for the hedge fund industry suggest that mutual funds are becoming more like hedge funds as a matter of investment strategy while hedge funds are becoming more like mutual funds as a matter of the regulatory framework. The chapter conceptualizes confluence as an emerging process and shows that confluence of mutual and hedge funds has implications for the evolution of the hedge fund industry, the governance of the mutual fund industry, the growth of the retail alternative fund market, and the structure of federal securities regulation.
**_Keywords:_** _Hedge fund, Mutual Fund, Hedge Funds, Hybrid Funds, Liquid Alternative Assets, Retail Alternative Funds, Asset Classes, Proliferation, Confluence, Investment Styles, Securities Regulation_
**_JEL Classification_ :** F33, G15, G23, G28, K22
> * Associate Professor, University of Saint Thomas School of Law (Minneapolis). The authors would like to thank the editors, John Morley and William Birdthistle as well as Quinn Curtis, Bentley Anderson, [___], and the participants at the 8<sup>th</sup> Annual Investment Fund Roundtable at Boston University School of Law. The author is grateful for outstanding assistance provided by research librarians Nick Farris and Ann Bateson.
CONFLUENCE OF MUTUAL AND PRIVATE FUNDS
# TABLE OF CONTENTS
|I.|INTRODUCTION............................................................................................................................................. 3|
|---|---|
|II.|PROLIFERATION OFPRIVATE-ANDRETAILALTERNATIVEFUNDS............................................ 5|
|III.|PERSISTENTDIFFERENCES ANDNOMINALCONFLUENCE........................................................ 7|
|IV.|CONFLUENCE OFPRIVATE ANDMUTUALFUNDS..................................................................... 10|
|_1._|_Investor Preferences ............................................................................................................................... 10_|
|_2._|_Regulation ................................................................................................................................................... 13_|
|V.|IMPLICATIONS OFCONFLUENCE.......................................................................................................... 15|
|_1._|_Evolution of the Private Fund Industry ........................................................................................... 16_|
|_2._|_Mutual Fund Governance .................................................................................................................... 17_|
|_3._|_Retail Alternative Fund Growth ......................................................................................................... 17_|
|_4._|_Structure of Federal Securities Law ................................................................................................. 19_|
|VI.|CONCLUSION......................................................................................................................................... 20|
CONFLUENCE OF MUTUAL AND PRIVATE FUNDS
# **I. Introduction**
A combination of market forces and regulatory reform are calling into question the traditional distinctions between mutual and hedge funds (Citi Fund Services (2010) and Papagiannis (2013)). Mutual funds and hedge funds<sup>1</sup> occupy distinct segments of the investment market, employ different investment strategies, and serve largely different classes of investors. They are subject to different legal rules. However, several combinations of factors suggest that the traditional distinction between mutual and hedge funds may be eroding, resulting in a confluence of mutual and hedge funds. Marketdriven factors contributing to this confluence include the emergence and proliferation of so-called retail alternative or hybrid funds, such as synthetic hedge funds and unconstrained mutual funds (Kaal & Anderson (2016)). Other important confluence factors include the increasing side-by-side management of mutual funds and hedge funds; and public offerings of alternative asset managers, among other, in combination with the fundamental reshaping of the regulatory landscape for the hedge fund industry through the Dodd-Frank Act<sup>_2_</sup> and the Jumpstart Our Business Startups Act (“JOBS Act”).<sup>_3_</sup>
The term “confluence” as used in this chapter in the context of mutual and hedge funds,<sup>4</sup> connotes a process associated with two separate yet connected phenomena with related consequences. Mutual funds are becoming more like hedge funds as a matter of investment strategy while hedge funds are becoming more like mutual funds as a matter of the regulatory framework. This chapter conceptualizes confluence as a process and identifies a trend that alternative mutual funds and other products that are fundamentally mutual funds are increasingly becoming more like hedge funds. It also shows that changes in the regulatory framework post Dodd-Frank Act pertaining to hedge funds tend to render hedge funds and hedge-fund-like-vehicles more mutual fund like. This is not just a result of more stringent regulations enacted via the Dodd-Frank Act in the aftermath of the financial crisis; the liberalization of the advertising restrictions post Dodd-Frank Act also makes hedge funds more like mutual funds.
Market forces are a significant factor in the emerging confluence of mutual and hedge funds (Mutual Fund Directors Forum (2014), McKinsey & Company (2014) and Warren (2012)). Changes to the capital markets precipitated by the financial crisis of 2007-08 and a very low interest-rate environment, in combination with the enormous
> 1 The terms “private fund” and “mutual fund,” as used throughout this article, are used as follows: a private fund is a fund with an (active) trading strategy run by human portfolio management staff (i.e., investment recommendations are not based on an algorithm), and, in most such private funds (unlike mutual funds), there is no substantive limitation on, for example, (a) the types of securities which the fund may trade, (b) the location of the markets where those securities may be traded, or (c) the degree of concentrated ownership of a security (or securities), or the degree of exposure to an industry or market that the fund may take on. By contrast, mutual funds can be (i) standard registered open-end investment management companies, (ii) closed-end funds, (iii) ETFs, and/or (iv) UITs. The author recognizes that while the fund industry itself may use all of these offering-types as synonyms, each in fact has substantively different legal and regulatory characteristics.
> 2 Dodd-Frank Wall Street Reform and Consumer Protection (Dodd-Frank Act), Pub. L. No. 111-203, §§ 401-416, 124 Stat. 1376, 1571 (2010).
> 3 Jumpstart Our Business Startups Act, Pub. L. No. 112-106, § 201(a)(1), 126 Stat. 306, 313-14 (2012).
> 4 The term “private fund,” as used in this article, is an umbrella term for any unregistered investment vehicle including, among others: hedge funds, private equity funds, venture capital funds, liquidity funds, real estate funds,
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growth of hedge funds, created, and over time increased, the demand for retail alternatives (SEI (2013)).<sup>5</sup> The net assets of mutual funds employing alternative strategies have increased almost 200% from 2009 to 2014.<sup>6</sup> Evidence of a growing number of sideby-side management structures, in which an investment advisor manages both mutual funds and hedge funds (Nohel et al. (2010)) further suggests that investment advisers are adjusting their operations to satisfy retail investor demand for alternative investments.<sup>7</sup>
The fundamental reshaping of the regulatory landscape for the hedge fund industry removed many of the legal differences separating the two industries. The DoddFrank Act and JOBS Act streamlined core legal requirements for the hedge fund industry, aligning them more closely with those applicable to the mutual fund industry and helping the hedge fund industry transition from a secretive industry to a less secretive industry supported by a more widely recognized and influential group of investment managers (White (2013)). The registration and increased disclosure requirements for certain hedge fund advisers under the Dodd-Frank Act subjects hedge fund investment advisers to similar registration and reporting obligations as mutual fund advisers. The registration requirement under the Dodd-Frank Act in combination with the removal of advertising restrictions for hedge fund advisers under the JOBS Act and the equal treatment of mutual and hedge funds for FSOC’s SIFI designation in effect assimilated legal requirements applicable to mutual and hedge funds.
The confluence factors identified in this chapter have implications for both the private and mutual fund industries (Kaal & Anderson (2016)). The confluence of mutual and hedge funds affects the evolution of the hedge fund industry, rendering it a more widely recognized industry that is part of mainstream of finance. Confluence factors also make governance alternatives and possible governance improvements available for the mutual fund industry. Other implications include a positive effect on the growth of the retail alternative fund market and possible support for the proposition that the public/private distinction in federal securities regulation may be dissipating.
This chapter has five parts. Part II provides a short discussion of data on the growth of the hedge fund industry and, more specifically, the growth of so-called retail alternative funds. Part III evaluates historical differences between private and mutual funds and forms of nominal confluence. Part IV examines market-driven factors of confluence and regulatory confluence of mutual and hedge funds, including the DoddFrank Act and the Jumpstart Our Business Startups Act. Part V shows the impact of mutual and hedge fund confluence on the evolution of the hedge fund industry, the governance of the mutual fund industry, the growth of the retail alternative fund market, and the structure of federal securities regulation. Part VI concludes.
> 5 Retail alternatives are investment vehicles that offer the attractive features of mutual funds, such as significant diversification, relative stability, and transparency, with the more aggressive strategies and the corresponding prospect of absolute returns of private funds.
> 6 Calculation (Rate of Growth) using the Investment Company Institute data in Table 42 (“Alternative Strategies Mutual Funds: Total Net Assets, Net New Cash Flow, Number of Funds, and Number of Share Classes”). Final calculation was 192% growth in net assets between 2009 and 2014. Investment Company Institute 2015.
> 7 For the year 2012: 53% of investors would consider using alternative investments, 74% of advisors now use alternative strategies, 75% of advisors in the past year have increased their allocation to alternative assets. SEI 2013.
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# **II. Proliferation of Private- and Retail Alternative Funds**
The hedge fund industry has been growing consistently since the early 2000s (Stulz (2007)). Although by comparison to the overall asset management industry, hedge funds still represent a small portion of the business (Investment Company Institute (2015) and BarclayHedge (2015)), the changing demands by institutional investors have had an astounding impact on alternative investments, precipitating growth reaching $2 trillion in assets under management (AUM) by the end of 2013 (Deutsche Bank (2014)). Between 2013 and 2015, the private fund industry grew by 26%, increasing from just over 2 trillion dollars AUM in 2013 to 2.7 trillion dollars AUM through 2015 (Barclayhedge (2015)). According to Hedge Fund Research/Preqin/McKinsey analysis, alternative investments, such as hedge funds and private equity, have grown twice as fast as traditional investments, such as mutual funds and closed-end funds, since 2005 (Baghai (2015)).
Alternative investments have grown twice as fast as traditional investments since 2005.
<!-- Start of picture text -->
Global assets under management, $ trillion CAGR,3<br>2005-13<br>63.9 5.9%<br>57.0<br>50.9 51.6 52.0<br>46.9 48.1<br>42.9<br>40.3<br>56.7 5.4%<br>42.8 46.0 45.7 50.2<br>Traditional 37.1 37.9 42.8<br>investments<br>Alternatives² 3.2 5.0 5.0 5.3 5.9 6.3 6.8 7.2 10.7%<br>2005 2006 2007 2008 2009 2010 2011 2012 2013<br>1Figures may not sum, because of rounding.<br>2Does not include retail alternatives (ie, exchange-traded funds, mutual funds, and registered closed-end funds).<br>3Compound annual growth rate.<br>Source: Hedge Fund Research; Preqin; McKinsey analysis<br><!-- End of picture text -->
Retail alternative funds (retail alternatives) are a rapidly emerging sector in the asset management industry. For purposes of this chapter, “retail alternatives funds” are defined as regulated funds under the investment company act that attempt to replicate the strategies of the private fund industry - including use of leverage, derivatives, shortselling and purchase of nontraditional asset classes. Different authors and industry representatives use different for “Retail alternative funds,” as used in this chapter, including: liquid alternatives, unconstrained funds, alternative mutual funds, and synthetic hedge funds (Vanguard (2014)). Retail alternative funds combine the structure of a traditional mutual fund (with the attractive liquidity and daily valuation features) with the higher returns and risk mitigation associated with private funds. Because of their portfolio diversification and comparatively high risk-adjusted returns, retail alternative investments have become increasingly popular over the past twenty years and have become an integral part of institutional investor portfolios.<sup>8</sup>
> 8 The mutual fund industry utilized the popularity of private funds as a tool for wealth creation and the private investment advisers’ registration obligation with the SEC, supposedly a source of comfort to investors otherwise apprehensive about entrusting capital to unknown managers, to create the liquid
CONFLUENCE OF MUTUAL AND PRIVATE FUNDS
Several studies have applied different methodologies and provide different estimates of the growth of retail alternatives funds over the last several years. According to SEI, investments in retail alternatives have more than doubled since 2008 and represent over $550 billion in assets as of 2013 (SEI (2013)). Similarly, the Investment Company Institute’s mutual fund data reveals startling growth in the retail alternatives segment, growing that segment from 41 billion in 2007 to 170 billion by 2014 (Investment Company Institute (2015)). The author’s analysis of ICI data in Exhibit 1 suggests that net assets of mutual funds employing alternative strategies have quadrupled since 2007 (a 27% annualized growth rate). The number of funds offering investors alternative strategies has grown from 181 in 2007 to 402 in 2014 (Investment Company Institute (2015)). Similarly, KPMG/Strategic Insight Simfund claims that the total assets in retail alternatives funds has jumped to nearly $450 billion in 2015 from less than $50 billion in 2008 (KPMG (2016)). Additionally, this growth is not expected to slow down, as JP Morgan/Strategic Insight estimate that by 2022, 15.8% of all mutual fund AUM will be tied up in alternative mutual funds, making it a multi-trillion dollar industry (JPMorgan Investor Services (2013)).
Additionally, the author has recently published a study on a sub-type of alternatives mutual fund, called “unconstrained mutual funds” which are fixed income mutual funds that attempt to replicate fixed income hedge fund strategies (Kaal & Anderson (2016)). In that study, the author found not only significant growth in these funds by launches, but also provided evidence pertaining to the extent to which unconstrained mutual funds differ in trading strategy from traditional mutual funds – unconstrained mutual funds use futures, short sales, and derivatives. Even unconstrained mutual fund turnover and fee structure appeared more similar to hedge funds than traditional fixed income mutual funds.
This substantial growth in retail alternatives can at least partially be explained with the growing retail demand for hedge fund strategies that were previously only accessible to accredited investors and large institutions (Investment Company Institute (2015)).
> alternative product. Although it was an important objective for the mutual fund industry to be able to offer a new product, mutual fund managers were interested because adding one or more subadvisers to the mutual fund simply did not create significant additional regulatory obligations for the mutual fund manager or for the private fund adviser.
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|2000%<br>40.00%<br>60.00%<br>80.00%<br>100.00%<br>Rate of|Growt|h (Ass|ets) ac|ross F|unds|||
|---|---|---|---|---|---|---|---|
|-40.00%<br>-20.00%<br>0.00%<br>.||||||||
||2008|2009|2010|2011|2012|2013|2014|
|Alternative Mutual Funds|-24.64%|86.46%|56.51%|13.97%|22.58%|32.13%|1.08%|
|All Mutual Funds|-19.98%|15.72%|6.48%|-1.70%|12.21%|15.19%|5.44%|
|Hedge Funds|-31.77%|6.60%|9.00%|0.95%|5.19%|19.90%|16.31%|
|Private Equity|-2.69%|12.57%|10.36%|10.74%|7.95%|10.64%|4.64%|
|Alternative Mutual Fun|ds<br>All|Mutual Fu|nds<br>|Hedge Fun|ds<br>Pr|ivate Equi|ty|
Exhibit 1: ICI Data – Rate of Growth of Fund Categories 2008 to 2014.
# **III. Persistent Differences and Nominal Confluence**
Mutual funds and hedge funds have evolved in different market and regulatory structures. The two asset classes employ different investment strategies, serve largely different classes of investors and have therefore traditionally occupied distinct segments of the investment market. Mutual funds serve mostly retail and institutional investors. They offer risk mitigation by way of diversification, a limited array of investments and strategies, instant liquidity, and daily valuation. They have traditionally been allowed to advertise. Mutual funds and investment advisers to mutual funds are required to register with the SEC and provide regular disclosures including funds’ holdings.<sup>9</sup> By contrast, private investment fund investments have traditionally have been limited to accredited high net worth and institutional investors. Investors in hedge funds need to be able to fend for themselves,<sup>10</sup> and they are subject to more rigorous verification procedures<sup>11</sup> and contractual requirements (Strachman (2007) and McCrary (2002)). Private investment fund advisers employ a near unlimited array of investments and strategies, and they are subject to redemption restrictions (Morley (2012)). Unlike mutual fund advisers, hedge fund advisers are able to avoid registration with the SEC (Kaal (2016a)), provided they comply with certain safe harbors under the securities laws. Until 2014, private investment fund advisers could not advertise.<sup>12</sup> Unlike mutual funds, hedge funds are typically
> 9 15 U.S.C. § 80b–3 (2012) (describing registration of investment advisers).
> 10 17 C.F.R. § 230.501(a) (defining “accredited investor”); _S.E.C. v. Ralston Purina Co_ ., 346 U.S. 119
> (1953) (private offerings turn on whether the offerees are able to “fend for themselves” and therefore do not need protection under federal securities laws).
> 11 17 C.F.R. § 230.506(c)(ii) (2014) (“Verification of accredited investor status. The issuer shall take reasonable steps to verify that purchasers of securities sold in any offering under paragraph (c) of this section are accredited investors.”).
> 12 Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule
> 144A Offerings, 78 Fed. Reg. 44,771 (Jul. 24, 2013); Kaal 2011 (pre Dodd-Frank summary of private fund regulation).
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organized as Delaware LLCs or LPs,<sup>13</sup> and they are not subject to an SEC or other requirement that the fund, for example (among many others): has to have an independent board;<sup>14</sup> provide daily valuation of fund positions/holdings;<sup>15</sup> provide daily liquidity to investors;<sup>16</sup> report holdings publicly and to investors on a regular basis;<sup>17</sup> adhere to ’33 Act and ’34 Act disclosure/filing/trading/purchase sale (etc.) requirements (Deringer (2015), Glazer (2016) and Pisarri (2016)); use transfer agents and underwriters (Cogan (2016)); comply with Subchapter M of the IRC;<sup>18</sup> or refrain from engaging in certain kinds of transactions that encourage undue leverage.<sup>19</sup> Moreover, the size of the investment in trading and operational technology and in experienced portfolio management, trading, reporting, operational, risk management, and other staffing incurred by a mutual fund adviser is materially larger than what a hedge fund manager must expend to operate its business.
Hedge fund managers and advisers to mutual funds face material differences in the context of litigation and other enforcement. Mutual fund advisers are subject to ongoing, high-dollar-value, private-party litigation initiated by investors in registered mutual funds (Sjostrom (2005) and Langevoort (2005)). Indeed, many parts of the ICA authorize private rights of action against the mutual fund manager in the event of a violation.<sup>20</sup> Investors and their lawyers are not reluctant to use these provisions. Recent cases include cases brought against mutual fund managers for charging excessive fees,<sup>21</sup> which would be unheard of in the hedge fund sphere, as well as several recent cases alleging deviations from investment strategies (e.g., the current case against
13 For private funds organized outside of the U.S., such as in the Caymans (which would be relevant for U.S. tax-exempt investors, for example), there are even fewer requirements relating to governance and reporting to investors than would apply to private funds organized under U.S. (e.g., Delaware) law. Browning, “A Hamptons for Hedge Funds,” _New York Times_ (2007).
14 15 U.S.C. § 80a-10(a) (2012); Kirsch (2015).
15 17 C.F.R. § 270.22c-1(b)(1) (2014) (“The current net asset value of any such security shall be computed no less frequently than once daily, Monday through Friday . . .”); Deringer (2016) (“Rule 2a-4 under the Investment Company Act mandates accurate valuation of each portfolio security.”)
16 15 U.S.C. 80a-22(e) (2012); Revisions of Guidelines to Form N-1A, Investment Company Act Release No. 18612, 57 Fed. Reg. 9,828 (Mar. 20, 1992) (Mutual funds can invest no more than 15% in illiquid assets); Deringer (2016 _)_ (“Section 22(e) of the Act requires that open-end funds stand ready to redeem shares daily and pay redeeming shareholders within seven days of receiving a redemption request.”) 17 U.S. SEC. & EXCH. COMM’N, OMB NO. 3235-0307, FORM N-1A (2015), https://goo.gl/0CHmKU; Kleiman (2016)
18 Subchapter M requires mutual funds to comply with certain distribution and portfolio diversification requirements in order to not be subject to federal income tax on income and capital gains it distributes to shareholders. 26 U.S.C. § 851(b)(2) (2012) (company must derive at least 90% of its gross income from dividends, interest, and gains from the sale of securities).
19 15 U.S.C. § 80a-12(d) (2012) (limiting margin purchases, short selling securities, or investing more than a small percentage of assets in other investment companies); 18(f) (mutual funds must have 300% asset coverage for any borrowings from a bank); Use of Derivatives by Investment Companies Under the Investment Company Act of 1940, Investment Company Act Release No. 29776, 76 Fed. Reg. 55,237 (concept release Sept. 7, 2011) (seeking review of the use of derivatives by mutual funds). 20 15 U.S.C. § 80a–35(b) (2012)
> 21 _Redus-Tarchis v. New York Life Inv. Mgmt. LLC_ , No. CV 14-7991, 2015 WL 6525894, at *1 (D.N.J. Oct. 28, 2015) (investors alleging excessive management fees taken by manager of four mutual funds); _R.W. Grand Lodge of F. & A.M. of Penn. v. Salomon Bros. All Cap Value Fund_ , 425 F. App'x 25 (2d Cir. 2011) (investors brought action against various mutual funds alleging excessive fees in violation of the ICA).
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Schwab).<sup>22</sup> By contrast, private-party litigation involving hedge fund managers is minimal because of the extent and nature of the disclosures well-counseled hedge fund managers provide to their investors (who are, in turn, supposed to be sophisticated) and because the statutory regime establishing a hedge fund investor’s right is severely limited,<sup>23</sup> almost to the point of non-existence (both in the U.S. and in jurisdictions like the Caymans and BVI, where a significant number of hedge funds are chartered) (WalkersGlobal (2015)).
The cases brought by the SEC against mutual fund managers and advisers to hedge funds show substantial differences in the scope and number of charges. Given the extensive scope of obligations for mutual fund advisers under the ICA, the ’33 Act, and the ’34 Act, the SEC may pursue the adviser for a large number of potential rule violations. The string of SEC investigations involving so-called “distribution-in-guise” payments by mutual fund advisers (SEC Press Release (2015)) provides a sense of the distinction in the nature of regulatory claims that the SEC might bring against mutual fund advisers.<sup>24</sup> Provided industry-standard disclosures are made to hedge fund investors, there is simply no basis for the SEC to bring a “distribution-in-guise” claim against a hedge fund manager.<sup>25</sup>
The term “nominal confluence” as used herein describes otherwise identical legal requirements for mutual and hedge fund managers that can be materially different in practice. While the applicable statutes and regulations may appear to apply nominally to both mutual and hedge fund managers, the nature of how the investment vehicles are structured, operated, and how they conduct business can make their application materially different in practice (Zask (2013)). For instance, an investment adviser to a registered mutual fund is subject to the same Investment Advisers Act obligations as an investment adviser to a hedge fund (Leonard. (2012)). The scope of private and mutual fund managers’ Investment Advisers Act obligations, however, diverge significantly. Because of the nature of their respective businesses such obligations are far more onerous for mutual fund managers.<sup>26</sup> As the two industries evolve and converge, it seems
> 22 _Northstar Fin. Advisors Inc. v. Schwab Investments_ , 779 F.3d 1036 (9th Cir. 2015), _cert. denied_ , 136 S. Ct. 240 (2015) (plaintiff alleged that the mutual fund in question violated ICA/state securities laws by deviating from the fund’s investment objective by investing in CMOs, 9th Circuit held that the plaintiffs could go forward with breach of contract and breach of fiduciary duty claims against Schwab). 23 The unique American securities regulation regime creates a distinction between “public” and “private” offerings based on the concept of “accredited investors.” Accredited investors (the requirement to become an investor in a hedge fund or private equity fund) are theoretically able to “fend for themselves,” while small investors need the protection of securities laws. _See_ 15 U.S.C. § 77b (15) (2012) (defining accredited investor); 17 C.F.R. § 230.506 (2014) (safe harbor for private offerings); _SEC v. Ralston Purina Co_ ., 346 U.S. 119, 125 (1953) ("[S]hould turn on whether the particular class of persons affected need the protection of the Act. An offering to those who are shown to be able to fend for themselves is a transaction ‘not involving any public offering.’”)
> 24 Grind, “SEC Cranks Up Probe into Fund Firms’ Fees,” _Wall Street Journal_ (2015).
25 ICA claims can only be made by registered investment companies, like mutual funds. For a discussion on the SEC’s mutual fund fee initiative sweep- Cavoli, “The SEC’s Mutual Fund Fee Initiative: What to Expect,” _Securities Litigation and Regulation_ (2010).
26 In addition to the best execution differences described in the next paragraph, valuation of fund positions is another example where private and mutual fund managers are subject to similar legal requirements with much different practical implications. Mainly because a private fund manager is not required to report publicly a daily NAV (or, indeed, any NAV), or provide daily liquidity to investors, mutual fund managers’ valuation obligations are, in practice, far more complicated. It takes a significant amount of capital to
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possible that other regulatory commonalities emerge that are in fact still only nominally identical but practically still subject to differences that only dissipate over time.
Best execution requirements offer a prominent example of nominal confluence. Best execution obligations are similar but practically different for private and mutual fund advisers. In practice, best execution requirements are far more complicated and burdensome for the mutual fund manager than for the hedge fund adviser. Private and mutual fund managers have an obligation to seek to obtain best execution of the trades they direct to brokers.<sup>27</sup> The registered mutual fund manager has to be able to report daily on the fund’s operating costs and expenses, including trading-related expenses, and therefore invests significantly in - and operates - technology-based systems to collect and track trading-related expense information with a high degree of precision. Constructing, maintaining, and supervising such a system is costly and subject to a great deal of investor and SEC scrutiny. Mistakes in such a system can lead to significant SEC fines and private party litigation initiated by mutual fund shareholders. By contrast, a hedge fund manager trying to satisfy best execution obligations does not have to create the same technology-based system, but can elect to periodically (e.g., quarterly) and manually review its internal trade processes and select a reasonable sample of trade data for review. Accordingly, in comparison with the mutual fund manager who is exposed to much higher regulatory and litigation risks, the hedge fund manager incurs minimal time and expense obligations in fulfilling best execution obligations.
# **IV. Confluence of Private and Mutual Funds**
Market-driven trends in financial markets suggest that traditional distinctions between mutual and hedge funds are eroding. Responding to investor demands for a combination of risk mitigation, liquidity, the lower fees, and the absolute returns of hedge funds, investment managers introduced so-called hybrid or alternative funds, including hedged mutual funds and synthetic hedge funds, and they increased side-by-side management of mutual funds and hedge funds. The growth of hybrid funds and public offerings of alternative asset managers, among other factors, allow retail investors increasing access to hedge-fund-like investments. Investor demand for alternative investment products will likely continue to shape the evolution of the two asset classes.
The fundamental reshaping of the regulatory landscape for the hedge fund industry intensifies the market-based assimilation of the private and mutual fund industries. The Dodd-Frank Act and the JOBS Act reframe core regulatory assumptions about the hedge fund industry and support the increasing recognition of hedge funds’ critical role in capital formation. These regulatory changes increase the demand for retail alternative funds and may supplement the confluence of the mutual and hedge fund industries.
# _1. Investor Preferences_
Market-driven trends in financial markets suggest that the traditional distinction
design and implement a system to value in real-time every position in a trading portfolio, not just with respect to technology, but in other infrastructure (e.g., people).
> 27 Securities; Brokerage and Research Services, Exchange Act Release No. 34-23170, 51 Fed. Reg. 16,004,
> 16,006 (Apr. 30, 1986); In re Portfolio Advisory Serv., Investment Advisers Act Release No. 2038, 35 SEC Docket 703, 2002 WL 1343823, at *2 (June 20, 2002).
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between mutual and hedge funds is dissipating. Starting in the mid-2000s, retail investor demand for absolute returns precipitated public offerings of alternative asset managers (Davidoff (2008) and Timmons (2006)) and, despite regulatory restrictions,<sup>28</sup> retail investors gained increasing access to hedge-fund-like investments through exchange traded funds (ETFs) and ever more sophisticated publicly available trading tools (Davidoff (2008)).
The market-driven confluence of mutual and hedge funds is perhaps best illustrated by the rise of retail alternative funds in the early 2010s (Citi Fund Services (2010)). Alternative mutual funds are investment vehicles that are legally structured as mutual funds and registered under the 1940 Investment Company Act. Despite different legal obligations and opposing incentives for private and mutual fund managers who operate alternative mutual funds,<sup>29</sup> alternative mutual funds offer the attractive features of mutual funds, such as significant diversification, daily pricing and liquidity, relative stability, and transparency. By offering investors exposure to hedge fund strategies (including going short, investing in illiquid securities, currencies, long-short equity, private equity, real estate, commodities, and global macro) and certain asset classes, complex trading techniques, and leverage, retail alternative funds combine mutual fund characteristics with the more aggressive strategies and the corresponding prospect of absolute returns of hedge funds (Kaal & Anderson (2016)). Changes to the capital markets precipitated by the financial crisis of 2007-08, investors’ post crisis flight to safety, a very low interest rate environment, in combination with the enormous growth, increased visibility, and popularity of hedge funds created and, over time, increased, the demand for alternative mutual funds (McKinsey (2014)). Alternative funds generally cannot generate the same absolute returns as hedge funds (Hasanhodzic & Lo (2007) and McCarthy (2015)), which is attributed by some to the lighter touch regulation and better incentives applicable to hedge funds. The increasing availability of alternative funds can have an effect on the overall demand for hedge funds (Stulz (2007)) and startup hedge funds (Kaal (2016b)).
Retail investors are a core factor for the proliferation of the retail alternative fund market. Starting in the early 2000s, retail investors, traditionally excluded from hedge fund investments, gained access to hedge-fund-like investments through exchange traded funds (ETFs) and ever more sophisticated publicly available at-home trading tools (SEI
28 17 C.F.R. § 230.506(c)(ii) (2014) (“Verification of accredited investor status. The issuer shall take reasonable steps to verify that purchasers of securities sold in any offering under paragraph (c) of this section are accredited investors.”)
29 Differences persist in the nature and scope of the obligations faced by mutual fund managers and those applicable to the private investment advisers who serve as subadvisers to funds/ subfunds/accounts of a mutual fund. Very few substantive obligations exist for private fund managers who agree to subadvise a mutual fund or account. More specifically, none of the mutual fund manager’s regulatory obligations (such as daily valuation, public/SEC reporting, independent boards, etc.) apply to the private fund subadviser. Hence, participating as a liquid alternative subadviser may be a great deal for the private fund manager: the private fund adviser gets access to “sticky” capital (i.e., redemption from the “registered fund” may be drawn out, if it occurs) and likely in a meaningful quantity (e.g., initially in excess of $25-30 million, which is a good “ticket” in the private fund space), and the manager is able to associate its name with a mutual fund adviser, which has some potentially positive marketing implications. While private fund advisers and mutual fund advisers may be sharing an investment strategies via liquid alternative funds, the regulatory obligations of private and mutual fund advisers in a subadvised mutual fund offering are likely to remain dissimilar.
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(2013)). Alternative funds offered retail investors access to hedge fund strategies and higher returns than mutual funds while paying mutual fund fees, thus increasing demand by retail investors. Because of investment managers’ recognition of retail investors’ demand for alternative funds, retail investors gained increasing access to a broader array of alternative investment strategies, further increasing demand for alternative investments (McKinsey & Company (2014)). Retail investors are driving the overall demand in the alternative investment sector, seeking more than just the prospect of significant performance but also risk-adjusted and consistent returns that are not correlated to the market (Citi Fund Services (2010) and McKinsey & Company (2014)).
Multimanager series trusts illustrate the consumer demand-driven confluence of mutual and hedge funds. As a proliferating alternative model of mutual fund governance (SEC IM Guidance (2014)), multimanager series trusts enhance retail investor access to alternative funds (Krug (2016)). The traditional mutual fund governance model is characterized by a single group of directors that is typically beholden to the sponsoring investment advisor firm (Morley & Curtis (2010), Roiter (2016) and Krug (2013)), serving as a single board for multiple discrete funds (Morley & Curtis 2010)). The traditional governance model is, thus, subject to significant oversight challenges (Krug (2016)). By contrast, multimanager series trusts are not centered on the investment adviser but rather the funds’ administrator (Krug (2016)) a firm that is typically unaffiliated with the sponsoring adviser. Multimanager series trusts create numerous advisers, each managing one or a small number of funds within the group (Securities and Exchange Commission Press Release (2013)), providing governance improvements (Krug (2016)). The growth of the multimanager series trust governance model can be traced back to elevated retail investor demand for alternative investments and the associated increase in investment managers. In particular, growing numbers of smaller investment advisers (by assets under management) (Kern (2012)), hoping to attract retail investors, benefit from cost efficiencies associated with multimanager series trusts, which further enhances the growth of that governance model. The combination of factors enhancing the growth of this governance model, especially cost efficiencies for a rapidly growing number of smaller investment advisers trying to attract retail investors, elevates the confluence of mutual and hedge funds. The cost savings associated with the multimanager series trust governance model allow the increasing number of smaller hedge fund investment advisers to attract retail investors by setting up a mutual fund.
Finally, investment advisers satisfy investor demand for retail alternative products partially through side-by-side management of mutual and hedge funds. Side-by-side management describes the simultaneous management of both a mutual and a hedge fund (Nohel et al. (2010) and Cici et al. (2010)). Side-by-side management has been steadily increasing since 2010 and is expected to continue to rise as investment advisers are seeking to offer their clients a combination of hedge fund characteristics with the benefits associated with mutual funds (Cici et al. (2010)). An important limiting factor in the steady rise of side-by-side management is the inherent conflict of interest for the investment manager (SEC (2003), Chen & Chen (2009) and Cici et al. (2010)). Conflicts of interest can arise in situations where the investment adviser for the retail alternative fund manages both the fund and separate private or proprietary accounts, such as hedge funds (SEI (2013)). While the investment adviser does have a fiduciary obligation in this situation, the investment adviser has incentives to give preferential treatment to the hedge
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fund accounts that are associated with higher compensation (the 2 and 20 model vs. mutual fund fee structure) for the investment adviser.
# _2. Regulation_
The mutual and hedge fund industries evolved in different legal settings. Unlike hedge funds **,** mutual funds have traditionally been subject to a comprehensive system of federal oversight under the Investment Company Act of 1940 (ICA), as amended , including restrictions on compensation structures, numerous reporting requirements, and restrictions on leverage and investments, among others (Riggs et al. (1996) and Investment Company Institute (2015)). Hedge funds, on the other hand, throughout their history have been able to remain largely exempt from federal regulation, provided hedge fund advisers and their legal counsel complied with applicable safe harbor requirements. Through applicable exemptions from registering as investment companies, exemptions from registering their securities, and exemptions from registering the investment advisers, hedge funds have traditionally been able to operate in the financial markets without significant regulatory oversight. Without significant regulatory oversight, hedge funds were able to employ more exotic investment strategies involving more leverage to generate absolute returns for their investors.
The fundamental reshaping of the regulatory landscape for the hedge fund industry eradicates many of the legal differences separating the two industries. The Dodd-Frank Act<sup>30</sup> and the Jumpstart Our Business Startups (“JOBS”) Act<sup>31</sup> made important contributions to the increasing recognition of hedge funds’ critical role in capital formation and helped transition the hedge fund industry from a secretive association of elite investment managers to a more widely-recognized group of investment professionals (White (2013)).
The Dodd-Frank Act and the JOBS Acts converged formerly distinct legal rules applicable to the formerly distinct asset classes. The registration and increased disclosure requirements for certain hedge fund advisers under the Dodd-Frank Act subjects investment advisers to hedge funds to similar registration and reporting obligations as mutual fund advisers. Similarly, the removal of advertising restrictions for hedge fund advisers under the JOBS Act and the equal treatment of mutual and hedge funds for FSOC’s SIFI designation in effect assimilated the advertising requirements of mutual and hedge funds.
The registration and disclosure requirements for hedge fund advisers under the Dodd-Frank Act illustrate a core point of confluence of the legal regimes applicable to mutual and hedge funds. While the registration and disclosure requirements for hedge fund advisers under the Dodd-Frank Act are significantly less onerous than the registration regime applicable to mutual funds,<sup>32</sup> several core overlaps of the two
> 30 Dodd-Frank Wall Street Reform and Consumer Protection (Dodd-Frank Act), Pub. L. No. 111-203, §§ 401-416, 124 Stat. 1376, 1571 (2010).
> 31 Jumpstart Our Business Startups Act, Pub. L. No. 112-106, § 201(a)(1), 126 Stat. 306, 313-14 (2012).
> 32 Mutual Funds also must disclose use and details of derivatives contracts they trade, _see_ Investment Company Reporting Modernization, Investment Company Act Release No. 31610, 80 Fed. Reg. 33,590 (proposed Jun. 12, 2015); _see also_ Notice of Filing of Proposed Rule Change Relating to Amendments to NYSE Arca Equities Rule 8.600 to Adopt Generic Listing Standards for Managed Fund Shares, Exchange Act Release No. 34-76486, 80 Fed. Reg. 12,690 (proposed Mar. 10, 2015) (although no limitation on the
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registration regimes illustrate the confluence of mutual and hedge funds. For the first time in the history of the hedge fund industry, the Dodd-Frank Act required most advisers to hedge funds to register with the SEC. By eliminating previous registration exemptions and requiring investment advisers with assets under management (AUM) of more than $150 million to register with the SEC,<sup>33</sup> the Dodd-Frank Act mandated SEC registration and reporting of information that was hitherto considered proprietary and private.
Hedge Funds are becoming more like mutual funds because they are allowed to advertise. A key legal distinction between mutual and hedge funds was their unequal treatment for purposes of advertising. Mutual funds advertised broadly across multiple forms of media while hedge fund advisers were prohibited from advertising.<sup>34</sup> After more than six decades of private offerings with a ban on general solicitation and general advertising (GSGA) that applied when companies or funds make private securities offerings under Rule 506 of Regulation D,<sup>35</sup> with the passing of the JOBS Act in 2012<sup>36</sup> the SEC finally had a mandate to amend Rule 506.<sup>37</sup> The SEC’s new proposed Rule 506(c), for the first time, allowed GSGA in a Regulation D offering.<sup>38</sup> The Rule was finalized and published in the Federal Register on June 24, 2013, and became effective on September 23, 2013.<sup>39</sup>
The equal treatment of mutual and hedge funds as nonbank financial institutions for purposes of designating an entity a Systemically Important Financial Institution (SIFI) supports the identified trend towards legal confluence of these formerly more clearly distinct asset classes. The Dodd-Frank Act created the Financial Stability Oversight Council (FSOC),<sup>40</sup> a council of banking and securities regulators tasked with monitoring
percentage of an active ETF’s portfolio that may be invested in derivatives, ETFs would have to disclose more information about such contracts.).
33 Dodd-Frank Act §§403, 408 and 410 (removing exemptions for private fund investment adviser registration under the Investment Advisers Act of 1940 and mandating investment adviser registration at over $100k AUM).
34 15 U.S.C. §§ 80a-3(c)(1) (2006) (the pre-JOBS Act law banning private fund advertising).
35 Advertising was banned under the previous Rule 506- Revision of Certain Exemptions from Registration for Transactions Involving Limited Offers and Sales, Investment Company Act Release No. 33-6389, 47 Fed. Reg. 11,251 (Mar. 16, 1982). For discussion about why the solicitation ban was likely overinclusive and impeded full regulatory transparency- Martin (2014).
36 Jumpstart Our Business Startups Act, Pub. L. No. 112-106, § 201(a)(1), 126 Stat. 306, 313-14 (2012). 37 Section 201 of the JOBS act directed the SEC to lift the prohibition against general solicitation or general advertising, allowing a broadening of marketing efforts provided that all purchasers of the securities are accredited investors. Jumpstart Our Business Startups Act, Pub. L. No. 112-106, § 201(a)(1), 126 Stat. 306, 313-14 (2012). Under Section 201(a)(1) of the JOBS Act, the SEC is required to revise Rule 506 not later than 90 days of the enactment of the JOBS Act, i.e., July 4, 2012. However, the SEC Proposing Release was not issued until August 2012 and was finally adopted in October 2013.
38 Eliminating the Prohibition Against General Solicitation and General Adverting in Rule 506 and Rule 144A, Release No. 33-9354, 77 Fed. Reg. 54,469 (proposed Sept. 6, 2012) at 6 [hereinafter Rule 506(c) Proposing Release].
39 Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, Securities Act Release No. 33-9415, 78 Fed. Reg. 44,771 (Jul. 24, 2013) (codified as amended at 7 C.F.R. pts. 230, 239, 242). [hereinafter Final 506 Rule], http://www.sec.gov/rules/final/2013/33-9415.pdf.
40 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), Pub. L. No. 111-203 § 111, 124 Stat. 1376 (2010).
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systemic risk in U.S. financial markets<sup>41</sup> and correcting perceived regulatory weaknesses that may have contributed to the financial crisis of 2008–2009.<sup>42</sup> SIFI designation changes the regulatory burden for a nonbank financial institution substantially,<sup>43</sup> and may require a bolstering of the entity’s balance sheet and curtailing of risk. It can impact the respective entity’s growth (Elliot (2013)). While evidence exists that SIFI designation could have disparate affects on mutual and hedge funds (Stevens Letter (2015), the applicable regulatory framework does not distinguish between the two asset classes.<sup>44</sup> The three-stage process applied by FSOC for SIFI designation<sup>45</sup> does not distinguish between mutual and hedge funds.<sup>46</sup> In fact, while Dodd-Frank prescribes several considerations that the Council must take into account in its determination of what entities qualify as Systemically Important Financial Institution (SIFI), FSOC has some discretion in the systemic risk assessment process.<sup>47</sup>
# **V. Implications of Confluence**
The factors of mutual and hedge fund confluence identified in this chapter could over time have broad implications in several contexts. First, the confluence factors can affect the evolution of the hedge fund industry and its role in capital formation. Second, confluence has the potential to introduce and facilitate alternative mutual fund governance models that promise addressing core governance shortcomings in the mutual fund industry. Third, the factors of confluence can further increase the demand for and proliferation of retail alternatives, which in turn can accelerate confluence of the two
41 The Dodd-Frank Act defines potential systemic risk posed by U.S. or foreign nonbank financial entities as the “material financial distress at the [company], or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the [company that], could pose a threat to the financial stability of the United States.” Dodd-Frank Act § 113(a)(1)
42 Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Investment Advisor Release No. IA-3308, 76 Fed. Reg. 71,128 _,_ 71,129 (Nov. 16, 2011); _see also_ Dodd-Frank Act § 112(a)(1)(A)–(C).
> 43 Dodd-Frank Act § 115(a)(1) ( once designated as a SIFI, the respective entity will be subject to extensive regulation and supervision by the Federal Reserve Board under Title I of the Dodd-Frank Act); _Id_ . at § 115(a) ( noting that the regulatory standards for nonbank financial firms under Fed supervision are more stringent than the standard for nonbank financial firms outside of Fed supervision); _Id._ at § 115(b)(1) . 44 The latest FSOC solicitation for comment on SIFI designation makes no attempt to separate the two in their designation and risk criteria. Financial Stability Oversight Council, Notice Seeking Comment on Asset Management Products and Activities, 79 Fed. Reg. 77,488 (Dec. 24, 2014).
45 The numerical thresholds considered by FSOC in stage one, excluding nonbank financial institutions from review if they do not exceed threshold considerations, apply to all nonbank financial institutions and do not distinguish between asset classes. 12 C.F.R. § 1310 app. A(III)(a). Only those nonbank financial institutions that raised systemic concerns in stage one will be subject to more institution-specific and qualitative evaluation in stage two and thereafter possibly stage three. In stage two FSOC prioritizes those nonbank financial institutions identified in stage one based on quantitative and qualitative public and regulatory sources of information and initiates the consultation process with the primary financial regulatory agencies. 12 C.F.R. § 1310 app. A(III)(b). In stage three, FSOC contacts each identified nonbank financial institution to collect additional information that was not available in stages one and two. § 1310 app. A (III)(c). The combined information from all three stages is then evaluated. 46 12 C.F.R. § 1310 app. A(III) (applying same standards to all nonbank financial companies). 47 The quantitative systemic risk assessment measures are not specifically codified. FSOC can change thresholds and analysis via the rule making process _–_ Dodd-Frank Act §§ 113(a)(1), (a)(2)(K); 12 C.F.R. § 1310 app. A (2014).
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asset classes. Finally, the factors of confluence may have a lasting impact on the public/private distinction in federal securities regulation.
The emerging process of confluence of mutual and hedge funds can have unexpected peripheral effects that may themselves reinforce confluence of the two asset classes. I do not claim cause and effect in this context. Nor do I suggest that any of the observed possible effects will have drastic immediate repercussions for market participants. Rather, the discussion of confluence trends observed herein is intended to highlight possible long-term implications and peripheral effects that merit continued monitoring.
# _1. Evolution of the Private Fund Industry_
Confluence of private and mutual funds impacts the market position, recognition, and overall evolution of the hedge fund industry. Policy makers and commentators have traditionally excluded the private fund industry from mainstream finance. The high profitability of the private fund industry in combination with its penchant for secrecy alienated politicians (Knowles (2015), Sanders (2014), and Seretakis (2013)) and regularly triggered calls for increased oversight (Christie and Katz (2011)). The compensation of hedge fund managers has particularly angered many policy makers and regularly triggers public outcries for increased regulation (Lowenstein (2015), Stevenson (2015), and Fleischer (2015)). The media regularly accuses the hedge fund industry of excessive speculation (Mills (2003)) that impacts commodity markets, the real economy, and consumers (Allen (2010), Jickling & Austin (2011) and Elias (2014)). In fact, since its inception in the 1940s, the hedge fund industry has been the poster child for reckless investments and high risk-taking in financial markets (Mallaby (2011) and Lhabitant (2007)). It has often been accused of fostering systemic risk (Lee (2015)). Politicians and commentators blamed the hedge fund industry for triggering the financial crisis of 200708.<sup>48</sup> Policy makers regularly use the industry as a scapegoat when financial markets experience volatility (Lowenstein (2015) and Crutchfield et al. (2009)).
Factors associated with confluence of mutual and hedge funds help the hedge fund industry transition from an industry operating at the fringes of finance to be recognized as part of mainstream finance (Baghai et al. (2015) and Muhtaeb (2012)). Hedge funds have been able to proliferate and increasingly attract investors due in part to the Federal Reserve’s policies and resulting low interest rates in the early 2010s (Stevenson (2015) and Shilling (2012)). Unprecedented changes in the rules and regulations pertaining to the hedge fund industry under Title IV of the Dodd-Frank Act and the JOBS Act<sup>49</sup> allow increased oversight of the industry and contribute to the increasing recognition of the hedge fund industry as a fully regulated asset class. These changes established the hedge fund industry not only in the eyes of investors but also in the eyes of the SEC. Epitomizing the increasing recognition of the hedge fund industry and its important role in capital formation, in 2013 SEC chairwoman Mary Jo White declared, “Private funds, including hedge funds, play a critical role in capital formation,
> 48 _Hedge Funds and the Financial Market: Hearing Before the H. Comm. on Oversight and Govt. Reform_ , 110th Cong. 2 (2008) (statement of Rep. Waxman).
> 49 Including mandatory private fund adviser registration and disclosure requirements under the Dodd-Frank Act and general advertising and general solicitation criteria under revised Rule 506 of Regulation D under the Securities Act of 1933.
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and are influential participants in the capital markets” (White (2013)).
# _2. Mutual Fund Governance_
The confluence of mutual and hedge funds can also influence mutual fund governance. The proliferation of multimanager series trusts, for example, established a hitherto nonexistent alternative governance model for mutual funds. Given the proliferation of confluence between mutual and hedge funds, it is possible that other governance models for mutual funds emerge over time. Multimanager series trusts can support mutual fund governance. Unlike the board in a traditional mutual fund governance setting, the board in a multimanager series trust arrangement is largely independent of any advisers within the fund group. Thus independent directors on the board are not subject to conflicts of interest that often exist in traditional mutual fund governance settings (Roiter (2016) and Morley & Curtis (2010)) if directors are affiliated with the investment adviser. Apart from its involvement in approving each adviser in a group structure, the board in the trust setting also typically has no involvement in selecting the group’s investment advisers, creating fewer incentives for the board to comport with advisers in contradiction of fiduciary obligations (Krug (2016)). Despite the open issues and possible shortcomings of the multimanager series trust model, the trust model governance structure for mutual funds appears to offer lasting substantive governance improvements for mutual funds (Krug (2016)).
# _3. Retail Alternative Fund Growth_
Factors of mutual and hedge fund confluence increase the demand for retail alternative funds. While the Market-driven proliferation of retail alternative funds itself drives confluence, several additional nonmarket confluence factors support the growth of the market for alternative funds. For instance, several provisions in the Dodd-Frank Act revised legal requirements applicable to hedge funds and in effect assimilated the legal requirements of mutual and hedge funds. Merging the regulatory requirements applicable to mutual funds with the formerly more distinct rules applicable to hedge funds creates incentives for private investment managers to set up retail alternative funds. A higher supply of retail alternative funds, in turn, is likely to further increase investor demand for retail alternative funds. A higher demand for retail alternative funds, in turn, precipitates more sustainable market-driven confluence of the mutual and hedge fund industries.
The mandatory investment adviser registration provisions under the Dodd-Frank Act incentivize investment advisers to set up retail alternative funds. Prior to the enactment of the Dodd-Frank Act, the registration of a hedge fund was a significant disincentive for investment managers to enter into the mutual fund sector. Investment advisers to hedge funds disfavored registration with the SEC because they considered the associated disclosures intrusive and feared negative affects on profitability. By eliminating previous registration exemptions and requiring investment advisers with assets under management (AUM) of more than $150 million to register with the SEC,<sup>50</sup> the Dodd-Frank Act mandates SEC registration and reporting of information
> 50 Dodd-Frank Act §§ 403, 408, 410 (removing exemptions for private fund investment adviser registration under the Investment Advisers Act of 1940 and mandating investment adviser registration at over $100k AUM).
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that was hitherto considered proprietary and private. Hedge fund advisers who are required to register with the SEC have incentives to also manage mutual funds or set up retail alternative funds because the regulatory burden is minimally higher in comparison with preregistration legal requirements. Some registered hedge fund advisers may choose to offer hedge fund strategies in a mutual fund setting, thus increasing the trend towards confluence.
In addition to the restrictions applicable in accordance with the qualified purchaser definition in section 3(c) (7) of the 1940 Investment Company Act, the tightening of accredited investor provisions under the Dodd-Frank Act increases investor demand for retail alternative funds. The Dodd-Frank Act increases restrictions on certain individuals and institutions that previously qualified as accredited investors,<sup>51</sup> rendering an increasing number of investors ineligible for hedge fund investments.<sup>52</sup> The DoddFrank Act decreases the number of eligible hedge fund investors by raising the minimum net-worth requirement for individuals to qualify as “accredited investors.”<sup>53</sup> While the number of such investors may be negligible, investors who no longer qualify for retail alternative fund investments under Dodd-Frank qualified investor standards are likely to seek out hybrid funds.
Limitations to bank investments in the hedge fund industry, mandated by the Dodd-Frank Act, incentivize retail alternative fund investments for banks. Banks have traditionally been one of the largest investor groups in the hedge fund industry (Preqin (2012)). Despite banks’ prominent position as investors in the hedge fund industry, the Dodd-Frank Act in its “Volcker Rule” provisions<sup>54</sup> severely restricts the ability of banks to be large investors in hedge funds. Dodd-Frank’s Volcker Rule provisions both prohibit banks and bank holding companies from engaging in most proprietary trading activities and investing in or sponsoring private equity and hedge funds.<sup>55</sup> The final regulations prevent bank holding companies from sponsoring or retaining an ownership interest in most hedge funds after July 21, 2015, except in very limited cases<sup>56</sup> . By limiting banks’ investments in derivatives and the hedge funds they sponsor,<sup>57</sup> the Dodd-Frank Act limits access to hedge fund investments but incentivizes banks to access hedge fund strategies using a retail alternative fund. Given the prior role of bank investments in the hedge fund industry, the shifting of investments from the hedge fund industry to the retail alternative fund market could be substantial (SEI (2013)).
The JOBS Act also creates incentives for investment advisers to set up retail alternative funds. The legal uncertainty of investor verification after the ban on
> 51 Dodd-Frank Act § 413 (removing the value of the primary residence from the calculation of net worth for purposes of accredited investor status, reducing the number of accredited investors.)
> 52 Dodd-Frank Act § 413.
> 53 Dodd-Frank Act § 413(b) (the commission also may review the accredited investor standard every four years and make adjustments to protect investors, perhaps opening up a possibility of increasing restrictions to the accredited investor standard in coming years); 17 C.F.R. § 230.501(a) (2014).
> 54 Dodd-Frank Act § 619.
> 55 Dodd-Frank Act § 619.
> 56 Prohibitions and Restrictions on Proprietary Trading and Certain Interest in, and Relationships with,
> Hedge Funds and Private Equity Funds, 79 Fed. Reg. 5,536, 5,538 (Jan. 31, 2014).
> 57 Dodd-Frank Act § 737 (limiting banks’ ability to take derivative positions). Dodd-Frank Act § 619 (limiting investment in private funds to no more than 3% ownership and no more than 3% of investing bank’s Tier 1 capital.) Dodd-Frank Act at Title VII (entailing additional capital and margin requirements and limitations on use of derivatives).
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GCGA was lifted, among other reasons such as path dependencies and peer pressure, creates disincentives for private investment managers to advertise. Investment advisers to hedge funds have better incentives to set up retail alternative funds that allow them to offer features that are attractive to retail investors rather than to advertise under the uncertain new regime (Rule 506(c)) in an effort to attract a now smaller pool of qualified investors that are willing to invest in their hedge funds.
Despite the regulatory trends and investor preference trends favoring increasing confluence of mutual and hedge funds, the SEC might counteract some of the confluence drivers. First, the SEC is attempting to curtail the use of some hedge fund strategies, such as derivative trading and short-selling, used by retail alternative mutual funds to mimic hedge funds. It issued a concept release in 2011, soliciting comments about the issues raised by derivative use in mutual funds, although so far no final action has been taken.<sup>58</sup> Additionally, the SEC may increase the portfolio reporting by mutual funds, ETFs, and other registered investment companies to include disclosure of the terms of derivative contracts and the counterparty risks posed by these contracts.<sup>59</sup> The SEC also amended Regulation SHO, restricting short selling of stocks that are subject to significant downward price pressure.<sup>60</sup> Investment advisers to mutual funds may not be able to use certain hedging techniques after the amendment of Regulation SHO, making it less likely for investment advisers running mutual funds to attract retail investors who are seeking alternative investment opportunities. Lastly, SEC leadership has indicated in recent years that they will vigorously investigate whether retail alternatives are complying with 1940 Act rules on valuations, leverage, disclosure, and liquidity (Katz (2014), Champ (2014), and Marriage (2014)). In a recent speech, SEC Commissioner Kara M. Stein called for enhanced regulations to deal with retail alternatives, quoting a colleague that such funds are “bright, new, shiny objects in the marketplace that are also very sharp and fraught with risk.”(Stein (2015)) Commissioner Stein stated that perhaps the SEC should consider regulating retail alternatives under a different regulatory regime than the one applied against traditional, plain vanilla mutual funds (Stein (2015)).
# _4. Structure of Federal Securities Law_
Mutual and hedge fund confluence contributes to the gradual erosion of the public/private distinction in federal securities regulation. The literature on the public/private distinction in federal securities regulation (Langevoort & Thompson (2013), Sale (2014), Sale (2011), and Thompson & Langevoort (2013)) examines factors that contribute to the continuous blurring of the traditional boundary lines between regulated and “private” firms and transactions including: reforms introduced under the
> 58 Use of Derivatives by Investment Companies Under the Investment Company Act of 1940, Investment Company Act Release No. 29776, 76 Fed. Reg. 55,237 (Aug. 31, 2011).
> 59 Investment Company Reporting Modernization, Investment Company Act Release No. 31610, 80 Fed. Reg. 33,590 (proposed Jun. 12, 2015); Notice of Filing of Proposed Rule Change Relating to Amendments to NYSE Arca Equities Rule 8.600 to Adopt Generic Listing Standards for Managed Fund Shares, 80 Fed. Reg. 12,690 (proposed Mar. 10, 2015) (although no limitation on the percentage of an active ETF’s portfolio that may be invested in derivatives, ETF would have to disclose more information about such contracts.)
> 60 Securities and Exchange Commission, Amendments to Regulation SHO, SEC Release No. 34-61595, 75 Fed. Reg. 11,232 (Mar. 10, 2010).
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JOBS Act, private investment in public equity (“PIPE”) transactions, reverse mergers, and the Crowdfunding Act (Hemingway (2014)). This chapter adds to that literature by pointing out additional regulatory confluence factors that undermine the traditional public/private distinction in federal securities regulation. In addition to the widely discussed new rule 506(c), (Thompson & Langevoort (2013) and Hurt (2013)) the regulatory confluence exemplified by the mandatory registration of hedge fund advisers and their heightened reporting obligations in combination with the equal treatment of mutual and hedge funds by FSOC in its SIFI designation processes underscore the perhaps accelerating erosion of the public/private distinction in federal securities law (Kaal & Anderson (2016)).
# **VI. Conclusion**
The evidence presented in this chapter suggests that an increasing number of mutual funds are becoming more like hedge funds as a matter of investment strategy while hedge funds are becoming more like mutual funds as a matter of the regulatory framework. Such confluence has several implications. The chapter shows that such confluence of mutual and hedge funds can have implications for the evolution of the hedge fund industry, the governance of the mutual fund industry, the growth of the retail alternative fund market, and the structure of federal securities regulation. The evidence listed herein suggests that the traditional public/private distinctions between mutual and hedge funds is eroding at a higher than previously anticipated rate.
The observed possible effects of confluence are unlikely to precipitate drastic immediate repercussions for market participants but possible long-term implications and peripheral effects merit continued monitoring and regulatory scrutiny. At the time of publication of this chapter, the author was not aware of an effort to extend the far more onerous regulatory regime pertaining to mutual funds, i.e., under the ICA, ’33 Act, ’34 Act, etc., to hedge funds, either directly through the SEC enacting regulations, or congressional legislation, or indirectly through the SEC’s enforcement processes, by which the agency might seek to effect some of that extension. However, while mutual funds have historically used little leverage (or leverage-creating derivatives) and presented little risk, the increasing demand for alternative strategies (Kaal & Anderson 2016) creates incentives for mutual fund managers to seek ways to simulate leverage. Given this trend, it seems at least possible that the mutual fund industry of the future could be subjected to more risk than the historical averages suggested in the past. Given the comparative size of the mutual fund and hedge fund markets (Managed Funds Association (2015)) and the possible systemic implications, this could be a concern that may merit continued monitoring, scholarly evaluation, and regulatory scrutiny.
Proposed SEC Rule 18f-4<sup>61</sup> constitutes a potential threat for the business model of the alternative mutual fund industry. The proposed rule could undermine alternative mutual fund managers’ ability to structure their portfolios in ways that would allow the implementation of their overall investment strategy using derivatives. The SEC warns that the alternative mutual fund industry may be particularly affected by the proposed rule’s risk-based portfolio limit. However, the implications of proposed Rule 18f-4 on the policy analysis in this chapter are limited. Proposed Rule 18f-4 is the product of
> 61 Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. 31933, 80 Fed. Reg. 80,883 (proposed Dec. 28, 2015).
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several years of interactions between the industry and the SEC (starting in 2011) over a broader issue that is only indirectly related to the analysis of confluence factors in this chapter: whether mutual funds are taking on too much investment risk through derivatives.<sup>62</sup>
# **References**
12 C.F.R. § 1310 app. A(III)(a) (2015).
15 U.S.C. § 77b (15) (2012).
15 U.S.C. § 80a-10(a) (2012). 15 U.S.C. § 80a–35(b) (2012). 15 U.S.C. § 80b–3 (2012). 15 U.S.C. 80a-22(e) (2012). 17 C.F.R. § 230.501(a) (2015). 17 C.F.R. § 230.506 (2015). 17 C.F.R. § 270.22c-1(b) (2015). 26 U.S.C. § 851(b)(2) (2012).
- Allen, Katie, 2010, “Hedge Funds Accused of Gambling with Lives of the Poorest as Food Prices Soar,” _The Guardian_ (July 18), available at https://perma.cc/HWA8-ZEXQ.
- Amendments to Regulation SHO, SEC Release No. 34-61595, 75 Fed. Reg. 11,232 (Mar. 10, 2010).
- Baghai, Pooneh, Omar Erzan, and Ju-Hon Kwek, “The $64 Trillion Question: Convergence in Asset Management,” _McKinsey on Investing_ , February 2015, https://perma.cc/KS4DL684.
- Browning, Lynnley, 2007, “A Hamptons for Hedge Funds,” _New York Times_ (July 1), available at https://perma.cc/QJ5T-WVJ6.
- Cavoli, James G. et al., 2010, The SEC’s Mutual Fund Fee Initiative: What to Expect, _Securities Litigation and Regulation_ 16, 1-14, available at https://perma.cc/VS9C-MUPD.
- Champ, Norm. “Remarks to the Practicing Law Institute.” Speech presented at the Private Equity Forum, New York, NY, June 30, 2014, available at https://perma.cc/K4FA-T2VP
- Chen, Li-Wen and Fan Chen, 2009, Does Concurrent Management of Mutual and Hedge Funds Create Conflicts of Interest?, _Journal of Banking and Finance_ 33,1423-33.
- Christie, Rebecca and Ian Katz, 2011, Hedge Funds May Pose Systemic Risk in Crisis, U.S. Report Says, _Bloomberg Business_ (February 17), available at https://perma.cc/QSR2-N9WU.
> 62 18f-4 is really the culmination of a long running debate on derivatives that the mutual fund industry, the SEC, the Senate and other regulators have been engaging in for several years. For the original SEC concept release, s _ee_ Use of Derivatives by Investment Companies Under the Investment Company Act of 1940, Investment company Release No. 29776, 76 Fed. Reg. 55,237 (concept release Sept. 7, 2011) (“The Securities and Exchange Commission (the ‘Commission’) and its staff are reviewing the use of derivatives by management investment companies registered under the Investment Company Act of 1940 (the ‘Investment Company Act’ or ‘Act’) and companies that have elected to be treated as business development companies (‘BDCs’) under the Act (collectively, ‘funds’). To assist in this review, the Commission is issuing this concept release and request for comments on a wide range of issues relevant to the use of derivatives by funds, including the potential implications for fund leverage, diversification, exposure to certain securitiesrelated issuers, portfolio concentration, valuation, and related matters.”)
CONFLUENCE OF MUTUAL AND PRIVATE FUNDS
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- Citi Fund Services, 2010, The Convergence of Traditional and Alternative Investment Products: Regulatory and Operational Considerations, _Investment Lawyer_ 17, 1-10.
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CONFLUENCE OF MUTUAL AND PRIVATE FUNDS
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- Investment Company Institute, 2015, _Investment Company Fact Book_ , 55th ed., available at https://perma.cc/EG69-6ZXQ.
- Investment Company Reporting Modernization, Investment Company Act Release No. 31610, 80 Fed. Reg. 33,590 (proposed June 12, 2015).
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CONFLUENCE OF MUTUAL AND PRIVATE FUNDS
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- Nohel, Tom, Z. Jay Wang, and Lu Zheng, 2010, Side-by-Side Management of Hedge Funds and Mutual Funds, _Review of Financial Studies_ 23, 2342-373.
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CONFLUENCE OF MUTUAL AND PRIVATE FUNDS
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CONFLUENCE OF MUTUAL AND PRIVATE FUNDS
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http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171514096.
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