Alternative multi-manager mutual funds (AMMF) seem to give investors the best of both worlds: all the advantages of a traditional mutual fund (daily liquidity, lower fees, lower minimum investments, regulatory oversight) with exposure to hedge funds and other alternatives (better diversification, alpha generation). But there has been a steady performance drag over the last few years that could be a systemic problem caused by adverse selection of managers and sub-advisors.

AMMFs trail by about 200bps net fees

“While it’s still very early in the game, our analysis indicates that AMMFs are likely to be subject to a persistent performance drag over time,” writes Andrew Beer, CEO of hedge fund advisory firm Beachhead Capital Management. “Based on the more robust data pool from other liquid alternatives, our expectation is that the performance drag should be around 200 bps per annum, net of fees.”

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Investors need to watch out for poorly aligned incentives (as always)

Beer argues that the performance drag isn’t going anywhere because it arises from a built-in misalignment of incentives and the simple fact that forcing hedge fund strategies into the mutual fund box doesn’t always work.

AMMFs have to find hedge fund managers who are willing to manage sub-accounts at lower fees than they normally charge. For a successful manager with a closed fund and plenty of work to do, that’s a non-starter. So what’s left are middle of the pack managers (or worse) who need the work, probably for a reason. This could be rectified by offering higher fees, but even then hedge fund managers can’t be expected to cannibalize their own businesses. Their best ideas will go to the hedge fund instead of the sub-account unless there’s enough volume to make the same play for both, and even then investing for the hedge fund first could move the market before the sub-account gets involved.

If you’re considering investing in an AMMF, Beer thinks it’s fair to ask if how many sub-advisors or investment strategies have been rejected because the fees were too high. If you get a song and dance about keeping fees low, you have to wonder if the AMMF manager is settling for second tier sub-advisors.

Second, the appeal of starting a hedge fund is the lack of restrictions on which investments you can make. It’s not that surprising that taking even high performing hedge fund managers and forcing them to make trades within the confines of mutual fund regulations gives worse results. You might be tapping their talent, but in a different capacity than the manager’s hedge fund clients.