Alternative mutual funds, or liquid alts, are still a new phenomenon, with few extending back to before the financial crisis, but total assets under management are estimated to have already past the $200 billion mark. Whether it’s an alternative fund manager wrapping his strategy in 1940 Act regulations to tap the retail market or mutual fund managers branching out to win back the clients they are losing to ETFs, someone is learning on the fly and the Securities and Exchange Commission is conducting a coordinated review of 25 institutions that run liquid alt funds to make sure that risk is being adequately assessed and communicated to investors.

Alternative mutual funds, liquid alts

“The SEC is keen to shift from reactionary regulation (for which the agency was criticized after the 2008 crisis) to proactive oversight,” write Scott Weisman, Kent Knudson, Todd Humphrey, and Lauren Leipold in a PricewaterhouseCoopers regulatory brief. “We believe the SEC will scrutinize liquid alts and their managers closely in the upcoming sweep, likely focusing on the following requirements that commonly challenge liquid alts managers: liquidity, leverage, investment allocation, governance and sub-advisor oversight.”

Liquid alts: Alternative mangers coming to terms with the 1940 Act

Alternative managers who have started liquid alts suddenly have to calculate daily net asset value (NAV), meet daily redemptions, and restrict the amount of leverage in their portfolios. That means venture capital, infrastructure, merger arbitrage, and many real estate deals aren’t really feasible. Direct borrowing for investment is prohibited by the 1940 Act, but indirect borrowing through options trading is allowed up to a point. Managers that are new to how the 1940 Act regulations are interpreted might not know exactly where the SEC draws a line in the sand.

With so many strategies off the table, alternatives managers will also have to be careful not to oversell their uncorrelated returns, since correlations will almost have to be higher than they would be with a hedge fund to keep illiquid holdings below 15% of the portfolio as required. If managers continue to run a hedge fund (which pays a performance fee) alongside the liquid alt (which typically doesn’t), they will also need to have clear policies in place to handle conflicts of interest.

Traditional mutual funds expanding into new asset types and strategies

“Traditional mutual fund boards may need additional education and expertise to understand liquid alts trading strategies, including short exposure,” says the PwC report. “The SEC has made it clear that competent and informed board governance in the liquid alts space is important.”

It’s one thing to know how to accurately keep tabs of NAV on a daily basis, but one of the themes of the last recession was professionals who didn’t understand how much risk they were holding in new financial instruments. Traditional mutual fund managers should be able to show that they really understand the new asset classes and strategies they are using and haven’t just jumped onto the latest hot trend.