The recent credit crunch and economic turndown are creating unique opportunities for alternative investment asset managers. With headlines screaming the death of asset allocation, many financial advisors (RIAs and broker/dealers) are looking beyond traditional stock & bond investments, which makes tactical hedge strategies very appealing. What few hedge managers realize is that their strategy may work inside a mutual fund, in a so-called 40 Act hedge fund-style mtual fund, thus opening the door to raising retail assets.

Morningstar is only tracking 132 hedge fund-like mutual funds, so the opportunity for new entrants with proven strategies is great. High profile alternative managers are responding and are now offering such vehicles. Recently Gemini Fund Services, LLC ("Gemini") has facilitated the creation of a series of hedge fund-like mutual funds.

Gemini is an expert in creating pooled investment solutions i.e. where multiple investors are managed through a single trading account. These include alternative (hedge) funds, mutual funds, closed-end funds, collective funds, and variable annuities. Gemini offers a holistic suite of services to hedge managers including alternative fund administration, creating 40 Act vehicles and fund conversions.

The following is a summary of common questions asked by hedge managers intrigued at the prospect of creating a 40 Act fund. Please note that the details given to each question are general representations.

1. Which investment strategies work in a 40 Act vehicle?
The flexibility available often surprises managers. While there are limitations on the amount of leverage available, shorting and the allocation to derivatives, in almost all situations faced by Gemini, a mutual fund was able to be created that followed the original strategy. These include tactical asset allocation, managed futures, distress debt, global distressed, long/short equity, market neutral, arbitrage, absolute return, real estate, quantitative, & strategic asset funds.

2. How long does the process take?
It takes typically four months to register a mutual fund. Much of this is taken up by the SEC review process.

3. Are there minimum assets under management?
There is no minimum size restriction to either a hedge or mutual fund, but unless the manager is willing to cover the fund�s costs themselves, a certain minimum assets under management is recommended to cover administration costs. An equity-focused alternative fund�s minimum for assets under management is typically $5 million. This is the minimum required to cover the costs of administration and the annual audit. Mutual funds are higher at $15 million, which covers the costs of administration, transfer agency, shareholder reporting, board oversight and compliance.

There are structures that allow the manager to reward seed investors, including an "I" share class that does not charge the 12b-1 fee.

4. What are the costs for each vehicle?
The fund administration and audit costs for a hedge fund start at around $60,000 per year. A mutual fund is closer to $175,000 per year. Set up and organizational costs range from $25,000 to $50,000.

The hedge fund related fees cover fund administration and the annual audit, including creation of the K1. For mutual funds, these fees cover fund administration, annual audit, shareholder reporting and support, transfer agency, corporate governance and compliance. The mutual fund $15mm AUM minimum assumes the fund is paying all operational expenses of the fund and, as such, there will be no additional out of pockets for the advisor. The $175,000 is per fund although multiple fund families will have expense savings.

5. What are the management fee options?
Mutual fund fees typically approach those of their peer group i.e. a manager wouldn't want their fees to be much higher than similar funds, especially if they wanted to promote the fund through the broker and RIA distribution channels. However, this is less of a constraint with so few hedge fund-style mutual funds in existence. Annual management fees can approach 200bps. In addition, some hedge fund-style mutual funds may implement a fulcrum performance fee as well.

Most mutual funds charge a 12b-1 fee, typically through their A share class, to compensate the distributor, which might include a broker or fund platform such as Schwab or Fidelity.

6. Can performance be ported over from the hedge fund to the mutual fund? What are the rules about porting performance?
Porting performance is an area that requires analysis for any specific strategy or fund, but in general, the originating fund must meet these criteria:

It must be a multimember fund: The fund must have multiple investors, which rules out an SMA, for example.

Be 3c1 registered: A 3c1 fund is limited to 99 accredited investors.

Utilize the same investment strategy; the 40 Act fund must follow the same investment strategy as the originating fund.

Porting performance requires the original hedge fund to close and convert into a mutual fund. A manager may instead wish to start a mutual fund that mirrors their existing unregistered fund. In both cases, the manager can disclose the performance of the unregistered vehicle in the mutual fund�s prospectus if they follow similar investment strategies. However, the performance of the unregistered fund can only be used for marketing purposes if the originating fund closed and was converted into a mutual fund.

7. What are the restrictions?
Diversification: 50% of a mutual fund�s assets must be invested in diversified assets. This means 50% of a fund�s assets must be in holding of 5% or less. A mutual fund can also satisfy the diversification requirement by investing in other registered investment companies, such as mutual funds or ETFs. Cash and cash products are always considered a diversified investment.

Leverage: Mutual funds cannot exceed 33% leverage. This rule refers to leverage used by the fund itself and not to any underlying funds. The underlying investments can use leverage and levered ETFs can be a useful part of a portfolio.

Derivatives:Mutual funds investments in derivatives are allowed with some restrictions and tactical allocation to certain ETFs can provide a pass through.

Shorting: Mutual funds can sell short. It requires a tri-party collateral account with the bank and broker with assets segregated to cover the positions. An alternative approach could be a tactical allocation to certain ETFs that sell short themselves.

Commodities: While there is no direct limit on commodity investments, a mutual fund must receive 90% of its income through passive investments. Commodities are considered non-passive. However, investments in commodity ETFs can be treated as equity (pass-through) but they may be tax inefficient. This differing tax treatment depends on how the ETF is structured. Most ETFs disclose the expected tax treatment and advisors should consult with the tax department of their administrator. Most Exchange Traded Notes (ECNs) are 1933 Act structures and can be treated as passive income for tax purposes.

Daily Redemption: Mutual funds have daily net asset value (NAV) calculations and daily redemptions. Because of the possibility of daily redemption, most mutual funds keep a certain amount of cash available at all times.

Illiquid assets: Mutual funds must provide daily liquidity, so illiquid assets are limited to 15%. Closed-end funds can have 100% illiquid assets and are traded on the exchange under their own ticker. Another option is a closed-end interval fund. These can accept daily inflows, but withdrawals are restricted typically to quarter-ends. Closed-end funds do require their own trust and distribution agreements.

Investments: There are percentage restrictions on investment into other mutual funds and hedge funds.

8. How do I stop cannibalization of investors from my existing hedge strategy?
Fund managers are obviously concerned that their investors may switch into the cheaper mutual fund. Hedge funds can mitigate this risk by applying institutional strategies, leverage, and exposure to their alternative investment, thus keeping their more sophisticated investors aligned with their goals.

9. How does the Board & Compliance work?
A number of firms, including Gemini, provide the option of a turnkey solution. Many new funds opt to use a series trust that provides a board of directors and compliance oversight. The mutual fund benefits from the economies of scale available through the use of these shared resources. The Northern Lights Fund Trust has over $4 billion in assets and around 70 funds.

10. How does distribution work?
Funds can benefit from distributors affiliated with their series trust. Those firms may provide a complete suite of supporting services including developing fund collateral, FINRA compliance oversight, etc.

Mutual fund managers may want to consider hiring a third party marketing firm (3PM) or their own fund wholesaler to market the fund directly to the individual registered representatives.

Eddie Lund is vice president ofo business development at Gemini Fund Services. Gemini's sister companies include Northern Lights Distributors, Northern Lights Compliance Services and GemCom LLC.

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