Unconstrained Mutual Funds (UMFs) have proliferated in the recent past because of their attractive characteristics in an otherwise challenging investment environment. Record-low interest rates, significant market dislocations, and retail investors’ persistent efforts to boost income and protect capital have significantly increased the demand for UMFs in the last few years. In 2016, Morningstar categorized 448 mutual funds as involving some element of unconstrained or non-traditional characteristics. The popularity of UMFs can partially be traced back to their ability to pursue absolute returns in the fixed-income market without being affected by the constraints of conventional credit mutual fund benchmarks.

Managing UMFs provides investment managers with many benefits. The investment manager of a UMF typically has broad authority regarding the trading and investment of fund capital.

For example, the manager may have broad authority to take significant investment risks using derivatives, including as part of the investment adviser’s directional investment strategy, but also for hedging. Investment managers of UMFs may also be permitted to commit a significant percentage of the fund’s total capital to concentrated positions in one or more U.S. or non-U.S. issuers, or in particular U.S. or non-U.S. industrial sectors or markets; direct the fund to invest heavily in illiquid securities, non-investment grade securities, and potentially non-securities (e.g., bank loans); and shorten and lengthen the duration of the portfolio. Additionally, the manager may not be required to cause the fund to adhere to a performance benchmark or index. Many of these UMF benefits and characteristics are shared with private funds.

UMFs can exacerbate investment risks. For instance, some of the most popular UMF strategies could significantly increase a portfolio’s exposure to risk, especially during a downturn. UMFs are also characterized by high annual portfolio turnover. On average, UMF performance has disappointed over the last three years, with returns lower than the return on the 10-year Treasury; often poor UMF performance has been accompanied by high fees and increased credit risk. While the volatility of UMFs (3.83) was higher than that of intermediate funds (2.95), it was lower than that of long-term funds (5.98). According to some estimates, the average UMF has an annual turnover of around 198 percent; in other words, in the course of a calendar year, by Sept. 30 the average UMF could have turned over the entire securities portfolio it held as of the end of the preceding March. Moreover, the complexity of UMF trading has increased so much that leading analysts struggle to assess UMF portfolios and their performance. Because UMFs are not linked to any specific index and frequently may invest in bonds, interest rates, currencies, and securities, with a reservation of rights by the manager to trade even more types of securities and instruments in diverse markets while also engaging in short selling, some call these vehicles “go anywhere” funds.

1.  Regulatory differences between UMFs and private funds

Unlike private funds, as mutual funds UMFs are subject to the extensive regulatory requirements of the Investment Company Act of 1940, among many other legal requirements. Compliance with the provisions of the Company Act means that UMFs may be marketed and sold to all classes of retail investors, including retail investors who have limited, or even no experience investing in securities. Private funds, in contrast, are not marketed to retail investors. Instead, the opportunity to invest in a private fund is restricted to those who meet particular experiential and net worth investment criteria indicating that they are able to understand the risks associated with investing in the fund, including the risk that their investment could lose all or the greater part of its value. Because private fund investments are restricted to investors deemed to be sophisticated – a category that does not include the majority of retail investors – private funds generally are exempt from the registration and other substantive provisions of the Company Act.

In contrast with mutual funds and UMFs, private funds are generally not required to comply with the substantive requirements of the Company Act. This means, for example, that a private fund need not: register with the SEC; register a class of shares with the SEC; provide periodic financial and individual portfolio holdings information to the SEC or to investors; comply with Rule 12b-1 regarding the use of fund assets to pay fund marketing expenses; comply with the requirement to strike a NAV on a daily basis; pay investor redemption proceeds within seven (7) days; or limit its short selling or borrowing, including through the use of derivative contracts. Moreover, unlike for mutual funds (including UMFs), private funds are not required to have independent directors.

Operating a private fund without the duty to comply with the Company Act obligations that apply to mutual funds provides the private fund manager with significant benefits. For instance, the private fund manager has far greater flexibility to pursue diverse investment strategies, and to structure the terms of the contract between the fund and its investors. In particular, the manager may structure the fund to attain objectives that would be inconsistent with investor protection mandates common to mutual fund advisers. Those objectives may include: investing in sectors outside of the manager’s specialization, using any type of equity or fixed income securities or derivative instruments; investing heavily in illiquid securities; engaging in no hedging of fund positions; taking concentrated positions in the securities of a particular issuer, or the securities of several issuers in a particular sector or geographic market (including in non-U.S. markets); borrowing heavily against the fund’s positions and cash; reporting infrequently to investors regarding fund performance; severely limiting the amount of information provided to investors regarding the fund’s portfolio (including by disclosing no information regarding significant positions which the fund has taken); limiting the number of redemption requests that an investor may submit in a particular period (e.g., for any trailing 12-month period); limiting the amount of capital that an investor may redeem at any one time; suspending redemptions by investors entirely, where it is consistent with the investment manager’s fiduciary duty to do so; and calculating the fund’s NAV according to a methodology selected by the investment manager. Finally, private fund advisers benefit from staying exempt from the Company Act to avoid the significant expenses incurred in registering and operating a mutual fund (including a UMF) subject to the Company Act.

2.  Shared characteristics of UMFs and private funds

Analyzing multiple metrics, UMFs share important investment strategy and risk attributes with private funds. UMFs and private funds use similar strategies and investment products; UMFs and private funds use dynamic trading strategies and derivative holdings to avoid parametric normal distributions; and UMFs use a higher proportion of derivatives than the average mutual fund. Because of these shared investment strategy and risk attributes, the average UMF’s risk profile is substantially more complex, and generally involves more risks than that of the average mutual fund, and is closer to the risk profile of a private fund.
UMFs and private funds use similar strategies and investment products. The average private fund is authorized to use dynamic trading strategies, leverage, and derivatives in order to deliver alpha to investors. UMFs use a higher proportion of derivatives than other mutual funds. Moreover, private funds employ a broad range of investment instruments, including the following: 15.3 percent employ strategies involving forward contracts; 21.2 percent employ strategies involving futures contracts; 21.8 percent employ strategies involving options; 17 percent employ strategies involving swap contracts; and 29.1 percent employ one of the prior listed four instruments. While these percentage holdings are generally consistent with the traditional role of a mutual fund in a portfolio (that is, as part of a long-only, buy-and-hold investment strategy based on an allocation to standard asset classes), UMF trading of these instrument types in the aggregate exceeds most of these thresholds. UMFs therefore appear to follow instrument selection and trading strategies comparable to those employed by private funds.

Like private funds, UMFs use dynamic trading strategies and derivative holdings to avoid parametric normal distributions. Because of their use of options, UMFs, like private funds, can generate options-like returns and exhibit non-normal payoffs. However, while private funds’ unique management incentives combined with their flexibility in investment strategy (e.g., the authority to use potentially unlimited leverage and derivatives, and to take highly concentrated positions and engage in potentially unlimited short selling) can help explain their performance advantage over mutual funds, the performance record for UMFs is less clearly distinguished from that of other mutual funds.

UMFs use a higher proportion of derivatives in their portfolio than do other mutual funds. According to some estimates, a total of 71 percent of private funds trade derivative securities, which is more than three times larger than the number of mutual funds trading such securities. UMF derivative transactions greatly exceed the number of derivative transactions engaged in by other mutual funds. This is a core characteristic that UMFs share with private funds, and another important point of contrast with other mutual funds.

UMFs’ greater use of derivatives relative to that of other mutual funds concomitantly increases those funds’ risk profiles above that of the average mutual fund. Mutual funds display no systemic difference in risk or return measures between funds that do and do not use derivatives. UMFs engage in a higher number of derivatives transactions than the average mutual fund. Some evidence suggests that mutual funds that use derivatives engage in less risk-shifting than mutual funds that do not use derivatives, and that there is little influence through derivative use on the fund flow-performance relationship. However, derivative use by UMFs is closer to that of a typical private fund, which may mean that the absence of evidence on risk-shifting by the average mutual fund that engages in derivatives transactions is less relevant.

The average portfolio turnover rate for UMFs suggests a level more consistent with the turnover rate of a private fund. The average turnover rate for a UMF exceeds the portfolio turnover rate for fixed income mutual funds by more than 150 percent. The turnover rate in UMF portfolios relative to that of other mutual fund portfolios suggests that UMFs trade at levels consistent with those of private funds. The higher UMF turnover rate relative to that of other mutual funds can be partially explained by the strategies pursued by UMFs, including the extensive use of derivatives among UMFs.

3.  Retail investor concerns

The growth in the number of UMF launches, in combination with important investment strategy and risk attributes shared by UMFs and private funds, raise several potential retail investor protection concerns. The “go anywhere” features of UMFs may impede a retail investor’s ability to ascertain and understand the UMF’s investments, and the risks associated with those investments. More specifically, the lack of standard benchmarks for UMFs, the recent emergence of UMFs as an investment asset type, and the diversity among and complexity of UMFs’ strategies and risk exposures make it uniquely challenging for retail investors to evaluate the risks of investing in UMF securities.

Retail investors may be led to believe that UMFs, because they are marketed, offered, and regulated as mutual funds, are “safe” products relative to other fixed income mutual funds. This is a risk that is unique to retail investors in UMFs: a private fund investor, who by definition is relatively more sophisticated and wealthier than a retail investor, would have no reason to believe that there is active government regulation of the private fund in a manner conceptually similar to what the SEC requires of mutual funds. Nonetheless, the mutual fund characteristics of a UMF may cause the average retail investor to conclude that the investor’s past experience selecting mutual fund investments for his or her personal portfolio will provide adequate grounding to understand the risks associated with purchasing UMF shares.

Any such conclusion would be mistaken, as retail investors in UMFs face many of the same types of investment strategy and other risks as those faced by relatively more sophisticated and wealthier investors in private funds, a group who the SEC has determined can “fend for themselves.” Accordingly, retail investors’ experience investing in “traditional” mutual funds is likely to be a poor indicator of whether a retail investor will understand the risks associated with investing in a UMF.

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Wulf A. Kaal

Wulf Kaal is a tenured associate professor of law at the University of St. Thomas School of Law in downtown Minneapolis. He is a leading expert on hedge fund regulation in the United States and the European Union.  Before entering the academy, Kaal worked for Cravath, Swaine & Moore LLP in New York and Goldman Sachs in London.  Kaal has published more than two dozen articles in the United States and Europe. His articles were published in leading peer reviewed law and finance journals and in American law reviews such as the Minnesota Law Review, the Washington & Lee Law Review, and the Wake Forest Law Review, among others.  Kaal’s study on the effects of hedge fund registration requirements under Title IV of the Dodd-Frank Act has gained national attention and was covered in a Business Week article and other journals. He is the author of a book chapter on Investment Advisers and Investment Companies in the Securities Law Handbook published by Edward Elgar.
He has also been a consultant to major corporations and hedge funds regarding various aspects of financial markets and regulation.

 Wulf A. Kaal
Associate Professor
University of St. Thomas School of Law
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