Creating a ’40 Act Mutual Fund: Top Questions

The recent economic downturn has created unique opportunities for alternative investment asset managers. With headlines screaming the death of asset allocation and new products and strategies like managed futures becoming available, many financial advisors (RIAs and broker/dealers) are looking beyond traditional stock & bond investments, which makes tactical hedge strategies very appealing. This has opened the door for alternative managers to access the 40 Act Mutual Fund space, thus allowing them to take advantage of some possible benefits* like:

• Efficiency: combine smaller accounts, ramp up strategy with ease, single trading account, more time to devote to high net worth clients
• Cost Savings: trading costs and shareholder servicing
• Growth: vast distribution and sales opportunities in retail, institutional, and RIA channels

Gemini Fund Services, LLC (Gemini Fund), is an expert in creating pooled investment solutions 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.

The following is a summary of common questions asked by managers intrigued at the prospect of creating a 40 Act Fund. Please note that the details given to each question are general representations and Gemini Fund would be delighted to discuss your specific needs on an individual basis.

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, many strategies work within the 40 Act structure. These include tactical asset allocation, managed futures, distress debt, global distressed, long/short equity, market neutral, arbitrage, absolute return, real estate, quantitative, and 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 for a mutual fund, but unless the manager is willing to cover the fund’s costs themselves, a certain minimum amount of assets under management is recommended to cover administration costs. Mutual funds typically break even around $15 million, which covers the costs of administration, transfer agent, shareholder reporting, board oversight and compliance.

4. What are the costs for creation and ongoing operating costs?
Set up and organizational costs range from $45,000 to $100,000 (not including platform addition fees) depending on the complexity and the structure of the fund.

At a minimum, the annual mutual fund operating expenses (not including sales & marketing expenses) are approximately $175,000 to $200,000.

These fees cover fund administration, annual audit, shareholder reporting and support, transfer agent, corporate governance and compliance.

5. What are the management fee options?
Mutual fund fees typically approach those of their peer group. A manager would not want his fees to be much higher than those of similar funds, especially if he wants to promote the fund through the broker and RIA distribution channels. Annual management fees typically range from 75 bps up to 150 bps, but can approach 200 bps.

6. Can performance be ported over from a hedge fund or SMA strategy to the mutual fund for marketing purposes? What are the rules about porting or using past performance?

Generally porting performance is an area that requires analysis for any specific strategy or fund. Some hedge fund performance can be ported if the hedge fund meets these criteria:

• The fund must have multiple investors.
• Utilize the same investment strategy; the 40 Act fund must generally follow the same investment strategy as the originating hedge fund.

Porting performance generally 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 his existing unregistered fund. In both cases, the manager can disclose the performance of the unregistered vehicle or SMA in the mutual fund’s prospectus if the new fund follows similar investment strategies and provided that certain other conditions are met.

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 holdings 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 fund investments in derivatives are allowed with some restrictions, although 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 which can accept daily inflows, but withdrawals are restricted typically to quarter-ends. Closed-end funds require their own trust and distribution agreements.

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

8. How do I stop cannibalization of investors from my existing hedge strategy?
Hedge fund managers are obviously concerned that their investors may switch into the less-expensive 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 the goals of the fund.

9. How does the Board & Compliance work?
Gemini Fund provides the option of a turnkey solution. Our series trusts, the Northern Lights Fund Trusts, provide 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 Trusts have over $13.8 billion in assets and over 140 funds.

10. How does distribution work?
In today’s market, distribution generally occurs through a platform or broker channel. Most mutual funds charge a 12b-1 fee, typically through an A-share class to help with the compensation of the distributor. Funds can benefit from Gemini Fund’s sister firm, Northern Lights Distributors, LLC (NLD), which has more than 500 selling agreements with different broker and fund platforms and is a member of FINRA. NLD provides a complete suite of supporting services including FINRA compliance oversight.

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

Industry Term Definitions
40 Act Fund: from the Investment Company Act of 1940, a fund registered as an “open-ended” investment company that issues redeemable securities

bps: basis point, a unit equal to 1/100th of 1% or .01%

ETF: exchange-traded fund, a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.

Long/short equity: a mutual fund strategy that mimics some of the trading strategies typically employed by hedge funds. Unlike most mutual funds, long/short funds use leverage, derivatives and short positions in an attempt to maximize total returns, regardless of market conditions. The amount of leverage used and the number of derivatives and short positions that long/short funds may contain are limited by law. These funds invest primarily in stocks.

Long position: buying a security with the expectation that the asset will rise in value

Passive investment: mirrors a market index

Short position: selling a security with the expectation that the asset will fall in value

*Note: Asset managers have different needs as well as assets under management, therefore these benefits are dependent upon those needs and assets and will vary from manager to manager.