Describing Liquid Alts Common Requirements under the Investment Company Act of 1940
Liquid alternative mutual funds have become a popular investment category, but they are not easily described by a single label. “Liquid alts” tend to exhibit risk, return, and regulatory characteristics unique to particular strategies. Because of their legal structure and status under the Investment Company Act of 1940 (’40 Act), however, funds investing in alternative strategies and asset classes share the following characteristics:
Daily pricing and liquidity. Liquid alternative mutual funds must calculate net asset value every business day and offer daily share redemptions with timely payment. To support daily liquidity, a 15-percent limit is imposed on the portion of the fund’s underlying portfolio that can be invested in illiquid securities.
Limitation on composition of underlying investments. To maintain qualification as a regulated investment company (RIC) and favorable tax treatment under the ‘40 Act, a fund must derive at least 90 percent of its income from permitted sources. This requirement is commonly referred to as the “income test,” and it is particularly relevant to many alternative strategies that require significant market exposure to commodity investments. Gains from trading in commodities—whether from physical holdings, commodity futures, or options—are classified as “bad income” and cannot be counted toward the 90-percent requirement of the income test without the use of specialized fund structures.
Limitations on leverage, shorting, and derivatives. The ‘40 Act limits funds’ use of leverage, short sales of securities, and derivative transactions. Leverage is limited to 33 percent of the gross asset value of the fund, using either derivatives or securities as margin collateral. Short sales of securities are limited as a proportion of the overall portfolio and require a tri-party agreement between the RIC, a prime broker, and an independent bank custodian. Derivatives trades require the use of segregated funds and asset coverage with liquid securities, designed to prevent excessive risk of loss and serve as a “practical limit on the amount of leverage the investment company may undertake.”1
Mandated standards of oversight and transparency. Portfolio holdings must be filed quarterly with the Securities and Exchange Commission (SEC) and made available to the public. Funds must be overseen by an independent board of directors, which owe a fiduciary duty to shareholders and must avoid conflict of interests. Fund investment strategies must be consistent, predictable, and aligned with the specification of the fund prospectus.
Prohibitions on portfolio concentration. Funds are required to maintain a specified level of diversification as mandated by the “asset diversification test,” which prohibits investing more than 25 percent of the fund’s portfolio with a single issuer or security. Some relief from this prohibition is possible if a large position is held in underlying funds that are themselves diversified, such as exchange-traded funds tracking a broad market index.
Fee structure. Federal law imposes a fiduciary duty on a mutual fund’s investment advisor regarding the compensation it receives from the fund, typically in the form of a management fee. This differs from hedge funds, where performance fees can reach 20 percent in addition to a management fee.
Lack of minimum eligibility requirements. Average retail investors have access to a broad spectrum of alternative strategies historically available only to institutional investors and high-net-worth individuals. The lack of minimum eligibility requirements also opens the door to the inclusion of liquid alternative strategies within defined contribution retirement plans. Widespread offering of liquid alternative strategies within employer-sponsored defined contribution retirement plans could transform the asset-management industry at large, considering that U.S. 401(k) plans contained more than $4.4 trillion in assets as of the second quarter of 2014 (ICI 2014).2
1 See https://www.sec.gov/divisions/investment/imseniorsecurities/ic-10666.pdf.
2 See http://www.ici.org/pdf/ppr_14_dcplan_profile_401k.pdf.
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