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Introduction and Overview of 40 Act Liquid Alternative Funds
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the aggregate portfolio remains in alignment with
trading rules and portfolio limitations.
In both instances, it is the aggregated fund that faces
off against trading and financing counterparties,
including prime brokers. Thus, the underlying sub-
advisers are required to use the broker-dealers and
partners dictated by the IM. There are often additional
operational challenges the IM must address with
these structures, since they need to have oversight
to ensure the fund remains in compliance with
trading rules and can meet the daily liquidity and
NAV requirements. Sub-advisers have an easier time
operationally in the multi-alt structure because,
as noted earlier, they typically contribute their sleeve
of the fund’s activity via a separately managed
account (SMA). The fund’s management fee earned
by the IM is shared with the fund’s sub-advisers.
A good example of the multi-alt mutual funds is the
Arden Alternative Strategies (ARDNX) fund, which
is sub-advised by hedge fund managers Babson,
Chilton, CQS, Eclectica, E&P, JANA, MatlinPatterson,
Numerica and York Capital. The fund has a distribution
agreement with Fidelity Investments.
Managed Futures Mutual Funds
Managed futures products and commodity mutual
funds have been in existence for many years, as
the CTA product has always been well suited to a
liquid public market. Since these funds do not invest
in equities or debt securities, they are classified as
alternative and fall under the classification of liquid
alternatives.
The main difference between commodity funds
and other open-end ’40 Act mutual funds is due
to the type of income the funds receive from their
investments. Traditional mutual funds receive income
from dividends, coupons and price appreciation
in the underlying securities, whereas commodity
investments are typically executed using futures
trading contracts, which do not realize the same type
of income. The IRS considers the futures income to
be bad income, and because the mutual fund is a
regulated investment company (RIC) it can therefore
not receive the profits or losses from transacting in
futures contracts.
To address this income issue, commodity funds
establish an offshore entity to block the bad income
and pass back income to the onshore mutual fund
as a dividend stream. The offshore entity is set up
as a controlled foreign corporation (CFC) which
is a wholly owned subsidiary of the mutual fund
corporation or unit trust. The CFC then contracts
with external CTAs, who are engaging in commodities
investment strategies that primarily invest using
futures. These CTAs act as sub-advisers to the CFC
entity, which then passes back profits or losses to the
parent mutual fund. This structure is illustrated in
Chart 3 below.
The mutual fund is limited to investing only 25% of its
assets into the CFC, but this type of offshore vehicle
has no restrictions on leverage, so with sufficient
trading margin the fund can achieve significant
enhanced returns from just the 25% of assets
invested. There are also no restrictions on paying a
performance fee to the CTA manager acting as a sub-
adviser to the CFC, so these structures can encourage
high-quality managers to develop a partnership with
the mutual fund investment manager. The challenge,
however, with paying a full load 2/20 fee to the
sub-adviser is that when fees are combined with IM
management fee and a distribution agent fee the
drag on performance can be significant, which can
make the overall fund unattractive to retail investors.
These fees will be discussed further in the marketing
and distribution section.
A good example of the managed futures mutual
funds is the Altegris Managed Futures Strategy Fund
(MFTAX) which is sub-advised (via the CFC blocker)
by Winton, Welton, Abraham, Lynx, Cantab, QIM and
Capital Fund Management.