Historically, a gulf has existed between investing in hedge funds versus mutual funds and offerings governed by the Investment Advisers Act of 1940 (40 Act). The gulf has been marked by differences concerning SEC registration, transparency and marketing, with particular differences concerning fee structures, leverage and liquidity.

Lately, however, this gap has narrowed, driven by growing market forces since 2008. Investors are interested in alternative strategies, and hedge fund managers are now willing to make changes to increase their asset base. The regulations have not changed regarding 40 Act products; however, firms are developing instruments to broaden the scope of potential investments and strategies. At the same time, hedge funds are seeing the regulatory burden increase as assets shrink, driving them to consider new structures.

Differences that are narrowing:

• Registration with the SEC. Hedge funds with assets over $100 million must register under the 40 Act; those with assets below must register with their respective states.

• Fees. Dozens of hedge fund managers offer mutual fund versions of their strategies. These funds have a management fee but no performance fee, helping to reduce costs.

• Independent oversight. Hedge funds are hiring advisory boards; those offering mutual fund versions have boards of directors.

Differences likely to diminish:

• Transparency. Most hedge funds do not publish holdings but use third-party services such as Measurisk or Risk-Metrics to examine holdings and issue high-level exposure reports. Hundreds of funds now disclose holdings.

• Disclosure of strategies. Today, legal documents permit hedge fund managers wide latitude to pursue varied investment strategies. Institutional investors have pushed back, and we are seeing more narrowly defined strategies.

• Advertising and sales materials. Provisions from 2012’s Jumpstart Our Business Startups Act (JOBS Act), relaxing restrictions on advertising and private placement solicitations, will likely be applied to unregistered investment pools.

Differences that will partially remain:

• Leverage. Many strategies that require leverage (a number of arbitrage strategies, for example) cannot meet a mutual fund’s 300 percent asset coverage requirement (e.g., for every $100 of assets, the fund may borrow $33.33). While creative use of derivatives has circumvented these rules, highly leveraged strategies will remain predominantly in hedge fund structures.

• Liquidity. Hedge fund strategies in mutual fund format compute daily net asset values and stand ready to redeem investor shares at NAV, so there is no reason that hedge funds of a similar strategy cannot offer favorable liquidity. That said, many strategies invest in instruments that cannot realistically support daily liquidity and remain best served to offer liquidity only once every quarter.