Blueprint for a 40 Act fund
By Bryan Haft, Senior Vice President, and Steve Hoffman, Senior Vice President, Citco Mutual Fund Services (USA) Inc.
Published: 30 June 2014
For a manager launching a US-registered alternative mutual fund, structure is key. Opting for an open-end or closed-end fund and deciding on the trust for the fund have major implications for how it can invest, who can invest in it and how it fits with the manager’s other offerings.
The choice of open-end or closed-end is most important. Both fund types are registered with the US Securities and Exchange Commission (SEC) and subject to regulatory oversight, but only open-end funds are available to the general public. Investors in closed-end funds are required to meet the SEC’s definition of an accredited investor. This distinction will have an obvious impact on the distribution channels the manager pursues and on its marketing strategies.
Open-end funds offer daily liquidity
Liquidity requirements are also a major difference between the two structures. Open-end funds provide liquidity to redeeming shareholders on a daily basis without limit. The SEC allows up to seven days to settle redemption requests, but industry practice is to settle on a trade-date-plus-one basis.
As a result of this requirement, at least 85% of an open-end fund’s investments must be in liquid securities. In contrast, a closed-end fund offers to buy back a portion, for example between 5% and 25%, of its shares on a periodic basis (for example, quarterly or semi-annually). Therefore the fund may choose an investment strategy that involves significant use of illiquid securities.
A closed-end fund must maintain enough liquid investments to meet 100% of the amount redeemed.
Deciding on trust status
Consideration must also be given to the trust that will contain the fund. Does a shared series trust or a standalone proprietary trust make the most sense? The series trust option takes advantage of an existing trust structure. It uses a board of directors and a service provider that are already established and in operation. The new fund will be added to the trust as an additional fund (i.e., as part of a series). However, it can have its own prospectus, investment manager and unique brand.
Because some operating costs are shared among all funds in a series, certain expenses (for example, board of trustee fees) are generally lower with this option. Reduced start-up cost and time to market are also advantages. The SEC review time for a new fund being added to an existing trust is 75 days from the filing of the new fund’s prospectus.
The shared series trust option is however not generally available to closed-end funds, and may not be a good fit for all managers looking to start an open-end fund.
If the proprietary trust route is pursued, a new trust will be required, with the manager acting as sponsor. As a first step, a qualified board of directors must be identified and put in place, with 60% of members independent of the advisor. The board will then need to approve and engage all other service providers, including legal counsel, auditor, custodian, distributor, transfer agent, fund accountant, etc. While the time frame required to establish the trust and fund will vary according to specific circumstances, six or more months is not unusual.
Redemptions and trusts are just some of the factors that will need to be addressed by managers looking to participate in this exciting and growing market segment. Partnering with a service provider that not only has the necessary experience with registered products, but that also understands the unique perspective of traditional hedge fund managers, will be key to their success.