"Two and 20" refers to the standard hedge fund fee structure of 2 percent of assets and 20 percent of profits. That's much higher than so-called liquid alternatives, which usually charge between 1 percent and 3 percent of assets invested. The latter follow the strategies of high-profile hedge funders at a much lower cost than investing in the funds themselves.
The question now is if there will be an influx of institutional dollars. The big money has been slow to end their love affair with high-cost hedge funds, whose assets still dwarf that of public vehicles replicating their strategies. But industry observers say they see growing interest from pensions, endowments, foundations and others.
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Individual investors have already shown big interest in these "hedged" mutual funds. A wave of new products has made liquid alternatives the fastest-growing segment of the retail money management industry. Liquid alternatives have grown by 16 percent annually since 2005 and now stand at almost $900 billion, according to a recent McKinsey report.
In theory, they provide better protection against market downturns compared with traditional funds that only bet on rising stocks, for example. These "alternative" investments can also add diversification to a portfolio by taking advantage of strategies beyond just equities and bonds like commodities, shorting stocks, or playing mergers between companies.
Individual investors can buy into this strategy in a number of ways.
Some liquid alternatives use a portfolio of low-cost exchange-traded funds to replicate hedge funds, like the IQ Alpha Hedge Strategy Fund. Others, like the Direxion iBillionaire Index exchange-traded fund, parrot the stock holdings of major hedge fund managers like Dan Loeb and David Tepper, using their public disclosures about the companies where they are putting their money. ETFs usually track indexes and are traded like stocks but customarily have significantly lower fees than hedge and mutual funds.
Investors also can choose actual hedge fund managers in a fund of funds model, such as Goldman Sachs' GS Multi-Manager Alternatives Fund. Some established hedge fund managers, like Avenue Capital or Gotham Capital, also have launched retail versions of their strategies.
Despite the growth, large investors haven't yet made a big move from private to public funds.
"That adoption has been slow so far, but that could increase over the next three to five years," said Robert Worthington, president of $3 billion Hatteras Funds. "Part of that is are they going to be convinced that you can achieve a suitable risk return objective in that liquid format."
He said Hatteras, which manages mutual fund-style hedge funds and a traditional fund of funds, has received calls from some of the top money management consulting firms over the last 12 months about the strategy.
Even if institutions don't switch, the rise of liquid alternatives may pressure traditional hedge funds to be more investor-friendly.
"What it's done for the industry," Worthington said, "is it's starting to bring down fees ... it's providing a much higher model of transparency ... and of course you have liquidity. That's a good thing."
Avery Kiser, a vice president at Neuberger Berman's alternative investment management unit, said smaller institutions are the most likely candidates to switch given their relatively limited access to hedge funds. Liquid alternatives are especially good for replacing hedge fund strategies that focus on liquid markets, such as those that bet on the appreciation of large company stocks.
"It's really a question in the institutional world of how much should I pay and for what," Kiser said Monday at the Alpha Hedge West conference in San Francisco. "Any place where you can use (liquid alternatives) I think they are certainly taking a pretty long, hard look at it."
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Morningstar data appears to back up the claims of increased interest from institutions. As of Aug. 31, institutions had $96.08 billion in alternative open-ended U.S. mutual funds; retail investors had $65.6 billion. Institutional net flows hit a record high in 2013 of $22.2 billion and are already at $18.1 billion as of Aug. 31. Despite that fast growth, that's still far less than the hedge fund industry, which managed $2.86 trillion globally as of July 1, according to new data from HedgeFund Intelligence.