What is a ’40 Act fund?
A ’40 Act fund is a pooled investment vehicle offered
by a registered investment company as defined in
the 1940 Investment Companies Act (commonly
referred to in the United States as the ’40 Act or, in
some instances, the Investment Company Act (ICA).
Such pooled investment vehicles fall into two broad
categorizations: open-end and closed-end. When
combined with the Securities Act of 1933 (the ’33
Act) and the Securities Exchange Act of 1934, the ’40
Act defines the way in which these types of pooled
investment vehicles can be packaged and sold to retail
and institutional investors in the public markets, and
places their governance under the responsibilities of
the Securities & Exchange Commission (SEC). The ’40
Act also contains a number of exemptions, including
one for privately offered funds such as hedge funds,
private equity funds, and real estate or infrastructure
investment funds. All ’40 Act funds are registered as
securities with the SEC and are therefore considered
to be publicly offered, a very different process than
the creation of a private co-mingled fund (typically a
limited partnership, or LP).
Both the 1933 and 1940 Acts were originally based
upon a philosophy of disclosure, and require that the
issuers of open-end or closed-end public funds fully
disclose all material information that an investor
would require in order to make the most informed
decision about an investment. Unless they qualify for
an exemption, securities offered or sold to the public
in the United States must be registered by filing a
registration statement with the SEC. The prospectus
for the investment is included as part of the
registration statement and must describe the offering,
its management, details about the investments which
will be made across asset classes and details of the
key service providers for the security. This document
will explain the different types of funds being offered
and provide an overview of the key requirements.
What is an alternative ’40 Act fund?
There is no universal definition that describes what
makes a ’40 Act fund ‘alternative’, but the tag can be
applied broadly to any investment strategy that is
not purely pursuing long-only investing in equities or
debt instruments. The scope of alternatives therefore
includes traditional hedge fund strategies (equity
long/short, market neutral, global macro, eventdriven, fixed income, relative value, etc.) and also
includes investing in commodities and currencies.
It also extends to private equity and real estate
investment vehicles; however, for the purpose of this
primer we will cover mainly the liquid public market
strategies where investments can be bought and
sold on exchanges, either bilaterally or via brokerdealers. An alternative ’40 Act fund is therefore a
fund structured to allow for the implementation of
an investment strategy that engages in techniques or
asset classes that differentiate them from fully paid
for, long-security investments.
Section I: Introduction and Overview of 40 Act Liquid
Alternative Funds
This document is an introduction to ’40 Act funds for hedge fund managers exploring the
possibilities available within the publically offered funds market in the United States. The
document is not a comprehensive manual for the public funds market; instead, it is a primer for
the purpose of introducing the different fund products and some of their high-level requirements.
This document does not seek to provide any legal advice. We do not intend to provide any
opinion in this document that could be considered legal advice by our team. We would advise all
firms looking at these products to engage with a qualified law firm or outside general counsel
to review the detailed implications of moving into the public markets and engaging with United
States regulators of those markets. For introductions and referrals to qualified lawyers who
have experience with these products, please contact us at [email protected]
6 | Introduction and Overview of 40 Act Liquid Alternative Funds
The alternative ’40 Act products with the largest
potential audience and the most uniform structure are
the open-end funds. These products are commonly
referred to as mutual funds in the United States, and
they span both single manager and multi-manager, or
multi-alternative, products.
All mutual funds must be brought to market by a
sponsor that has the ability to create the proper
structure for the mutual fund, file the regulatory
documents, apply to the exchanges for a ticker
symbol and set that symbol up for public access.
There are a limited number of providers eligible to
act as a sponsor for mutual fund products; those
thinking about launching a product must access one
of these providers.
Once the fund is officially launched, mutual funds
are priced daily and accept orders for subscriptions
and redemptions. They are incorporated either as
corporations or unit trusts and can have unlimited
investors in a variety of standard share classes,
ranging from institutional to retail. As pooled
investment vehicles there is no limit on their overall
capacity, although there may often be minimum
investment sizes that investors must meet to purchase
fund shares. Mutual funds must provide daily liquidity
to investors and subscribe to a set of trading rules
that govern how they invest their capital. Under these
trading rules they must:
ƒ Maintain 85% of their portfolio in liquid assets
and hold no more than 15% of their assets in
illiquid securities (defined as instruments that
take longer than a single day to liquidate in the
public markets);
ƒ Cover the full value of liabilities created by any use
of short sales by holding an equivalent amount
of collateral within a separate brokerage or
custodial account;
ƒ Limit any use of leverage in their portfolio to 33%
of the gross asset value of the fund, using either
derivates or securities as margin collateral.
Mutual funds are prohibited from charging
performance fees. The investment sub-adviser and
investment manager of alternative mutual funds
typically charge a combined management fee of
between 100 and 200 basis points of the fund’s AUM
for the institutional or investor share class, and then
offer additional share classes with additional fees
that are outlined in more depth in the marketing and
distribution section of this primer.
All mutual funds in the United States issue a 1099
form at the end of each year to investors that
categorizes the tax treatment of the fund’s income
and distributions. This differs from the privately
traded hedge fund industry, in which investors are
issued a K-1 form. Many individual investors view
1099s as superior because they must be issued by
January 31 of the following calendar year, whereas
K-1s have no mandated filing date. As such, most
investors in mutual funds are able to file their taxes
early in the year and benefit from any anticipated
tax refunds.
There are three different types of mutual fund
structures that are classified as ‘liquid alternatives’:
single-manager funds, multi-alternatives, and
commodities (or managed futures) funds.
Single Manager Mutual Funds
A mutual fund has both an investment manager
(IM) and an investment adviser (IA) associated with
the offering. There are two execution models for
single-strategy mutual funds. The first model is one
where the IM and the IA are the same company.
This approach most closely resembles a typical
hedge fund structure. The second model is one
in which the hedge fund manager is a single subadviser (IA) to a mutual fund owned by a different
investment manager.
The mutual fund is set up either as a corporation or
a unit trust (we will discuss the pros and cons of each
legal structure in the next section). An independent
board of directors and set of service providers are
assigned to provide custody, fund administration,
transfer agency services, investor services and prime
brokerage services. The fund has a single IA who
has trading authority on the portfolio while staying
in compliance with all of the trading rules previously
discussed. The IM and the board are responsible for
overseeing the IA, as well as the calculation of the
daily NAV by the fund administrator.