'40 Act Compliance in Focus as Funds Introduce New Liquid Alts

Liquid alternatives — new post-crisis products meant to package risk into traditional structures like exchange-traded funds (ETFs) and mutual funds — are very much on the rise.

According to data from Vanguard, fully half of liquid alts' $449 billion in assets have been invested since 2013, as more investors chase alternatives-level returns without the requirement of qualified investment.

Some of these offerings have come from familiar giants, Vanguard included, but a sizeable chunk has also developed among buy-side shops with little — sometimes zero — previous exposure to public markets.

Among these is Larch Lane Advisors, a Rye Brook, N.Y.-based asset management shop that has long focused on fund-of-fund and early-stage hedge fund seeding, but in 2014 partnered with Rothschild Asset Management on a joint venture, creating its first SEC-registered mutual fund last July.

"Up until last year we operated in the private world, but around two years ago we started to recognize that there were significant flows coming from retail investors into the mutual fund space and new parties that were developing these funds," David Katz, Larch Lane's COO, tells Buy-Side Technology. "So we began to think about the potential ability to create a product that would be unique to the market, using decades of investing expertise and then parlaying that experience into a liquid product that could be constructed in a mutual fund format. We knew Rothschild was thinking about liquid alts similar to the way we were — they run liquid portfolios in Europe and we have run liquid portfolios in the US — and so it became clear that there were synergies."

In dealing with '40 Act, we are monitoring regulatory rules daily, including limits around diversification, commodity income, position concentration, liquidity, and leverage, to name a few. Many of the rules in place require us to address potential issues immediately. - Eric Konigsberg, CRO at Larch Lane Advisors

Quicker to React

The two firms now have several joint committees governing the '40 Act offering, including management, investment, compliance, and risk. But Katz says "the most important thing," tasked to chief risk officer Eric Konigsberg, was developing an additional risk monitoring platform to handle the regulatory limits implied by '40 Act rules.

After an exhaustive search, Imagine Software was selected behind their willingness to customize a solution. "There was no off-the-shelf product that was perfect, and they had the experience to customize something for us," Katz says. "We manage and monitor risk in all of our businesses obviously, but the regulatory requirements for '40 Act are different and that required us to work closely with Imagine to make sure we capture all of these specific requirements."

For his part, Konigsberg says the major challenge for a small fund manager tackling '40 Act is reacting at speed.

"A lot of the challenge is around data collection and the rules for '40 Act compliance," he explains. "On the fund-of-funds side we generally receive data on a monthly basis, P&L-type fund data. We'll get that and then run quantitative analytics around it, but it provides transparency. Seeding is a little bit different in that we do have daily transparency, like we do with the mutual fund. In dealing with '40 Act, we are monitoring regulatory rules daily, including limits around diversification, commodity income, position concentration, liquidity, and leverage, to name a few. Many of the rules in place require us to address potential issues immediately."

Iterative Approach

After hashing out the project specifications with Imagine, the plan was to create an additional function within Larch Lane's platform that tracks '40 Act rules separately from standard investment measures. The design process, Konigsberg says, was purposely iterative, because some of the rules are "pretty historic" and many could soon be modified by the SEC as the regulator takes a closer look into these products.

"We use the system in two ways: investment risk —running stress tests and what-if scenarios — but then we worked with Imagine to build an additional dashboard that tracks the '40 Act rules separately," the CRO says. "Part of the complexity we have with building this type of product is that, with some of the calculations on different rules, there isn't a lot of guidance coming from regulators, which required us to do a lot of research and work closely with experts in the field. We ultimately would get rules defined and work together to create the appropriate dashboard, testing it and modifying over time."

As Larch Lane has used the system more and more, there have been "tweaks post-launch," he adds. "We’ve worked with them to refine the technology, and now we rely heavily on what we’ve built together."

And it is set to influence the way the firm operates more broadly, according to Katz. "The way we're looking at risk in the mutual fund transfers to our other portfolios. Imagine was flexible in helping us create this particular product, and we're sure it will inform us on how we manage risk going forward."

The Bottom Line

• As alternatives houses eye '40 Act mutual funds as a new vehicle to raise capital and investors seek easier access to risk, they have found few technology solutions that can handle '40 Act rules without significant customization.

• Among these requirements are limits around fund diversification, commodity income, position concentration, liquidity, and leverage, which Larch Lane Advisors — a new '40 Act entrant partnering with Rothschild — built into a proprietary monitoring dashboard with the help of Imagine Software.