Fueled by an investor appetite for liquid alternative investment strategies, hedge fund conversions have been a growing trend over the last few years.

With growing concerns about hedge fund returns and structure, interest in hedge fund conversions has spiked. These funds, typically offered in the form of a mutual fund, provide entree to a proven strategy and management team that most investors wouldn’t otherwise have access to. But, just how are these funds converted? And what are the benefits and risks of these products? Here, we offer an in-depth look at the hedge fund conversion processes: the upsides, the downsides and, of course, the tax implications.

Hedge fund conversions are best compared to mergers. In the same way two companies might merge, shareholders, or limited partners in a hedge fund, end up holding the same shares in the mutual fund, with the hedge fund contributing portfolio securities to the mutual fund. At conversion date, all investors in the hedge fund have their investments converted into shares of the mutual fund. If there are any holders in the hedge fund that do not want to be party to the conversion, they must exit the hedge fund ahead of the conversion.

These conversions require a good deal of due diligence and must be registered with the Securities and Exchange Commission. Mutual fund managers interested in converting hedge funds typically look for hedge funds with desirable strategies and excellent performance records that will also be compatible with a mutual fund structure. It’s also critical that the team managing the hedge fund continue managing the mutual fund.

For shareholders, the benefits of hedge fund conversions are many: more accessibility, daily liquidity, more transparency, more regulatory oversight, lower fees, lower minimum investment and access to proven strategies.

The most appealing benefits of these products are that liquid alternative mutual funds usually possess low minimum investment hurdles and are available to people other than accredited investors. Investors are also attracted to the fee structure.

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Most hedge funds converted into mutual funds offer the same strategy, with no performance fee and a management fee that is less than 2 percent. (Traditional hedge funds tend to run under the 2 percent management fee, plus a 20 percent performance fee structure). As an added bonus, liquid alternative mutual funds offer daily liquidity and publish returns daily. Another benefit of converted funds is that they can generally be offered in a broader array of investment accounts, such as 401(k) plans.

Like any investment strategy, there are some criticisms of hedge fund conversions. But for every criticism, there’s a strong counter-argument. Investors should understand the risks of investing in these funds, but also understand the whole picture.

Some have claimed that, on average, converted hedge funds’ returns tend to deteriorate post-conversion. While there may be a handful of examples to support this statement, there is a flaw in this analysis — typically related to benchmarking against equities when many conversions have happened during one of the strongest bull markets in history. For example, benchmarking a managed futures strategy to equities from 2007 to 2009 and then from 2009 to 2017 would yield dramatically different results. In the first period, equities struggled and managed futures generated strong, uncorrelated returns, as expected.

During the second period, managed futures maintained uncorrelated returns and equities rallied. It would be illogical to conclude that excess returns eroded after a 2009 conversion simply because the strategy was inappropriately benchmarked to equities.

Investors should draw their own conclusions by examining a strategy in various market environments and reviewing a fund’s performance against its expected return profile or funds with similar objectives and strategies. This will provide a much more accurate picture of how the fund is likely to perform in a given market scenario.

As with any investment, a savvy investor must evaluate each option on its own merits. It’s key to make sure you are comfortable with the concepts of the investment and be confident the investment is appropriate with your financial plan.

There’s also a concern that investors cannot confirm that the converted fund is run in a substantially similar manner and that the past returns can be misleading. However, there are a number of requirements that must be met in order to carry over a pre-conversion track record of a converted hedge fund. One requirement is that the strategy is run in a substantially similar manner. This must be represented to the SEC, and is critical to the conversion process.

Audited Regulation S-X compliant financial statements for the hedge fund are also required to be published in the mutual fund offering documents. Like with any investment, investors should perform in-depth analysis on the investment strategy and past returns.

The tax implications of these conversions are typically minimal. The hedge fund portfolios are tested for Internal Revenue Service diversification prior to the conversion to ensure that the new mutual fund will be able to meet requirements for pass-through of income and gains.

On the date of conversion, the new mutual fund takes possession of the securities of the hedge fund and the holders of the hedge fund will be given shares of the mutual fund based on their value in the hedge fund. This is usually done on a “tax-free exchange” basis and should not be a taxable event to the shareholders of the hedge fund. The new mutual fund will continue to carry the underlying tax cost of the securities from the hedge fund and the mutual fund will recognize the tax gain or loss on those investments as they are sold off.

Additionally, on the conversion date the fund is generally not open for new money to ensure that the mutual fund meets the requirement that the hedge fund holders own at least 80 percent of the mutual fund after conversion.

It’s my belief that the many benefits of hedge fund conversions outweigh the risks. Many funds continue to meet or exceed their expected risk and return profiles post-conversion, just as they did while they were hedge funds. For investors looking for proven alternative strategies in a mutual fund vehicle, hedge fund conversions are a viable option.

— By Jerry Szilagyi, co-founder and CEO of Catalyst Funds