Investors' Paradox.

• Author: Krug, Anita K.

1. INTRODUCTION II. UNEQUAL OPPORTUNITIES A. Regulation of Mutual Funds B. Operational Structure of Mutual Funds III. THE PROMISE OF ALTERNATIVE FUNDS A. Liquid Alternative Funds B. Multi-Manager Series Trusts IV. THE RISKS OF REDUCING RISK A. Disclosure B. Distribution Channels 1. The Advice Channel 2. The Retirement Plan Channel 3. The Direct and Supermarket Channels V. OVERCOMING THE PARADOX A. Regulatory Response B. A New Direction 1. Reforming Distribution 2. Possible Challenges VI. CONCLUSION I. INTRODUCTION

   In the realm of commerce, goods and services that are "private" are often expensive or exclusive, while those that are "public" are often available to all and affordable. Although the divide between public and private reflects an income and wealth divide within the populace, it is the expected effect of the workings of capitalist society. Nonetheless, in many respects it is deeply troublesome. Perhaps the most problematic aspect of the gulf between those who have the most and those who have the least is that its very existence serves to widen it. As an obvious example, attending private schools often produces opportunities--whether in the form of mentors, job prospects, or other useful connections--that bolster one's ability to collect additional resources at a markedly faster rate, as compared with those without similar opportunities. (1)

   In the financial markets, the division between public and private--more specifically, between public ("retail") investors and private ("sophisticated") investors (2)--is no different, in that it signals more than simply a division of investment opportunities based on investors' relative resources. Rather, it signals also a dynamic in which those with relatively more resources are able to further increase those resources, as well as their lead over their less well-to-do counterparts. Put another way, the very distinction between investor groups widens the gap that separates them, demonstrating that, in fact, the rich do get richer, while the poor get poorer. (3)

   Yet the investment status of the "excluded many" has begun to change, thanks to the creation of new investment products designed to meet the needs of retail investors. The products emerging most recently are in the form of mutual funds--that is, entities that "pool" many investors' capital, deploying it on the investors' behalf by investing or otherwise transacting (4) in securities and other financial instruments. (5) Mutual funds are permitted to offer and sell their shares to retail investors because they are regulated in much the same way that Microsoft, Amazon, and other public companies are regulated.

   One new product is the "liquid alternative fund," which is a mutual fund (6) that pursues investment and trading strategies that are similar in many respects to the types of strategies pursued by hedge funds, (7) private equity funds, and other types of privately-offered funds. (8) Because these strategies involve financial instruments beyond publicly-traded securities, they are widely known as "alternative" strategies. And because the primary statute regulating mutual funds--the Investment Company Act of 1940 (the "Investment Company Act") (9)--requires all mutual funds to accept investor redemptions on a daily basis and to pay the proceeds of any redemption almost immediately, the securities and other instruments that liquid alternative funds hold in their portfolios must be readily sellable, giving rise to the "liquid" component of their moniker.

   Liquid alternative funds give retail investors exposure (10) to investments and trading positions that previously had been available only to sophisticated investors, through their investments in private funds. (11) Accordingly, a liquid alternative fund may buy and sell public securities, as most traditional mutual funds do. But it might also transact in commodity futures, swaps, options, or other types of derivatives; engage in investment and trading activities using borrowed funds; and sell securities "short," (12)as many hedge funds do. (13)

   A second new product is a subset of liquid alternative funds but serves dramatically to expand alternative investment options. It is the multi-manager series trust--or, more accurately, it is the group of mutual funds within a multi-manager series trust. (14) Multimanager series trusts are the offspring of changes in the private fund industry that recently have led investment advisers (15) that manage private funds to move into the retail investment arena. The costs associated with organizing, or "sponsoring," a mutual fund have often been prohibitive for these firms, given that many of them are smaller and less well-established than the investment advisers that seemingly dominate the mutual fund industry, such as Janus, Fidelity, and Vanguard. (16) The series trust solves the cost problem by supplanting the traditional model, in which the investment adviser to the mutual fund (the fund's "manager") sponsors the funds that it manages, with one in which a third party serves as the sponsor.

   Because the third party, rather than the fund manager, is responsible for creating each fund, registering it under the securities laws, and handling many other organizational matters, it also bears many related expenses that, for most mutual funds, the manager-as-sponsor would bear. In addition, because multiple managers are able to participate in a series trust, with each managing a separate fund--each fund being a separate "series" within the larger trust (17)--the managers are able to realize certain efficiencies that would not be present if each instead managed a stand-alone mutual fund. Most important, because series trusts introduce a wide range of private fund managers, as well as the alternative strategies they developed while managing private funds, to the mutual fund market, they constitute an important new locus of investment opportunities for retail investors.

   Nevertheless, despite the risk mitigation opportunities and increased portfolio diversification that liquid alternative funds, series trusts, and other emerging retail investment products (together, "alternative funds") promise to retail investors, that promise cannot, without more, be realized. Because of the complexity of their portfolio investments and trading activities, alternative funds render investor knowledge more critical than it has ever been. Yet, perhaps more than ever before, knowledge remains the province of sophisticated investors. (18)

   As an initial matter, for most retail investors, disclosure is largely ineffective, given both its length and complexity and human nature. (19) That is particularly so in the alternative fund context because alternative funds' more complex portfolio activities logically necessitate additional pages and greater detail. In addition, any given "bundle" of disclosure pertains only to a single fund and does not address the role that an investment in that fund might play in furthering an investor's diversification needs.

   These difficulties are punctuated by the mutual fund distribution process, by which shares of mutual funds, including alternative funds, are sold to retail investors. This process, which occurs through so-called distribution channels, has not been successful in filling the yawning gaps in investors' understanding of the investment options available to them or otherwise in countering the disclosure-related deficiencies noted above. However, it has been very successful at keeping the mutual fund ship afloat. (20) Indeed, the distribution process has steadily funneled investors into alternative funds, thereby creating the worst of all worlds. At the same time that investors lack a complete understanding of alternative funds' activities, purposes, diversification functions, and unique and substantial risks, too effective mutual fund distribution machinery increasingly leads investors to hand over their capital to these funds. (21)

   Given these concerns, the laudable promise of alternative funds seems more like a threat. And that is investors' paradox: the standard refrain from both securities regulators and financial advisers is that, to minimize investment risk, investors should diversify their portfolios by investing in a broad array of asset classes. (22) At the same time, the new opportunities that now make such diversification possible are hampered by circumstances that may unduly increase investment risk.

   Although the academic literature is replete with analyses of investor protection concerns in the mutual fund context, it has neither directed significant attention to alternative funds nor recognized the seemingly intractable conundrum created by the combination of diversification opportunities and the risks those opportunities may create for investors. Perhaps more astonishingly, to date, no other scholarly article has even mentioned the series trust structure and its relevance for retail investors.

   This Article addresses these gaps. It argues that, although retail investors increasingly have access to the same types of investment products that sophisticated investors do, structural factors prevent investors from using those products to their best advantage--and, indeed, they may inflict considerable harm on themselves to the extent they attempt to do so. As a result, despite the hope for retail investors that alternative funds bring, the investment arena continues to advantage the fortunate few to the detriment of the many.

   In order for investors to realize the potential of alternative funds, they need to become better informed. Toward that end, this Article contends that the disconnect between an ineffective, disclosure-centered regulatory regime and an all-too-effective, profit-centered distribution regime must be eliminated. Instead of allowing distribution processes to exacerbate the deficiencies of regulatory disclosure processes, those processes should be made to counter disclosure...