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Investors of all stripes, burned by severe losses in even the most diversified investment portfolios, have been craving downside protection as they wade back into the markets. Sensing a business opportunity, money management firms have been all too happy to oblige. The net result: Twenty-four new hedge fund–like mutual funds have been launched over the past 18 months.

Many of the new offerings come from traditional mutual fund players like Putnam Investments, Rydex|SGI and Eaton Vance Corp. But a surprising number have also been launched by firms better known for their institutional and hedge fund businesses. In January, for example, AQR Capital Management, which runs $22.5 billion primarily for institutions, introduced a no-load mutual fund called AQR Diversified Arbitrage Fund. In April, Permal Group, a large fund-of-hedge-funds firm and an affiliate of Legg Mason, launched the Legg Mason Partners Permal Tactical Allocation fund. And in June hedge fund manager Bull Path Capital Management converted one of its long-short funds into a mutual fund.

The launches may be a response to new demand, but they also speak volumes about the state of the hedge fund industry, says Nadia Papagiannis, a hedge fund analyst at Morningstar in Chicago. With the HFRI composite index down 19.03 percent in 2008 and this year’s gain of 13.95 percent through August not enough to overcome those losses, many firms are no longer earning their 20 percent incentive fees. Last year, according to Morningstar, hedge funds lost $136.1 billion because of market action and outflows. That leaves many hedge fund managers with much smaller asset bases from which to generate their typical 2 percent management fees. “At this point, running a hedge fund may be less profitable than a mutual fund,” says Papagiannis, who points out that the new hedged mutual fund products command a high average expense ratio of 2.1 percent, although they do not feature an incentive fee.

The new products are certainly striking a chord with investors seeking the added transparency, liquidity and regulatory oversight that a mutual fund provides. “Our core business is institutions and will continue to be — but there’s no doubt institutional investors ran into substantial challenges last year with illiquidity and other issues,” says David Kabiller, co-founder and head of business development at AQR in Greenwich, Connecticut. “We’re doing this in response to those issues as well as demand from financial advisers.” 

For Kabiller introducing the AQR Diversified Arbitrage Fund was a good business decision. Last year was tough for his firm, and AQR’s convertible arbitrage strategies lost 30 percent. The firm’s assets have declined from a peak of $38.5 billion in August 2007. Kabiller says that the plan to ramp up AQR’s mutual fund launches has been in the works for two years — and in July the firm introduced three new no-load mutual funds based on its own momentum indexes. “We’ve always wanted to build an asset management firm, not just a hedge fund business,” he says.

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