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News January 22, 2007 Issue

Mutual Funds Begin Disclosing Aggregate Hedge Fund Expenses

Beginning this month, open-end and closed-end funds that invest in hedge funds will disclose in their prospectus fee table the aggregate amount of management fees, incentive allocation fees, and other expenses they indirectly incur as a result of their hedge fund investments.

Last summer, the SEC adopted three new Investment Company Act rules dealing with certain fund of funds issues. As part of that rulemaking, the SEC added a new line item in the fund fee table: "Acquired Fund Fees and Expenses." Per that new item, if a registered fund invests in one or more registered or unregistered funds, the registered fund must disclose the aggregate fees and expenses incurred as a result of those investments. (If total fees and expenses incurred as a result of investing in underlying funds do not exceed one basis point of the registered fundís average net assets, the registered fund does not need to break them out separately and can simply include them in the "Other Expenses" subcaption in the fee table.)

"[I]nvestors may not be aware that a fund of hedge funds may have higher fees and expenses than an alternate fund of funds or a fund that invests directly in debt and equity securities," said the SEC in its release.

And no complaining that claw-backs, high water marks, and other hedge fund fee conventions make it too difficult to predict performance fees or estimate management fees. "Given the extensive due diligence that we understand fund of hedge fund managers undertake in order to create an investment strategy for the fund, we believe that each acquiring fund should be able to provide these estimates of expenses based on written fee arrangements with acquired funds in which it invests or intends to invest," said the SEC.

In response to concerns raised during the comment period, the SEC allowed closed-end funds of hedge funds to drop a footnote to the new line item noting the typical performance fee charged by the hedge funds in which the registered fund invests. The footnote, said the SEC, also could state that hedge fund fees are based on historical expenses and could be substantially higher or lower due to potential fluctuations in the hedge fundsí performance.

Could an open-end fund that invests in hedge funds also drop a similar footnote (even though a conforming amendment was not added to Form N-1A)? Check with your favorite lawyer for their two cents, but we have a pretty good hunch that it would be absolutely fine.

Registered funds must disclose fees and expenses associated with investment in any registered investment company or any 3(c)(1) or 3(c)(7) fund. The Investment Company Institute recently circulated a members-only memorandum in which it reported that the SEC staff has indicated that it did not expect the SEC or the staff to object if a fund did not include fees and expenses of structured finance products, collateralized debt obligations, and other securities that are technically 3(c)(1) or 3(c)(7) funds, but that are not traditionally thought of as pooled investment vehicles.

The new disclosure requirement applies to new fund registration statements on Forms N-1A, N-2, N-3, N-4, or N-6, and all post-effective amendments that are annual updates to effective registration statements on Forms N-1A, N-2, N-3, N-4, or N-6, filed on or after January 2, 2007.