There are few investors who were not caught out by the lack of liquidity and transparency in their holdings in 2008. Managed accounts can address these issues, as well as the more publicised fraud concerns that keep investors awake at night.
Despite being around for more than a decade, hedge fund managed accounts represent less than 2% of the hedge fund market. The biggest historical impediment to their widespread use has primarily been a general reluctance on the part of the manager to embrace this type of structure due to higher costs and increased operational requirements. But in the wake of the events in 2008 and as a reaction to a change in investor sentiment, managers are beginning to embrace the managed account model. A recent Deutsche Bank study showed that 43% of investors are now considering making investments through managed accounts. This, along with CalPERS’ public commitment to managed accounts, is causing a shift in the hedge fund industry.
Broadly defined, a hedge fund managed account is any vehicle in which a hedge fund manager is employed as a sub-advisor to the vehicle. The manager’s role is limited to the right to make investment decisions. This differs from a traditional fund in which a hedge fund manager is the investment manager of the fund and has broad control over the assets of the fund being managed.
There are two fundamentally different types of managed account structures – the separately managed account (SMA) and the co-mingled managed account (CMAP). The SMA mimics the separately managed account of the long-only world in which an investor opens accounts with custodians/prime brokers and employs managers as sub-advisors to make investment decisions on their behalf. By contrast, the CMAP approach looks more like a traditional hedge fund structure – multiple investors buy interests in a vehicle sub-advised by the hedge fund manager but managed by an independent third-party who controls the operation of the fund.
The primary impetus for the accelerated shift to managed accounts has been the need to mitigate the fraud, liquidity and transparency risks inherent in the existing hedge fund model. By moving control of assets away from the hedge fund manager, the managed account approach, along with a set of comprehensive controls can help reduce the chances of these risks occurring. Other benefits of the managed account approach and the increased transparency it provides include improved portfolio construction while providing investors the opportunity to detect style drift earlier.
There are some major challenges of adopting managed accounts. The root cause of these challenges is the structural change inherent in managed accounts. By shifting control over assets from the hedge fund manager to the investor, significant responsibilities are also shifted. This shift creates many new risks that need to be managed by the investor.
In the traditional hedge fund approach, the hedge fund manager controls all of the functions needed to operate a hedge fund. Beyond portfolio management, there are many functions necessary for the operation of hedge funds. Some obvious examples are valuation, accounting and collateral management. While traditional hedge funds outsource some of these functions to third-parties, in reality the hedge fund manager still retains ultimate control over these functions and their smooth integration.
In the managed account model, control of any non-portfolio management functions by the hedge fund manager would compromise independent control of the assets, negating the major value propositions of a managed account. However, if the hedge fund manager is going to play a pure investment advisor role, the investor must fill the functional gap left by the manager’s limited role. That would require a typical investor to understand the nuances of the hedge fund management process. In the managed account world, a full understanding is critical to setting up a robust investment program.
The functions required for a managed account are different from those for a conventional fund, which adds further complications. While there is overlapping, some functions such as shareholder services, are not needed in a managed account. At the same time, the use of managed accounts creates the need for new functions that are not part of a typical hedge fund operation. An example is the need to ensure the managed account is treated fairly, relative to direct hedge fund investors, from an investment and returns perspective. Even in highly liquid strategies, this is a poorly understood aspect of any program and gives rise to significant angst among the investors, managers and service providers.
In more complex hedge fund strategies, the shift of some functions from manager to investor is so daunting that it is often used to refute the viability of managed accounts. A classic example of this is asset valuation. The argument often made is that only a hedge fund manager is qualified to value complex or illiquid assets. This is a fallacy – even if the hedge fund manager is better equipped than most third-parties to assess valuation, a third-party can and should have control over the valuation process. A hedge fund manager’s expertise is an important input to the valuation process, but an independent third-party retains control over the process used to determine a final valuation.
A third approach to managed accounts – the separately managed account platform (SMAP) – is beginning to emerge. This is a hybrid of the SMA and CMAP approaches. In a SMAP, a platform provider operates a platform with a more open architecture, tailoring the platform to each investor. Each tailored solution may contain some common technology and processes, some existing platform managers and possibly the legal framework already used for other investors. The platform provider manages any other service providers used and reduces the expertise and manpower needed by the investor.
In the current economic climate, some of the established CMAP’s may well be willing to go beyond their standard offering of managers and services and create SMAP’s. For them to be willing to do this, an investor is typically going to be required to commit assets of $500 million.
New entrants and smaller CMAP’s may well promise significantly more flexibility in platform design and also in required asset levels. Some of the potential trade-offs to consider in selecting a smaller player, whether as a CMAP or a SMAP, are the limited track record, the likely availability of less established managers and higher project execution risk.
Regardless of the type of solution adopted, investors must have a good understanding of the managed account approach before embarking down this path. They also need to understand what will be required of them in establishing and overseeing the program. This effort may not be a huge undertaking, but it can be a challenge for anyone unfamiliar with the way these programs should work. The challenge is compounded by the fact that the managed account space is immature, such that there are few industry professionals with real experience of constructing or operating these programs successfully.
Managed accounts are fast becoming a major component of the hedge fund investment space. They offer the potential to address most of the pressing problems inherent in the current hedge fund model but they are not a panacea. Unlike the parallels in the traditional investment space, they require a very significant change in approach from both an investor’s and a manager’s perspective. This introduces significant new risks to be mitigated.
There are several ways to move in the direction of managed account investing, each of which has its own costs, benefits and risks. None of the options are turnkey solutions to investor needs. Consequently, it is crucial that an investor fully understands their needs and capabilities, as well as the solutions available in the marketplace before proceeding with a managed account program. This is the only way for an investor to ensure they have selected a program that can properly handle their investments and deliver the benefits they desire over time.
This article first appeared in www.finalternatives.com on 14 August 2009.