With hedge funds attracting an increasing proportion of assets from institutional investors, transparency is becoming an area of increasing focus. A large US hedge-fund manager noted, “An increasing demand for transparency will drive demand for customized solutions such as funds of one and managed accounts.” A managed account gives the investor transparency on the underlying portfolio holdings whenever it is required—accounts can typically be viewed on a “live” basis. This can be contrasted with a commingled fund, where the level of transparency is typically limited (e.g., only aggregate risk exposures or top 10 positions provided) and available on a weekly or monthly basis at best. Full transparency puts the investor in the best possible position to evaluate the hedge-fund investment and its implications for their wider investment portfolio.
The asset segregation that a managed account provides gives the investor full ownership of the underlying assets and ultimate control, including authority on when to invest and divest. This removes the impact of other investors’ actions and the risk of the hedge-fund manager suspending disinvestments (e.g., gates and side pockets), which has been a very apparent possibility for investors in commingled funds.
Further control is provided to the investor in that the manager is typically only afforded trading authority for the account. This gives the manager sufficient powers to manage the portfolio on a day-to-day basis, but limits wider authority such as the ability to move cash or securities. The greater oversight this provides contrasts markedly with a commingled fund, where the manager has full control, with a typically more opaque structure.
In addition, the investor has the ability to take immediate control of the portfolio from the hedge-fund manager should it be required—for example, in the event that the manager repeatedly breaches risk guidelines. Ultimately, the investor has the scope to replace the manager and this can be done without upsetting the managed account structure and the underlying investment portfolio—i.e., by terminating the existing manager’s IMA and appointing a new manager through another IMA.
Finally, the benefits of transparency and control afforded to an institutional investor by managed accounts also allows the investor to manage the hedge-fund investments as a portfolio themselves (or as a component of a broader investment portfolio) by adding overlay investments “on top of” the hedge-fund portfolio for purposes of hedging, adding incremental leverage, pursuing incremental alpha, etc. Utilizing commingled vehicles for hedge-fund investing simply does not give the appropriate access, transparency or control of the underlying hedge-fund portfolios to facilitate an extension of the investment process in this manner.
- Liquidity
The transparency provided by a managed account, and clarity on the specific underlying investments, gives the investor improved understanding of the liquidity of its hedge-fund investment. It also reduces the levels of liquidity that the investor must consider, with the sole concern being at the underlying asset level. In a commingled FOHF, for example, the investor must be cognizant of liquidity at the FoHF level, the underlying hedge-fund level and their underlying investments. Under this approach, the investor can be impacted by the actions of other investors in the commingled fund—for example, when gates are imposed due to excessive disinvestment requests from investors.
The managed account may still contain illiquid assets as permitted by the investment mandate, and such assets will be affected by underlying liquidity conditions. The investor is, however, much better positioned to assess actual liquidity with fewer levels of liquidity to consider.
- Customization
With the majority of hedge-fund investments made in commingled funds, investors typically have to accept the investment characteristics of the respective fund. There are, however, increasing signs that the hedge-fund industry is evolving to increasingly become a provider of “solutions,” rather than “products”—i.e., an increasing focus on customization. A large UK fund manager noted, “Managed accounts provide a bespoke solution that enables pension funds to set guidelines and manage volatility.”
A managed account gives the investor scope to set the hedge-fund manager a specific investment mandate. With the ability to specify the exact investment targets, guidelines and restrictions, this enables the investor to develop a portfolio that is customized to its circumstances. For
example, the investor may only want exposure to an equity long/short manager’s expertise within a certain geography, whereas the commingled fund offered by the manager may permit it to invest globally.
The scope for customization extends beyond the investment terms with a managed account structure also enabling the investor to negotiate commercial terms with the hedge-fund manager. This is particularly relevant within the hedge-fund industry, where fees are widely publicized as being high relative to other asset classes, as well as the changing investor type in hedge funds—i.e., an increasing proportion of larger and more fee-conscious institutional investors. The scope to negotiate fees within a commingled fund is typically limited, and often constrained by most favored nation agreements.
- Ongoing monitoring and risk management
The transparency given by a managed account directly improves the investor’s ability to monitor the ongoing performance of the hedge-fund manager. Such accounts can typically be viewed on a live basis, with regular (e.g., daily) reporting. This greater clarity allows a better understanding of exactly how returns are being generated and most crucially offers full insight from a risk-management perspective (e.g., early detection of style drift). This enables the investor to build a knowledge of how the manager runs the portfolio, which puts it in a better position to challenge the decisions made, as well as understand periods of underperformance.
The benefits of this to the investor are not limited to the hedge-fund investment. It will also have a beneficial impact in the monitoring and risk management of the investor’s wider portfolio that the hedge-fund investment is part of. This is because it allows the underlying positions and exposures of the hedge-fund portfolio, which typically have to be estimated in a commingled fund, to be aggregated with those of the other asset classes invested in. This enables more accurate assessment of the overall risks in the investor’s total portfolio, aiding more comprehensive risk management.
The managed account structure also affords improved risk management from an operational perspective. With operational weaknesses often the source of fraud related to hedge funds, operational due diligence is often a key area of focus by investors prior to investing in a hedge fund—this entails the research of areas such as fund structure (e.g., jurisdiction) and third-party service providers (e.g., auditors and custodian), which are decided by the manager. This risk is limited, or arguably transferred, within managed accounts with the investor responsible for setting up the operational structure and appointing third-party service providers.
Challenges for managed accounts
- Managers offering managed accounts
A key reason for managers to offer investors managed accounts is the potential commercial benefits to them—i.e., increased investor base and assets under management. Certain well-established managers will not, however, need to offer managed accounts as they already have sufficient investor demand and may even be closed to new investors. In addition, offering investors managed accounts will potentially increase costs for the manager both from an investment and operations perspective with the management of more, potentially quite different portfolios. The increased cost and complexity to hedge-fund managers (and investors, for that matter) who offer managed accounts are the reasons the industry of infrastructure providers has arisen in the past several years. Such providers have made the offering of managed accounts more palatable to hedge-fund managers and investors because of their ability to handle most of the operations as an outsourced managed service.
There will also be certain hedge-fund strategies where managed accounts are not suitable. While the traditional lack of transparency associated with hedge funds has declined materially over the past decade, some managers continue to view their underlying positions as key intellectual property and want to limit the opportunity for position replication and trade crowding by others (e.g., within event-driven strategies).
These factors will limit the range of hedge-fund managers willing to offer investors managed accounts, which could lead to an adverse selection bias if investment is predicated on a managed account being available.
- Reduced alignment of interests
A key feature of commingled hedge funds is the ability of the manager to invest in the fund alongside their investors. Given that the manager would not be able to invest in a managed account, there is a risk that the alignment of interests between the investor and the manager would be negatively impacted.
This can, however, be mitigated by structuring fees in favor of incentive fees (with the accompanying moral hazard noted). It would be further mitigated to some extent by the likelihood that the managed account would follow broadly similar strategies, and make some of the same investments, as the manager’s
commingled fund.
The article is a continuation of KPMG’s special publication entitled Accessing hedge funds through managed accounts: The future is now.
R.G. Manabat & Co., a Philippine partnership and a member-firm of the KPMG network of independent firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.
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