Wed, 25/11/2009 - 19:01
While some of the froth surrounding managed accounts is gone, investors have an ever-broadening range of options to choose from, says Marion Mulvey (pictured), EMEA Head of Alternative Investments Global Transaction Services, Citi, and Lou McCrimlisk, EMEA Head of Relationships, Prime Finance, Citi.
Turn back the clock nine months and everyone involved in the hedge fund industry was talking about managed accounts. Investors were still reeling from the double whammy of the post-Lehman liquidity crisis and the Madoff scandal. Trust in hedge fund managers was at an all-time low. Focus turned to managed accounts as a structure by which the investor can retain ownership of the assets and achieve transparency and liquidity. In short, they are seen to deliver all the benefits of alpha-driven investing without the drawbacks associated with manager risk.
To add to the list of pluses, investors keen to go the managed account route found the hedge fund industry more responsive than it had ever been. Many single-strategy hedge fund managers who had previously been averse to providing managed accounts access to their flagship funds now bent over backwards to accommodate new inflows (e.g. Tudor providing access to Tudor Momentum via Lyxor). Large funds of funds managers who saw the writing on the wall and are now setting up managed account platforms to service their funds of funds offering as a result.
Today, a lot of the unsustainable froth or “knee jerk” reaction has gone. With the recovery in the markets, big investors have regained an element of their sang froid. Whilst most have not abandoned the idea of managed accounts, a lot are taking their time assessing which of the many different structures fits best. ‘We believe as many as one in two institutional investors is actively taking steps to figure out how to do this,’ says Simon Hookway, Managing Partner of MAG Consultancy, which designs managed account and governance solutions for investing institutions.
There are a range of options on offer. At one extreme there are the long established managed account platforms developed and largely still run by the investment banks. They were set up to service their owners’ structured product desks and many still do. That has given rise to a lively debate over the potential for conflicts of interest. It also explains why many of these platforms have historically focused on the more liquid strategies (something that is starting to change) and why some hedge funds have historically chosen not to be part of them.
The platforms deliver segregation of client assets, a common legal structure and a common approach to valuations, risk management and reporting – but at a cost. Typically, these platforms charge between 50 and 100 basis points.
At the other extreme there are individually tailored managed accounts set up by single strategy hedge funds on behalf of large investors. They are designed to track the flagship fund in every respect, but the investor retains control over the assets and enjoys full transparency. Unless handled carefully the costs in administration, custody, risk monitoring, IT staffing and data management can render these structures uneconomic for any but the biggest slabs of cash. ‘Practically, we don’t recommend the do-it-yourself approach for any hedge fund investment portfolio of under USD1 billion as the unit account sizes with the hedge fund managers are just too small,’ says Mr Hookway.
Then there is a growing ‘middle way’. An increasing number of independent platforms are emerging, many of them constructed by independent companies unaffiliated with investment banks but most have encountered a slow response from investors because whilst often charging less than 50 basis points, investors still face a narrow choice of managers and an added layer of cost on top of the existing fund of funds management fee or the costs of going direct.
However, there remains a large and rapidly building demand from institutional investors for a genuinely independent, conflict free, reasonably priced platform offering a broad choice of managers. Other, new players are being pulled into the market as a result. These new players include consultants, administrators and custodians. “The Holy Grail is to create platforms that can serve as asset allocation utilities whilst being broadly ‘fee neutral’ vs. the costs of going direct to the hedge fund manager and at the same time delivering all the advantages of the managed account infrastructure to the investor”, says Mr Hookway
While managed accounts clearly have much to recommend them to institutions wary of investing directly, they also bring their own challenges. For a start, they demand a new skill set at the investor level. The managed account structure delivers a wealth of data. Interpreting that data is not always easy.
Take the issue of tracking error. Recent analysis by Olympia Research (Managed Accounts and Trading Error Risk, September 2009) of a range of managed accounts spanning several different investment bank platforms suggested not only considerable tracking error, but modest underperformance compared with the underlying flagship funds the accounts were meant to shadow. A variety of reasons for this have been put forward. They range from timing differences to variations in performance fee structure. The smaller size of a managed account may even allow a manager to undertake size-limited trades that would have no meaning for the flagship fund. However there is nothing inherent in an appropriately constructed and operated managed account architecture that guarantees the presence of these shortcomings, says Mr Hookway.
The challenge for the investor is to make sense of all this. Where does tracking error begin to matter? Does it come with higher volatility and imply lower risk-adjusted returns? Does it represent style drift? If so, what is the appropriate course of action?
With the right resources, this data can be empowering for institutional investors. At one level, it allows the investor to assess whether a hedge fund manager is keeping his or her promises. With enhanced liquidity, additional money can be invested quickly and easily – or money removed without delay. At another level, the availability of highly granular portfolio management information allows the investor to make better informed judgments about the achievement of diversification and other goals across the total investment portfolio.
However, with all this data comes added responsibility. ‘With the ability to see every position, price and trade, the investor has little excuse for inaction when it all goes wrong,’ says Mr Hookway. For certain investors, that extra level of responsibility is likely to continue to drive demand for third-party platforms as opposed to in-house arrangements.
Growing realisation of these practical challenges goes a long way to explaining why some of the initial froth surrounding managed accounts – which was apparent at the start of the year – has subsided. Managed accounts may not be for everybody, but whilst the concept is straightforward, the implementation is complex and needs careful thought, planning, resourcing and execution. Timing matters are also crucial as investors know that the current readiness of hedge fund managers to accommodate managed accounts represents a window of opportunity that could easily close. With an increasing diversity of platform choices, and the promise of lower costs to come, many investors will continue to be attracted by the control, transparency and improved governance managed accounts offer.
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