We live in an age where technological innovations like the e-hailing company, Uber – on track to becoming the most successful start-up ever – and Netflix, which data maps our viewing preferences, are empowering us to live increasingly customisable lifestyles. And in the world of hedge fund investing, the same rules apply, particularly for institutions who want control, transparency, and investment mandates that work on their terms, not those of the manager.
In that sense, managed account platforms are in a highly favourable position in 2015. Take the California State Teachers' Retirement System (Calstrs). It is currently discussing the possibility of moving up to 12 per cent of its portfolio, equivalent to a whopping USD20billion, into US Treasurys and hedge funds. If they do, one can be sure that a dedicated managed account will be the preferred option.
Andrew Lapkin is the CEO of HedgeMark, which BNY Mellon acquired on 1st May, 2014. Back in late 2012, HedgeMark launched its Dedicated Managed Account (DMA) offering to offer institutional investors a customised hedge fund managed account solution with an integrated position-level risk analytics platform to provide high-frequency risk and performance reporting.
As of 2nd February, 2015 HedgeMark's DMA assets totalled approximately USD1.6billion. Discussing with Hedgeweek how managed accounts are helping improve the way that institutions access hedge funds, Lapkin says that customisation is a key factor.
"For many large institutions, a direct allocation into an existing hedge fund is not what they necessarily need. We've seen this in what I call `high convexity' hedge fund strategies; these are similar to tail-risk strategies designed to make money in all markets not just in downward markets.
"It could, for example, be an options-based strategy, allowing the manager to put on more long-dated derivatives positions for a single investor with a longer time horizon. It means the manager doesn't have to worry about redemptions that could impact the strategy.
"Then you have the idea of tailoring. The right fund for pension fund A might be very different for pension fund B depending on their needs and risk tolerance. The nice thing about having a dedicated managed account is that it allows the investor to set the risk/volatility level that is most appropriate for them. Increasingly, we are seeing interest for our DMA solution not just to mirror the manager's flagship fund, but more to get exposure to the key investment ideas," explains Lapkin.
Amundi is one of Europe's leading managed account platform providers. The Dublin-domiciled MAP is seeing clear demand for fully customised mandates, which, according to Michael Hart, deputy CEO and global head of business development for Amundi's alternative asset unit, represent the majority of the platform's USD5billion in AUM.
"We are working on a large mandate for an institutional client. They liked the fact that we were proactive in our approach when looking at the managers and various strategies to fit with the mandate's objectives. They appreciated that we aren't just a distribution platform. We are also co-investors in mandates and our approach of selecting managers onto the platform is extremely stringent," says Hart.
"Another point that this client liked was that when they asked whether a manager they selected would be automatically added to the platform, our response was, `only if it passes our operational due diligence.' From an investment risk perspective, Amundi has never had a fund blow-up on the platform and we want to keep it that way. Also, our operational due diligence team do not report in to the investment committee; they work alongside the investment committee, they are completely separate and have power of veto."
So what is it that makes customisation beneficial to institutions, aside from all the usual features of control and enhanced transparency, when investing in hedge funds?
“Carve out” strategies
From a strategy perspective, it is clear that the main quid pro quo between manager and investor is enhanced alignment of interests. The earlier example of convexity strategies illustrates how managers are able to take comfort in knowing that the investor has a long-term commitment to pursuing the strategy. From the investor's perspective, they take reassurance that the manager will be able to execute the strategy without distraction, and hopefully maximise the alpha component.
Taking this a step further, a custom mandate enables investors to build out a portfolio that gives exposure to the best aspects of a manager's strategy, rather than the strategy as a whole. This is customisation at its best; stripping out X per cent of a strategy's exposure to certain securities and keeping the rest. This is typically referred to as a `carve out'. One option could be to build a mandate that only ever has exposure to a manager's top 10 or 20 investment ideas.
"We have done this for a couple of clients," says Hart, "where they've expressed interest in a strategy, but only certain elements of it. We would then approach the manager and say, `we'd like to invest in you on our MAP but we want this piece of the strategy carved out.' And typically managers are happy to do this as we usually invest a minimum of USD50million from day one. This normally happens when constructing a mandate with a client and a strategy doesn't exactly fit their overall investment objectives."
Lapkin confirms that carve out strategies have proven popular with HedgeMark's clients. Not only does this help investors control the make-up of the strategy, but having a segregated mandate also empowers them to dial up or dial down the amount of leverage that the manager employs. Some might want to juice up the returns, others might want to reduce them. This will depend on the strategy – a fixed income arbitrageur uses inherently more leverage than a global equity long/short manager.
"We've seen a much greater willingness among our clients for concentrated investments. One of the issues for hedge fund investors is that their approach to risk management is to diversify across a range of different hedge funds and the problem with that is you end up in an over-diversified world. Managed accounts allow investors to make a more concentrated investment with a particular manager because it is a risk-managed fund; it has investment guidelines and mitigates style drift.
"It might mean that the investor chooses to make the strategy a higher volatility version, for example, which they can effectively monitor within their overall portfolio," explains Lapkin.
Cash efficiency
Another area where managed accounts are useful is with respect to cash efficiency.
Investing in traditional hedge funds, if you want USD100million of exposure you have to allocate USD100million. However, by their very nature, hedge funds are cash efficient (especially those using derivatives) and as such a large portion of assets are held as cash.
In a DMA, the investor only needs to put in sufficient cash for the strategy to run properly and meet its margin requirements. That can leave 50 per cent cash – sometimes more – to be deployed elsewhere by the investor.
"We saw in the financial crisis that when investors needed liquidity they redeemed from liquid hedge funds, regardless of good performance," notes Lapkin. "With a custom mandate, investors using managed accounts would have the option to withdraw excess cash not required to support the current holdings, and therefore avoid having to redeem their entire hedge fund investment."
It's not only investors than can benefit from cash efficiency when using a managed account.
Managers can also reap the rewards, especially start-up managers who want to get their strategy up and running without incurring the substantial costs associated with setting up a standalone fund; which in today's regulatory climate are climbing higher.
Linear Investments Limited is an FCA-approved full service mini prime broker (Linear Mini Prime) providing full prime brokerage, custody and execution services to small and mid-sized hedge funds. Linear's clients not only benefit from going down the cost-efficient route of establishing a managed account, but also from getting access to some of the top prime brokers' electronic trading platforms. This is made possible because of an omnibus account structure that Linear uses, pooling together all of its clients' positions when executing trades on their behalf.
"Currently, we have 165 clients, of which 45 are hedge funds," says Jerry Lees, Chairman at Linear Investments. "That we perform trading and execution for most of our clients is important because it generates commissions fees, which keep our underlying prime brokers happy given how much focus they are placing on return on equity."
Linear offers a managed account solution that is beneficial to managers, and is an important adjunct to investor-focused MAPs. Lees says that the hedge fund PB currently has approximately USD500million in positions but several projects in the pipeline are expected to more than double these assets. "We expect to see our assets accelerate," states Lees. "Any emerging manager with less than USD100million in AUM struggles with the costs. One way of dealing with the cost/expertise issue is to outsource as many of the functions as possible. Linear bundles many of these functions together into monthly fees with no long term lock in or participation in the fee structure or shareholding of the fund manager.
"For example a manager might opt for trading desks for their team, all their emails and calls recorded and archived for seven years, disaster recovery, risk management, compliance management and an Appointed Rep structure, together with outsourced Capital Introduction. Linear package all of that together with our PB business.
"What we are providing is a transparent, economic solution to emerging managers that allows them to get on with their strategy and build track record without being borne down by detail and cost."
Currently, Linear has 60 prospective managers in the pipeline, all of who have gone through the screening process. Lees expects to bring 30 or 40 onto the platform over the next 12 months.
Multi-manager Managed Accounts – a new trend?
In the US, the rise in prominence of liquid alternatives has led to the proliferation of '40 Act alternative mutual funds. Structurally, these differ to alternative UCITS funds in Europe. Managers are not able to charge performance fees, and as such many '40 Act vehicles are constructed as multi-manager arrangements where individual managers agree to act as sub-advisors. What this means is that '40 Act funds are highly liquid versions of their hedge fund strategies; `hedge fund lite' in other words.
Over at Lyxor Asset Management, a similar approach is being developed to provide an additional solution on its managed account platform; specifically the Lyxor UCITS platform. The reason for this is to help clients meet their diversification needs, as well as reduce costs by investing in a single fund comprised of multiple managers as opposed to a traditional FoHF.
"Liquid alternatives that are packaged in a UCITS regulated framework are usually less expensive than the offshore version of the strategy. On the Lyxor MAP we have Jersey-domiciled funds, which make up the bulk of the platform. In the past two years we've added UCITS managed accounts for which we have negotiated the best possible fee level for our investors' fees that are lower than traditional offshore funds. For the same reason, a UCITS multi-manager managed account will be more cost-effective," explains Daniele Spada, Head of Lyxor MAP.
He says that the kind of clients who are targeting a UCITS multi-manager solution are not necessarily those who would invest in pure offshore vehicles and are more sensitive to regulatory constraints by nature.
"They need de-correlated and cost efficient investment opportunities, but in a regulated wrapper as regulation becomes stricter and stricter in terms of what alternative investments can be offered to retail investors. This is the route we take when structuring one of these UCITS multi-manager solutions. We typically discuss with clients what they believe is an acceptable level of fees for their own end investors and then we help them to select the best strategies and managers to fit their framework.
"Fee level is obviously not the main criteria to select strategies and managers. In general, when we approach managers to act as sub-managers to these initiatives, we usually target those who are already familiar with the concept of liquid alternatives. They are quite open to discussing these opportunities and we tend to find that fees rarely become a sticking point," says Spada.
Looking ahead
As market volatility returns, investors are looking for more defensive strategies to protect their portfolios from downside risk. This should act as a catalyst for MAP growth over the next 12 months. Amundi's Hart says that investors are looking more at platforms to get exposure to emerging and mid-sized managers "because they need that reassurance that the MAP has control and transparency – daily look-through, T+1 risk reporting, etc, which is provided to the client on an aggregated basis, through weekly reports, as opposed to relying on monthly reports from the manager when investing directly. They need a safety net, just in case something goes awry with the manager."
In conclusion, Lapkin thinks that another potential growth driver will be the need for active risk management, especially among FoHF managers as they look to enhance the transparency and risk reporting on underlying managers. This offers two potential benefits:
• The ability to improve portfolio construction – are managers working well together?
• Greater active risk management – closely monitoring correlations among managers in the portfolio, levels of beta exposure to the market, etc.
"We are seeing quite a lot of interest among FoHFs for our DMA solution as they look to build their own private platforms of managed accounts. It allows them to be more flexible with their investors in terms of building customised solutions using managed accounts as building blocks," concludes Lapkin.
