By Josh Kestler, HedgeMark – On April 14, 2016, the trustees of the New York City Employees’ Retirement System (NYCERS) voted to liquidate its hedge fund portfolio. Following California Public Employees’ Retirement System’s decision in September 2014, NYCERS announcement has once again ignited a debate regarding the future of the hedge fund industry.
While hedge funds are currently under pressure from politicians and some members of the investment community, their demise has been greatly exaggerated. Hedge funds offer many benefits to investors including access to unique investment opportunities and return streams, the ability to hedge certain risks and overall portfolio diversification. As a result, many institutional investors continue to increase and make new allocations to hedge funds and I expect that trend to continue for years to come.
The term “hedge funds” is broadly used to describe private pooled investment vehicles which (1) are only available to certain qualified investors, (2) may use one or more different investment strategies (which may use leverage, derivatives and/or take short positions in securities), and (3) charge a management fee and typically, a performance fee. Hedge funds are really a type of investment structure rather than a specific investment strategy or asset class. Many of the issues consistently raised by hedge fund investors relate to the investment structure rather than the investment strategies used by hedge fund managers. NYCERS cited concerns with the lack of transparency, “exorbitant” fees and overall performance of its hedge fund investments amongst the reasons for eliminating hedge funds from its portfolio. These concerns can be largely addressed by changing the investment structure through which institutional investors access hedge funds. In order to address these concerns, many institutional investors have begun to shift from making investments in traditional, commingled hedge fund structures to hedge fund Dedicated Managed Accounts (DMAs).
A DMA is a customized single investor hedge fund with portfolio assets ultimately owned (and controlled) by the investor. DMAs provide numerous benefits including greater control, transparency and governance of hedge fund investments, the ability to customize investment mandates, and the potential for fee compression. These benefits directly address the concerns raised by NYCERS and other institutional investors regarding hedge funds.
Transparency
Commingled hedge funds have traditionally provided limited portfolio transparency (e.g. top positions and high level exposures) and any such data is generally presented monthly on a time lag. This limited transparency has severely restricted the ability of investors and their advisors to effectively analyze, select and monitor hedge fund managers (both on an individual basis and as part of a broader portfolio). In contrast, daily position-level transparency is a key benefit to investing through a DMA structure. DMAs allow investors to monitor and analyze daily performance, performance attribution, and risk exposures. The frequency and granularity of this data should allow the investor and/or its advisor to have more substantive and informed discussions with managers and to more effectively manage their hedge fund portfolios.
Fees and Expenses
The flexibility of DMAs offers large institutional investors the potential opportunity to negotiate a discounted and/or tailored fee arrangement with each hedge fund manager. A DMA is a separate vehicle and can often have key differences from the manager’s commingled benchmark fund, such as reduced operational burden on the manager, differences in investment strategy and guidelines. The use of a DMA structure combined with a significantly sized investment can and often does allow the investor to achieve a material discount from the traditional 2% and 20% fee model. DMAs also allow the investor to design custom fee structures such as fixed or flat management fees, incentive fee hurdles, multi-year (deferred) incentive fees and performance claw-backs. The DMA structure also enables full transparency into trading-related expenses that a manager allocates to investors outside of the management fee. These fee structures can work to better align the interests of the manager with those of the investor.
Performance
While the DMA structure does not inherently improve manager performance, it does allow investors to customize investment strategies to their desired risk tolerance and investment goals and to better monitor and analyze managers and strategy over-lap. DMAs provide investors with the ability to directly negotiate custom, written investment guidelines with each hedge fund manager to, among other things, help to ensure that the portfolio is managed in accordance with the investor’s specific objectives and expectations and to help prevent style drift and extreme concentrations. The use of custom investment guidelines combined with the benefits of daily performance and risk transparency allow for far superior oversight of hedge fund investments both individually and as a component of the investor’s broader portfolio.
Conclusion
While NYCERS and other investors have raised legitimate issues with the traditional hedge fund investing model, there is an alternative to exiting hedge fund strategies altogether. An increasing number of institutional investors are using DMAs as a mechanism to address these key issues and to obtain greater control, transparency and a reduction in manager fees. As the hedge industry continues to mature, we believe that DMAs will increasingly become the preferred hedge fund investment structure for institutional investors.
