Managed accounts are proving to be an effective tool for institutions to better control fee structures in hedge funds. What’s more, by building customised mandates using carve-outs of managers’ strategies, investors are able to enjoy a better investment experience that fits their individual risk appetite.
An article by CNBC on 17 October 2016 revealed that New York state had paid hedge fund managers USD1 billion in fees over the last eight years. The New York State Department of Financial Services said pension investments in hedge funds had been a giant failure, resulting in USD2.8 billion in underperformance.
This is exactly the kind of negative press that hedge funds get tired of. At the end of the day, institutions should know exactly what they are buying, and how much it will cost, and enter into each hedge fund investment with eyes wide open. One billion dollars in fees is a significant figure, but ultimately investors have to take responsibility for the fees they negotiate and, more importantly, the managers they choose to invest with.
The fee issue will forever polarise opinion but one of the most effective ways to control fees is to use managed accounts.
“Amid low interest rates and a strong performing equity market, whilst few hedge fund strategies are outperforming but are providing diversification benefits, people will question whether the higher fee model makes sense,” says Peter Sanchez, CEO of Northern Trust Hedge Fund Services.
He says that while investors who choose to invest through managed accounts probably incur costs to set up a MAP or fees from joining an existing platform, “investors will potentially reduce the performance fees or management fee that they pay to the manager if they are delivering a significant capital allocation”.
Negotiating fees is precisely what managed account platforms like Man FRM, one of the industry’s leading platforms with approximately USD10 billion in AUM, will do on behalf of their large institutional investors; those looking to have their own dedicated structures.
Keith Haydon is Chief Investment Officer at Man FRM. He believes that one can control the expenses in a managed account much more effectively than investing in a manager’s offshore fund. “There are often extra chargeable items in a hedge fund that are not included in the headline fee (e.g. the hedge fund incurs costs for travel and research) but might be included in the small print. We would look to exclude the pass-through of costs.
“We have some funds where we don’t pay them a management fee at all, but we do pay them a higher performance fee after a 5 or 6 per cent hurdle. If a manager makes 6 per cent, I might not mind giving him a 30 per cent performance fee for any returns over and above that hurdle rate,” says Haydon.
Using managed accounts to negotiate fees should be exercised with caution, however, depending on who the manager is. If they are running hundreds of millions in AUM, Haydon’s reference to hurdle rates and higher performance fees is fine. If, however, they are an emerging manager with a modest AUM, stripping the management fee can be dangerous.
Bruce Keith is the CEO of InfraHedge, an open architecture MAP owned by State Street, which has seen its total AUM climb from USD19.3 billion to USD26.3 billion during 2016. He says: “Customised mandates make up the vast majority of the AUM with very few clients choosing to mirror a manager’s commingled fund.
“The main driver for large institutional investors choosing private managed account platforms is the desire for enhanced transparency and oversight of customised portfolios at a lower price point.”
Performance woes
The last few years have tested investors’ faith in hedge funds, as a broad asset class, with performance considerably lower than expectations. This, alongside the fee issue, has added to the negative perception of the industry. In an environment where hedge fund returns are not beating the S&P 500 and likely not beating bond portfolios in terms of returns and volatility, says Sanchez, “institutional investors will invest in hedge funds. If they get full transparency where, for example, they can manage style drift and leverage; if they are able to protect against fraud; if they can negotiate fees. That’s where managed accounts can give them improved transparency at reduced costs versus a normal LP investment.”
Of course, managed accounts cannot improve performance, per se. There is no secret sauce to using them. But what they can do is allow investors to more effectively monitor their investments.
Northern Trust supports platform sponsors by giving them an aggregated investment book of records across all their managers and self-managed funds, providing what it calls `operational alpha’ services.
“Once you have a consolidated view across managers, we find sponsors leveraging our platform to centralise the service model for things such as collateral management, cash and FX execution, etc. This leads to reduced costs, improved efficiency and drives net performance across their business,” explains Sanchez.
That ability for platforms to offer a consolidate view across investors’ traditional and alternative managed account portfolios can go a long way to helping them understand the drivers behind their hedge fund allocations and build a much clearer picture of where the best alpha-generating returns are coming from; this in turn can help institutions justify their hedge fund allocations to investment boards.
Use of carve-outs
One of the most effective ways of using managed accounts is to materially adjust a manager’s investment strategy to an investor’s particular requirements. This ability to customise a strategy is often referred to as a carve-out and it is something that Man FRM does for the majority of mandates on its platform.
Again, whilst this will not guarantee out-performance, a carve-out can at least provide the best possible opportunity to achieve a desired outcome.
Haydon points out that there is often a natural gap between what hedge funds want to produce when they are privately owned, and what clients want to buy. Managers want longevity and growth, there is a lot invested in the hedge fund and if it goes wrong it’s a disaster.
“For an investor, they might hold a diversified portfolio of 10 and 20 hedge funds and if one goes wrong it’s not a disaster, they just replace it with another one. So there is a different psychological view as to what a hedge fund represents to the manager and to the investor.
“The investor running a diversified portfolio may want much greater risk in the individual funds than a hedge fund manager wants to run in his own business. This constitutes a gap in the utility function and the appetite for risk, which can be hard to close without using managed accounts,” explains Haydon.
Dial up the risk
The simplest approach to closing that gap is for the multiple fund investors to increase the risk level in the strategy they wish to allocate to. In many cases this is possible because hedge funds often don’t use all the capital that the investor places with them. Leverage tends to come from the instruments as opposed to borrowing money.
Take a CTA with a 10 per cent volatility profile. He may deploy USD15 out of every USD100 and the other USD85 might be held in T-bills.
“An investor could adjust the mandate at three times the exposure level, move it from 10 per cent to 30 per cent volatility and they would still have USD50 out of every USD100 sitting in T-bills to cover margin calls. The manager might not want to run a 30% volatility product for their private fund, but this can potentially be achieved using a customised managed account,” says Haydon. “We run most of our equity long/short exposure at 1.5 to 2 times the level of exposure that might be available in a manager’s flagship fund.”
By having a dedicated MAP, institutions are able to look at hedge fund managers as trading experts. “That means they are able to go after some of the smaller managers that can generate higher risk-adjusted returns because, from the operational side, they don’t have to worry about the risk of fraud, for example: they own the assets and are simply using the manager for his trading acumen,” says Andrew Lapkin, CEO of HedgeMark, a BNY Mellon company.
Discussing carve-outs, Lapkin comments that one of the benefits they offer investors is the ability to invest in a portion of a strategy. They might really like two thirds of a global macro strategy, for example, but may feel there is too much emerging market equity exposure, or too much credit exposure.
“By using a managed account, investors can tailor the strategy specifically using one of these carve outs, allowing them to exclude certain exposures that they may already have in their portfolio. Taking this tailored approach can also increase the willingness of the manager to do a managed account as it may be perceived as reducing the potential for cannibalisation of the manager’s existing commingled fund,” says Joshua Kestler, President and COO of HedgeMark.
He confirms that some of the more typical carve-outs HedgeMark has seen include changing the risk profile, echoing Haydon’s point, whereby an investor might want a more levered version of the strategy, or reduce the risk and use the strategy as a fixed income replacement.
“Being able to adjust the leverage profile to fit the investor’s investment goals is a powerful proposition for a dedicated managed account,” says Kestler.
Strategies that investors favour for carve‑out purposes include CTAs, macro strategies and credit strategies, as well as tail-risk strategies.
“This is largely because investors want an effective way to hedge against market risk. Managed accounts work very well for these types of high convexity strategies because each investor is going to be slightly different in terms of the use of derivatives, etc,” adds Lapkin.
Management of liquidity
Dedicated managed accounts can also be used by investors to better manage their liquidity.
Where there is a mismatch between the liquidity of instruments in the vehicle and the liquidity terms that the investor has with the hedge fund, in such a situation people tend to be uncomfortable pooling their assets in a commingled vehicle. If other investors in such a vehicle decide to redeem, one might be left holding illiquid assets in the fund that cannot be sold in line with one’s liquidity requirements.
They might then choose a managed account, with no carve-out, but at least they hold the assets and don’t have to worry about other investors redeeming.
“We might look at a strategy where 95 per cent of it is held in liquid assets, whereby we would be comfortable getting our money back within say 40 days following a market stress event, but the other 5 per cent is held in private markets. If we say to the manager, `We’d like to run a managed account so please remove that 5 per cent allocation,’ they often will. Straight away you’ve mitigated the problem of liquidity by doing that,” comments Haydon.
That is one of the reasons why so many managed accounts have failed to produce good investment returns because the liquidity transformation that has been imposed on the manager has been too strong: i.e. the investor wants daily liquidity in a quarterly liquidity strategy. The manager might end up with a much more constrained version of the strategy and any previous track record no longer applies
“Liquidity transformation can be abused on the part of the managed account holder and they may end up shooting themselves in the foot,” opines Haydon.
With MAPs continuing to embrace technology, they are helping investors overcome the very issues that often get sensationalised in the wider mainstream media: high fees, lack of transparency and so on. Moreover, with carve-outs offering a bespoke investment experience, there is a good chance that institutions will continue to invest and keep faith in alternative assets.
“Offering overlay FX management and aggregated collateral, cash and treasury management are unique ways for platforms to provide operational alpha. I would say that some MAPs are on the cusp of providing these capabilities,” concludes Sanchez
