Hedge fund managers are increasingly employing managed accounts instead of the fund of hedge funds model predominantly used in the past. This trend stems primarily from recent market events, as well as the increased focus by managers and their investors on market risk and liquidity in investment strategies, and reflects the increased level of transparency and control over the portfolio’s underlying assets offered by the managed account structure.
Funds of hedge funds have recently seen redemption requests met by the underlying funds establishing gates or suspending redemptions due to their own liquidity challenges, preventing the funds of funds meeting their own investors’ redemption requests. Funds of funds now seek more transparency on holdings in the underlying portfolios, better enabling them to carry out risk analysis and assess the likelihood of encountering gates or suspensions should they seek redemptions in the future.
Fund of funds managers are also more conscious of the need to match the liquidity provisions of underlying funds with what they offer to their own investors. In the past bridge financing enabled them to pay out redemption amounts without having to redeem from their underlying positions before they felt it necessary; but the volume of redemptions experienced by funds of funds in 2008 and the tightening of credit presented managers with a liquidity issue. The problem was compounded for funds of hedge funds with leverage financing in place, which in some cases were obliged to impose gates or suspensions themselves.
Meanwhile, hedge fund managers have become more willing to support managed accounts as they seek to attract new assets and retain existing investors. Whereas in the past, minimum managed account mandates were as high as USD100m, in recent months accounts have been established with as little as USD10m, depending on the strategy. As well as funds of hedge funds, investors such as pension funds, sovereign wealth funds and other large institutions are now investing more assets via a managed account structure.
Yet this may not suit all investors. For a fund of funds, it is typically more expensive than investing through a pooled vehicle due to the increased infrastructure required. Rather than simply accounting for a single investment and receiving valuations from the underlying fund, they now need sophisticated systems and expertise to track investments, calculate the value of all underlying positions and perform risk analysis.
In the future, the pendulum is set to swing back to some degree and smaller managed accounts will become rarer, in large part because institutions need a critical mass of assets to justify the infrastructure cost and effort. However, the extra expense can be mitigated in various ways, and the benefits can outweigh the costs – particularly for larger mandates where the underlying managers have more latitude to customise fees.
Other alternatives can help funds of hedge funds fill the infrastructure gap cost-effectively. Fund managers can benefit from the platforms and applications built by third-party service providers such as SEI, which has drawn upon its extensive experience in managing back- and middle-office operations of single-manager hedge funds and funds of funds to create a scalable platform and comprehensive analytical tool set.
In the end, it’s hard to pick a model that will fit everyone’s needs completely. Instead, managed accounts are just one solution managers should think about in determining what works best for their business and investors.
Jim Cass and Mike Leahy are managing directors in SEI’s Investment Manager Services division