Demonstrating control in a crisis (again): How Covid-19 has reaffirmed the hedge fund allocator shift to dedicated managed accounts
By Joshua D Kestler, Global Head of HedgeMark, BNY Mellon – In the 12 years since the 2008 financial crisis, many large institutional investors have adopted Dedicated Managed Account (DMA) structures in order to address the challenges in commingled hedge funds that were exposed during the crisis (click here for a brief refresher). These investors were well-prepared to more effectively manage their portfolios through the market volatility which has resulted from the Covid-19 pandemic while eliminating many of the structural risks that can be exacerbated during a crisis scenario.
Let’s look at some of the ways that allocators in 2020 have been able to use the benefits of DMAs to more effectively manage through the market impact of Covid-19.
The flexibility and dynamic nature of DMAs
DMA structures provide significant flexibility with regards to the timing of subscriptions and redemptions and allocator-directed adjustments in gross exposure. DMA allocators took advantage of this flexibility in multiple ways throughout the first half of 2020. Certain DMA allocators saw market declines in March 2020 as a buying opportunity. DMAs allowed these allocators to deploy additional capital to their managers’ intra-month to promptly take advantage of depressed prices. In addition, DMA allocators were quickly able to make opportunistic co-investments in high conviction assets and investment themes particularly during the early stages of the market dislocation.
The control and flexibility of the DMA structure allows the allocator to rebalance their portfolio at any interval. If performance or other factors require a portfolio rebalance, the DMAs can be rebalanced intra-month on any day desired by the allocator, rather than waiting for a month-end or quarter-end redemption date within a commingled fund.
This feature is particularly valuable in times of market volatility. For example, certain DMA allocators were able to redeem capital from trend-following managers after these strategies had performed quite well during the market decline in March 2020. These allocators were able to quickly redeploy the redeemed capital to other opportunistic investments (eg their long equity portfolios). In a time of extreme market stress or volatility (such as the market experienced earlier this year), DMA allocators are able to rapidly rebalance their portfolios in response to significant market and performance changes. These allocators were able to rebalance and adjust their portfolios more quickly and dynamically than allocators that implement their hedge fund programs through investments in commingled funds.
Lastly, many DMA clients utilize the concept of a “Trading Level” with their underlying managers. Trading Level is the amount of notional capital that the underlying hedge fund manager will invest on behalf of the DMA. As many hedge fund strategies (eg CTA, equity long-short, and macro) do not require full cash funding to achieve the desired exposure, many DMA clients use a Trading Level approach to minimise the amount of cash that needs to be deployed to each DMA. Cash that is freed up through the Trading Level structure can be deployed by the allocator in other ways. Trading Level can typically be adjusted on any day by providing notice to the hedge fund manager.
During this year’s market dislocation, DMA allocators have used Trading Level to increase or decrease their volatility targets for particular DMAs based on their comfort level with a given manager, strategy and/or prevailing market conditions. In certain cases, DMA allocators have decided to increase the Trading Level in order to achieve greater exposure to their hedge fund strategies. In other cases, allocators have decided to take down the Trading Level of certain hedge fund strategies and, for example, increase long beta exposure with the additional free cash.
Asset segregation & control
The dedicated managed account structure segregates an allocator’s assets from other investors, removing co-investor liquidity risk and provides the allocator with direct control over its assets. Further, since the assets are ultimately owned and controlled by the allocator in a dedicated managed account structure, the hedge fund manager has no ability to gate, suspend or side pocket the assets.
During the most volatile months of the first half of 2020, the industry saw both gating of redemptions and pressure on managers from counterparties to reduce their market exposure. DMA allocators benefited from asset segregation and control in several ways. Many managers, particularly in the credit space, experienced a liquidity crunch as a result of margin calls in March 2020. In a traditional commingled fund, managers may have been forced to sell depressed assets in order to meet margin calls. Certain DMA allocators decided to subscribe additional capital to these types of strategies in order to avoid a fire sale of assets. These allocators were later rewarded as markets improved over the next several months. This benefit of DMA structures can be referred to as the ability to “control your own destiny.”
In commingled funds, the behaviour of other investors can force a sale of assets, a liquidation of the fund in its entirety or cause the suspension or gating of redemptions. In a DMA structure, the allocator controls its own destiny. There are no other investors that can impact the disposition of assets or the investor’s ability to redeem capital. If the DMA investor has conviction in a particular strategy, the investor can remain invested through a crisis and can even add capital without fear that the fund will be liquidated or that there will be restrictions imposed on redemptions. Conversely, the DMA allocator can choose at any time to liquidate the fund or to redeem a portion of its assets. During times of market stress, DMA allocators can quickly terminate a manager and liquidate a portfolio or partially redeem assets from a DMA to deploy in another manner.
The historical lack of transparency in traditional hedge fund structures has made it much more complex for investors and their advisors to effectively analyse, select and monitor managers, both on an individual basis and as part of a broader portfolio.
Transparency is a core benefit of investing in DMA structures. DMAs provide investors with the ability to see, monitor and analyse daily performance, performance attribution and risk exposures. The frequency and granularity of this data should allow the investor and/or its advisor to more effectively manage their hedge fund portfolios from both an investment and risk perspective.
Throughout the 2020 market volatility, DMA allocators have benefitted from daily performance and position-level transparency in several ways. First, DMA allocators knew exactly what positions and exposures that they had each day. This information has allowed investors to better understand the investment and risk impact of their hedge fund allocations on their broader portfolio. As a result, DMA allocators have been able to more rapidly evaluate the potential need to rebalance and/or adjust their portfolios based on the availability of daily data.
Further, DMA allocators have been able to have a detailed and meaningful dialogue with their managers on any given day with regards to performance and portfolio positioning based on the daily data.
Lastly, DMA allocators have been able to respond quickly to management reporting queries from their boards and investment committees with respect to their hedge fund portfolios. For example, DMA allocators could quickly determine the performance of their hedge fund portfolio as well as total exposure to a security, industry, sector or region without having to contact each manager to request such information.
Times of crisis reinforce the importance of having position-level transparency to improve rapid investment and risk analyses and decision-making along with the ability to maintain a robust and meaningful portfolio dialogue with underlying managers, boards and investment committees.
The 2008 financial crisis proved that times of market stress reinforce the benefits of hedge fund managed account structures. The lessons learned in 2008 drove many investors to shift to investing through hedge fund managed accounts.
Institutional investors that now have their own DMA platforms had the opportunity to be rewarded during the Covid-19-related 2020 market dislocation. DMAs evidenced a more dynamic and controlled way of accessing the hedge fund asset class. By having a DMA platform, allocators have the ability to avoid many of the issues faced by commingled fund investors in times of market stress. In addition, DMA allocators have been able to use the dynamic and flexible nature of DMA structures to more effectively manage their portfolios and assist them to achieve their investment objectives.
Much like the 2008 financial crisis, the 2020 market volatility has resulted in an increase in demand in recent months for managed account structures and services. This trend is expected to continue into the near future as Covid-19 has once again reaffirmed the value of DMAs.
BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally. HedgeMark Advisors, LLC (“HMA”) provides dedicated managed account solutions to institutional clients comprising consultative, administrative, middle office, and technological services (directly or through its affiliates), including daily (generally T+1) investment guideline compliance monitoring, and daily holdings-based risk, performance attribution and performance analytic reporting provided by HedgeMark Risk Analytics, LLC. The managed accounts are referred to as “Funds” for purposes of this document. HMA transacts business in the United States and other jurisdictions where it is properly registered, or excluded or exempted from registration requirements.
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