For all the attendant challenges facing hedge funds – from greater fee pressures and more onerous compliance burdens to lacklustre performance and investor aversion – the industry has time and again demonstrated its ability to continually innovate and reshape the way it does business.
As the balance of power moves decisively away from managers and towards investors, managed accounts have continued to gain traction among allocators who want a greater degree of control, customisation and tailoring in their alternative investments, underpinned by the promise of increased transparency in portfolios and the appeal of lower fees.
As interest in managed account investing has piqued – industry estimates suggest an annual double-digit growth in this area – the notion of the structure gradually becoming the investment model of choice in the future appears to be borne out by the numbers: more than a third (36 per cent) of investors polled in last year’s JP Morgan’s annual Institutional Investor Survey allocated to hedge funds through managed accounts in 2018, up from 29 per cent in 2016 – with that number tipped to grow further.
“Year-over-year, there continues to be an increase in demand for managed accounts,” observes Joshua Kestler, head of the business at HedgeMark, the USD23 billion hedge fund dedicated managed account platform unit of BNY Mellon.
“As hedge fund managed accounts become more mainstream, we see increasing demand from new allocators looking to adopt the structure, and from existing investors to grow their exposure to manage accounts. I expect that to be the case into 2020 as well.”
Of those investors currently allocating to hedge funds through managed accounts, more than a third (34 per cent) planned to increase their usage, according to JP Morgan’s wide-ranging survey – with pension funds (60 per cent) and fund of funds (57 per cent) most keen to expand their use.
What’s fuelling this upsurge? Nathanael Benzaken, chief client officer at Lyxor Asset Management, identifies the prevailing macro environment as a major driver of growth.
“We have been seeing growing interests for ‘diversification strategies’, as most traditional asset classes – equities, fixed income and credit – are perceived as expensive, and within some regions negative long-term interest rates.” Consensus, according to Benzaken, suggests this sentiment is likely to last for some time.
“Hedge funds exhibit compelling diversification features while being reasonably liquid, compared to illiquid assets such private equity, real estate or infrastructure. As appetite for hedge funds and liquid alts grows, so does the average size of the investment. To have an impact on the overall portfolio, such investments needs to be properly sized. The bigger the size, the bigger the exposure to operational risk and the stigmata of the Madoff and alike is still vivid. The managed account framework provides a solution to mitigate this operational risk, enabling to scale up allocation with greater level of security.”
Control of capital
Transparency continues to be a dominant theme in the managed account-hedge fund-investor dynamic. But greater control over assets, fees and expenses has also become an increasingly live issue, according to JP Morgan’s annual survey – with clients placing a particularly keen focus on lowering the costs of a hedge fund investment programme.
“Large Institutional investors have discovered they have increasing leverage to customise the mandate and negotiate lower fees, which consequently can lead to increased risk adjusted returns,” observes Andrew Allright, CEO of InfraHedge, the hedge fund managed account infrastructure unit of State Street which currently manages in excess of USD25 billion. “But transparency and control are still clearly important elements and remain a key factor in investing via managed accounts.”
Alexander Hill, director of alternative investments consulting, at Societe Generale Prime Services adds: “I think the managed accounts model has obvious benefits to several strategy types if there is scalability.
“If it’s a pure futures only CTA strategy, for instance, then a managed account is beneficial because you can fund it with margin, rather than having to put the full amount of capital in. That, for some allocators, is a better and more effective use of the capital that they have to play with.”
On the other hand, however, Hill believes managed account structures can get more tricky when the strategies involve non-cleared products that are traded bilaterally. “This can increase the complexity of the execution set-up and reduce the scalability benefits due to higher funding requirements.”
A snowball effect
From the other side of the fence, there has been a sweeping change in hedge fund manager willingness to participate in, and offer, managed account products in recent years.
Close to two-thirds of hedge fund managers have reported successes in launching new and non-traditional offerings for clients, including customised portfolios and separately managed accounts, according to EY’s annual Global Alternative Fund Survey, published in November. As a result, hedge fund managers are now increasingly open to offering up their strategies to allocators in more tailored and bespoke formats.
Underpinning this momentum is the challenging fundraising environment for hedge funds over the past few years, as performance has remained decidedly mixed compared with other investment products. This has prompted managers to seek out alternative ways to attract investor capital, with managed account money increasingly comprising a bigger slice of hedge funds’ overall AUM.
“Managers are beginning to understand that managed accounts are here to stay and that in many instances are becoming the preferred investment structure for institutional allocators,” says Kestler.
EY’s study found that more than 60 per cent of all hedge fund managers, including more than 75 per cent of those with assets greater than USD10 billion, now offer their strategies in separately managed accounts. In turn, managers report an increase in their SMA-based assets from 25 per cent in 2018 to 32 per cent in 2019. Looking ahead, close to 40 per cent of managers expect this trend to continue, EY’s report noted, double that number a year ago.
What has changed in the industry is the rise of what we call dedicated managed accounts,” Kestler continues. “Allocators have used their influence and dollars to change the conversation. Large institutional investors who can put USD100, or USD200 or USD300 million or more into a vehicle, are able to use this leverage to tell managers that if they want investor capital, they’re going to have to provide access to the strategy through a managed account.”
With the investor-manager-intermediary dynamic in a considerable state of flux, Evan Katz, managing director of New York-based hedge fund fundraising firm Crawford Ventures and former member of the Hedge Fund Association’s Board of Directors, sees managed accounts platforms reaching a critical mass.
“There is an increasing trend for a) investors looking at managed account platforms as a way of sourcing and allocating to hedge funds; and b) hedge funds looking to use MAPs in order to get increased and additional exposure to more alternative investment allocators, namely, more institutional investors and family offices,” says Katz.
“As more allocators and more hedge funds become increasingly familiar and comfortable with MAP concepts and technologies, the onboarding continues, and there has been an snowball effect. That is, with an increasing number of managers on the platforms, the more relevant and helpful they are to allocators. And conversely, the more allocators that are on the platforms, the more appealing it is for managers and funds to be on MAPs.”
The evolving landscape
The sheer range of choices on offer reflect the diverse and continually-evolving backdrop in this sector. Dating back to the 1990s, the managed accounts model for hedge fund investing initially surfaced out of a latent demand for exposure to trend-following strategies. Since then, though, managed account platforms have become home to the full scope of hedge fund strategies, with quantitative funds and strategies run by emerging managers attracting notable investor inflows into MAPs.
“A lot of smaller CTAs that are one-man bands or one-woman bands know how to make great money and to put up significant alpha with less-correlated returns, but many may not have sufficient infrastructure necessary to attract as many allocators as would larger and more established funds,” says Katz.
“Similarly, a lot of emerging manager hedge fund platforms have popped up because it seems to be a niche area that a lot of allocators know will produce some of the greatest returns.”
Underlining this point, Katz points to numerous hedge fund industry studies and research that found that emerging manager hedge funds, on average, achieve 100 to 300 basis points a year better returns than larger, more established funds.
“Industry experts theorise that such longstanding and continued outperformance is because the smaller and younger emerging manager funds are both a) more “nimble” and also b) “hungrier” than their much larger and more established colleagues,” he says. “Yet some allocators can be a bit skittish of some of the actual or perceived risks and infrastructure shortcomings of some of these emerging managers, and therefore may want to avail themselves of the platform approach.”
Expanding on this point, Katz continues: “99% of so-called emerging managers are, in fact, actually seasoned professionals who have run money very successfully at other shops. There are many who are in their late thirties, forties, fifties or even sixties, often with decades of experience.
“Many emerging managers have great teams, great track records and certainly enough infrastructure to support allocations even from some of the world’s top investors. But to the extent that some allocators may have misperceptions about emerging manager operational risks, managed account platforms may be a better way of accessing them.”
Along with shifts in sentiment, the sector is also seeing structural changes. While managed accounts are now often dedicated to clients, especially for large hedge fund allocators, there is nonetheless a growing demand for commingled managed accounts, offered to several clients, domiciled either offshore or onshore.
For Lyxor Asset Management, the strategic model is to offer both dedicated and commingled, primarily UCITS, managed accounts, says Nathanael Benzaken.
“For dedicated managed accounts large allocators have and will continue to adopt the managed account as their primary way of allocating to hedge funds when they want their hedge fund portfolio to have an impact on their overall allocation – to ‘move the needle’ as it is often characterised. But it requires sizeable investments,” explains Benzaken.
“For commingled managed accounts, the rise of UCITS outside the US as a way to access talented, often non-Europe based managers seems to be unstoppable. It is not only attractive for investors – it is a regulated ‘mutual fund’ – with all the managed account benefits, but it is also quite attractive for managers willing to diversify their client base outside their own markets. This is particularly true for managers outside Europe as the offshore format is restricted in Europe,” he adds.
Turning to current challenges and future opportunities, Benzaken believes the primary barrier to growth is available investment capacity.
“If there is available investment capacity from a manager, there is no good reason to refuse to manage a managed account. Premier managers have adopted it,” he says. He notes that for UCITS managed accounts, certain UCITS rules regarding liquidity, volatility and ineligible assets means not all traditional hedge fund strategies can be structured in a UCITS format.
But, Benzaken adds, an advanced managed account solution continues to provide considerable added value for a client – “what is often called structural alpha,” he says – spanning greater transparency, fee structure negotiation, increased leverage for more cash efficiency, and optimisation of administrative costs and expenses.
More recently, as environment, social and governance (ESG) matters have become a firm fixture among investor concerns, managed account solutions have started to help build in an ESG framework into model. The most basic version is the implementation of a proprietary exclusion list, Benzaken notes. “We are working on expanding towards a proper comprehensive ESG framework,” he adds.
Looking ahead, while managed accounts continue to draw in investors, it remains to be seen whether the model will ultimately become the investment vehicle of choice when comes to investors allocating to hedge funds.
The product itself remains diverse in scope, while Allright also points to the growing geographical divergence in managed accounts. “In North America, there have been a string of new mandates and it is still the dominant area for managed account investing,” says Allright. “The APAC community is by and large still in discovery mode and to date there are few investors that invest in this vehicle. The demand in EMEA is principally through asset managers launching multi-manager UCITS”.
He also flags up a number of challenges for investors “both in the structuring of fund vehicles and the operational complexities of suddenly moving from a single line item to represent a fund valuation to potentially hundreds of thousands of line items.”
Commenting on InfraHedge’s approach, he continues: “Our platform focuses on the infrastructure to provide a window into how the fund is operating and performing and whether it is compliant with regulatory or investor investment guidelines. To do this, you need both expertise in fund investment, accounting and operational understanding and the automated technology to process, clean and normalise, and present reporting output in a meaningful manner.”
He adds: “Managed accounts are still predominantly used by the largest institutional investors as managers will still baulk at setting up accounts with low AUM. However, more thought is being given in the industry about creating fund platforms where smaller investors can allocate,” Allright says of current trends. “Some of these are gaining traction but there will I think always be the need for the traditional co-mingled flagship fund structure in the market.”