By Joshua Kestler, President and Chief Operating Officer, HedgeMark Advisors, LLC – Over the past several years, multiple public pension plans have implemented material Crisis Risk Offset (CRO) programmes to hedge or “offset” the significant growth risk in their portfolios. In other words, these programmes are intended to generate positive returns when equities decline.
CRO programmes are structured to invest in strategies that are expected to be uncorrelated or negatively correlated to equity risk premium. These investments are generally intended to have a similar level of volatility to equities so that they can effectively offset equity beta losses in times of stress. CRO programmes generally utilise three strategy components, which include Long Treasury Duration, Trend Following/Capture and Alternative Risk Premia. Three of the large plans who have implemented CRO programmes (CalSTRS, Employees’ Retirement System of the State of Hawaii and Employees’ Retirement System of the State of Rhode Island) have done so through the use of Dedicated Managed Accounts (“DMAs”) because of the significant benefits associated with these structures.
DMAs are typically single investor funds established for the exclusive use of an institutional investor, such as a public plan. A managed account platform provider may be hired by the plan to build and operate the DMA platform and to provide risk and performance analytics and investment guideline monitoring services to the plan and/or its consultant. This paper summarises the benefits of DMAs particularly in the context of implementing CRO programmes.
Segregation of assets and asset control
The DMA structure segregates a plan’s assets from other investors, removing co-investor liquidity risk and provides the plan with direct control over its assets. The ability to redeem from a manager for purposes of rebalancing, reallocation or otherwise is of critical importance to a CRO programme given that such programmes are intended to perform best in times of extreme market stress. As the industry experienced during the financial crisis of 2008, periods of market stress can cause a liquidity crisis in commingled funds. In such circumstances, investors are likely to need or want cash and the most liquid strategies in their portfolios (eg CRO-like strategies) will be the easiest source of cash. As a result, commingled funds may experience the classic “run on the fund” issue which may result in gates and suspensions of redemptions. In the context of a DMA structure, the assets are owned by the DMA and controlled by the plan and, as a result, the fund manager will have no ability to gate, suspend or side pocket the assets. Plans which use DMAs to implement CRO programmes can rest assured of their ability to rebalance, replace a manager or redeem in both ordinary markets and in times of market stress.
Customisation of investment strategy and guideline monitoring
DMA structures allow a plan to customise all aspects of their platform including the investment strategies and investment guidelines of each specific DMA. The plan can tailor the investment strategies of its underlying CRO managers to meet the particular needs and objectives of the programme. For example, volatility targets can be dynamically adjusted at the direction of the plan using a DMA as opposed to a commingled fund which would be more static or shift only in the discretion of the manager. Importantly, a DMA structure also empowers the plan to negotiate specific, contractual investment guidelines to ensure that the underlying CRO managers trade the portfolio in accordance with the agreed investment mandate, do not stray from specific investment parameters or take extreme concentrations. CRO programmes generally have specific investment guidelines which include prohibited and permissible instruments, volatility targets, maximum drawdown limits, amongst others. Rather than relying on manager self-compliance in a commingled fund, in a DMA structure the plan’s platform provider can monitor compliance with such guidelines on a daily basis.
Cash efficiency
The strategies utilised by CRO programmes (e.g. Trend Following/Capture and Alternative Risk Premia) require lower levels of collateral to achieve the desired exposure. As a result, managers implementing these strategies tend to hold significant amounts of cash. In a commingled fund, the investor would be required to fully fund an investment even if only a fraction of the cash investment is required to achieve the applicable exposure. DMA structures facilitate a much more cash efficient approach to funding. If desired, a plan could invest only the required margin along with a reasonable buffer to pay expenses and meet future margin calls resulting from changes in P&L. The plan could use the remainder of the cash as it sees fit to obtain a return. For example, a trend following manager might only require 30% funding to achieve the desired exposure.
Rebalancing flexibility
The control and flexibility of the DMA structure allows a plan to rebalance the CRO portfolio at any interval. If performance or other factors require a CRO portfolio rebalance, the DMA could rebalance intra-month on any day desired by the plan, rather than waiting for a month-end or quarter-end redemption date within a commingled fund. This feature is particularly valuable for a CRO programme in the event of outsized fund manager performance and in times of market volatility. For example, a CRO programme would require a certain allocation between the relevant strategies (e.g. 33.33% in each of the 3 strategies) to maintain the proper balance of strategies to achieve the CRO investment objective. In the event that P&L causes a material change in weightings (e.g. +/- 3.5%), a DMA would allow for an immediate, intra-month rebalancing adjusted as opposed to waiting possibly several weeks to make the change in a commingled product. In a time of extreme market stress or volatility, maintaining the appropriate allocation between strategies could materially impact how effectively the CRO programme meets its investment objective.
Fee negotiation
The DMA structure provides the plan with an opportunity to negotiate a discounted and/or custom fee arrangement with each underlying fund manager. A DMA is a separate vehicle and can often have key differences from the commingled benchmark fund (e.g. reduced operational burden on the manager, differences in investment strategy and guidelines, etc.). The use of a DMA structure combined with a significantly sized investment by the investor can, and often does, facilitate the ability to achieve a fee discount from the fund manager. Many CRO programmes deploy sizable allocations which exceed $100m and, in some cases, a multiple of that. These allocations are ripe for negotiating discounted fee rates with managers.
DMAs also allow the plan to create custom fee structures with the fund managers such as flat management fees, incentive fee hurdles, multi-year incentive fees and incentive fee claw-backs. These fee structures can work to better align the interests of the manager with those of the plan. The DMA structure also permits the plan to approve or select each of the fund’s service providers (fund administrator, auditors, etc.) and to negotiate specific fee arrangements with such service providers. In addition, the DMA structure can provide the plan with complete expense transparency and the ability to control specific operating expenses that are charged to the DMAs.
The importance of transparency
The use of a DMA structure will allow the plan to obtain daily performance and risk transparency as well as position-level drill down. The frequency and granularity of this actionable data should allow the plan and/or its advisor to better and more efficiently manage the CRO programme from both an investment and risk perspective. The plan would have access to performance attribution, stress testing, scenario modelling, and value at risk (VaR) analysis, amongst other data. These capabilities would, for example, allow the plan to (1) understand drivers of performance and loss on a manager-by-manager and from a CRO programme perspective, (2) evaluate the correlation of each manager in the CRO programme to each other as well as to the broader plan and (3) shock each manager and the overall portfolio to evaluate expected performance under specific market conditions. In comparison to the general opacity of most commingled hedge funds (which may provide some delayed monthly risk reporting, if at all), the power of daily performance and risk transparency cannot be underestimated in terms of both portfolio management and risk management for a plan implementing a CRO programme.
Conclusion
As summarised above, there are extensive and material benefits for plans to use DMAs to implement a CRO programme (as opposed to investing in commingled funds). The customised nature of DMAs along with the control and transparency afforded by such structures result in a superior investment, operational and risk management model for plans allocating to CRO programmes. As a result, DMA structures offer a “best practices” approach to investing in underlying CRO managers and should be the market standard for CRO programmes.
Important legal disclosures: https://www.bnymellon.com/us/en/disclaimers/business-disclaimers.jsp#as-dma
