Securities Services: Managed accounts: an efficient way to build hedge fund portfolios?
There has been a buzz around managed accounts for some time - but the problems with liquidity mismatches and outright fraud that bubbled up in 2008, and investors like CalPERS setting out plans to use them wherever they can, seem to have made the case even more airtight.
"The fund of funds model is great for the smaller institutional investor who does not have the wherewithal to trawl through 8,000 hedge fund managers," says Akshaya Bhargava, CEO of fund administrator Butterfield Fulcrum, which launched its Altinus managed account platform in February.
"But given what happened through 2008 in terms of gating, fraud, lack of transparency, I fail to see why anyone who can do so is not using managed accounts."
A platform certainly helps with the operational side of building an in-house hedge fund portfolio: it enables the investor to focus on asset allocation while using the IT, reporting, legal, prime services and custody infrastructure of the platform provider.
Moreover, the platform provider becomes the counterparty facing the fund manager, limiting the end investor to a loss of 100% of NAV in the case of the manager going bust - even if the broken strategy was leveraged.
"We wouldn't be surprised to find that some of the larger players that have opted to do it themselves do not eventually decide to revert back to an outsourcing model, because it's a very complex equation," says Nathanael Benzaken, head of managed accounts development at Lyxor.
But while much has been made of the operational and fraud risk mitigation associated with managed accounts, few have considered the advantages for investors who want to in-source their hedge fund allocation.
If you have the capacity to interpret the position-level reporting that a managed account can offer, that obviously helps to make the use of strategies as beta replacements. The enhanced liquidity also makes it easier to act upon this information.
"You have the ability to move your money about much more fluidly," says Paul Dackombe, head of UK institutions for Man Investments, whose managed account platform won a big mandate from the UK's Universities Superannuation Scheme (USS) in April.
Mike Powell, from USS's absolute return strategies team, explains that the scheme effectively leases Man Investments' operational infrastructure to support its own hedge fund allocation programme.
"We have ultimate ownership of the assets, daily transparency and risk monitoring and, because we negotiate an IMA directly with the manager, we can also put our own risk constraints around the strategy ourselves - to prevent them from moving into illiquid instruments, for example."
Of course, the ability to tailor liquidity exposure blurs the line between operational risk management and investment risk management.
At the Barclays UK Retirement Fund, head of manager selection Andre Konstantinow, puts a very different spin on the same capability. "With bespoke mandates we can tailor the liquidity we want and therefore capture returns from some of the illiquid strategies like distressed," he says. "We are able to get exposure to those strategies at the right time and with the right liquidity constraints."
As Benzaken notes, none of this means anything if your managed account platform neglects the "performance-engine aspect" - in other words, picking good managers and reproducing their strategies faithfully.
This has always been the sceptic's objection - that negative selection bias, liquidity constraints and the lack of priority given by the best managers to their managed account clients drags on performance - which makes the latest contribution to the debate, from Investcorp CIO and head of hedge funds Deepak Gurnani and Allstate Investments hedge fund portfolio manager Christopher Vogt, worth noting.
Their regressions of 44 months of returns from a managed account dummy portfolio and 13 strategy dummies based on their own live multi-manager portfolios show the managed accounts outperforming by a massive 7.9% annualised (and by more than 10% during the stresses of 2007-08).
"In addition to reducing volatility, risk management for separate accounts improves returns by reducing severe losses," Gurnani and Vogt argue.
"The liquidity of separate accounts enables investors to rebalance their portfolios even during times of stress, when some commingled hedge funds might restrict or even suspend redemptions."
The appendix to their paper, ‘Separate Accounts as a Source of Hedge Fund Alpha', makes it clear that setting up separate accounts "is neither easy nor free", but as they suggest, if a separate account portfolio outperforms a fund portfolio by 10% during times of stress and there is a 10% chance of a material drawdown in a hedge fund portfolio, the "actuarially fair" insurance premium would be 1% of assets.
For large investors, the full cost of separate accounts is likely to be "substantially smaller", the authors point out, and since the costs are fixed, the larger the allocation the more favourable the cost-benefit equation becomes.