Alternative Investment Management Association Representing the global hedge fund industry
Everyone knows managed accounts are great for investors. If something goes wrong there is no messing about with redemption requests and gates - you get your money back straight away. What could possibly be wrong with that?
Unfortunately, quite a lot, when the assets involved are illiquid enough that holdings are measured in days of trading volume. Then the promise that you get your money back turns out to be a bit misleading, as all you really get is the right to sell the assets that have been bought in your name. Let’s do a thought experiment on what would really happen.
Imagine a manager who has 10 clients in his hedge fund until half of them decide to redeem during a 2008-style crisis. So the manager goes to the fund board, explains he can’t sensibly liquidate in one month, the gate closes and he starts selling. Let’s say it takes him three months and he gets only 70% of what he valued the positions at the day before the five phone calls, because selling in a crisis is never easy.
The result is that everyone hates the manager. The redeeming clients only get 70% of NAV, and not when they wanted it but three months later. From what I’ve heard, they will wrongly blame the decision to invoke the gate rather than the decision to buy large, illiquid positions in a fund with monthly liquidity, but either way they blame the manager. Maybe other clients believe in stop-losses and are shaken out, but even if they stay in until prices recover they won’t have enjoyed the ride. In summary, it’s a mess.
Since that didn’t work well, let’s try to improve the situation by putting all 10 investors in separate managed accounts. Now, when the manager tells the five redeemers that it will take him three months to liquidate their positions, they are able to instead take control of the assets and start to sell themselves. They all want their money right now, and if they wait it just means someone else will sell first. So what price do they get?
With five competing sellers in a crisis it certainly isn’t 70%: is it 30%, 20%, or even worse? There is no floor until some well-capitalised prop desk decides to step in and take the risk of holding for a few months… but unfortunately, in a crisis, there are far more cherries than cherry-pickers. In a crisis, zero is the only certain floor.
The hedge fund situation was bad, but this is just awful. However acute their demand for liquidity, taking 30% now instead of 70% in three months is an appalling trade for the five redeemers. At the end of the liquidation process, each investor in each managed account is worse off than they were in the fund.
What goes wrong with the multiple managed accounts is that there is no-one with a mandate to look after the interests of the investors as a group. I guess we all have concerns about how well some fund boards actually fulfilled this role during the crisis, but there is no doubt about the value of the role. The board is there to look after the collective interests of all the shareholders. If you take away this role then each investor is on his own, and is exposed to the market impact caused by the most urgent seller among the other sellers. If several want to sell at the same time then the result is entirely predictable carnage.
The choice between managed accounts and comingled funds is actually an example of a prisoner’s dilemma. It is in investors’ interests to co-operate and share a commingled account. With a good board, this gives an imperfect but sensible solution. Unfortunately it is unstable, because any one investor can apparently get a better deal for himself by setting up a managed account – he gets more control over his own assets and, provided he is the only one to do so, this appears to come at no cost to him. However, other investors are likely to follow the same logic.
Some investors prefer managed accounts because they think they are insulated from the short-term actions of other investors. But this is a mirage. You are more exposed to the actions of other investors in managed accounts than you are to other investors in a commingled fund. You don’t know them; you have no reason to trust them; you have no control or influence over them; you just have to hope. Sound like a good approach to risk control?
This is the reason that responsible managers who invest in less liquid assets will continue to be extremely wary of managed accounts. It is also the reason that if you are a fund investor, “What managed accounts do you run?” should be high up your list of due diligence questions.
I am confident that come the next financial crisis, many of the worst losses will be taken by investors who believe their managed accounts guarantee them all the liquidity they need.