The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

A HFOF investor's view on the managed account space

Riva Waller

Man Investments

Q2 2008


Since their first appearance in the market in the late 1980s, separately managed hedge fund accounts (managed accounts, for short) have become increasingly sophisticated. The author’s company has been working with managed account platforms for over fifteen years and in this article sets out some of the key features and benefits, as well as some of the challenges which users of these powerful tools can face.

Not all managers are open to running managed accounts in parallel to their own funds. Many either reject the idea or are only prepared to contemplate the arrangement if it is with a substantial investor who has commitment to their strategy and, crucially, the know-how and resources to set up and operate the managed account, in a way which does not divert the manager from the business of trading.

Managed accounts are also resource intensive in terms of running costs and the intellectual capital and systems required to structure, maintain and monitor them. At a certain level, even where managed accounts are available, the cost/benefit of ownership may not stack up – and the lower more economic levels of transparency/control available in more conventional fund of funds allocations to underlying manager funds may appear a reasonable trade, given an often greater spread of investment.

In many ways, today’s managed accounts look like mini fund complexes, with their own service provider relationships and books and records.

With managers constantly in search of new alpha, simple stand-alone trading vehicles are increasingly giving way to the use of more complex master-feeder structures, to address, for example, US tax and regulatory challenges, or they are supplemented by SPVs, for example, to facilitate particular types of trading (such as Hong Kong, Korea or Mauritius SPVs, in the case of some emerging markets).

It follows that platform providers need appropriate resources to understand, establish and monitor these structures together with strong and open lines of communication to the manager given that there is often considerable deadline pressure to implement. A multi-strategy managed account adds the further dimension of cross strategy allocation and reconciliation to the complex.

As a separate trading entity, with its own organisation and offering documents, a managed account provides an opportunity to fashion a different commercial relationship with a manager than is available through its pooled investment vehicle: a relationship which can be better tailored to the managed account investor’s needs and contribute to enhanced risk monitoring.

Crystallised in an investment management agreement, between the manager and the managed account, the terms of this relationship may include preferential commercial terms, key man provisions, special termination events, tailored investment management guidelines, access to current and new capacity, and restricted manager responsibilities.

While any specific tailoring will complicate any monitoring of the managed account against the manager’s existing fund performance, it does not make it impossible - just more expensive for the manager and for the investor, both in terms of actual costs and resources and the risk of performance differences or “slippage”.

It is important in due diligence. prior to committed capital and in ongoing diligence, to ensure that managers have the technology and infrastructure to fully execute within expectations of their role and responsibilities embedded in the investment management agreement.

The selection and monitoring of managed account service providers is usually done independently from the underlying manager and is controlled by the managed account vehicle.

Among the many service provider relationships, an independent valuation is a key attribute of any managed account. It is critical to select a suitable administrator who can provide the necessary level of oversight and independence. In the case with complicated strategies such as credit, distressed or new alternatives specialised providers may be necessary to support the administrator. Pricing complicated instruments requires a detailed knowledge of those instruments and the ability to question and push back on assumptions. Investors and managers rely on the information provided by all service providers and if this proves to be inaccurate and unreliable, the entire risk monitoring process will break down.

Controlling the valuation process means responsibility for the initial and ongoing due diligence on the service provider level and monitoring the relationship between the manager and the administrator. Although the valuation is “outsourced”, it is important to stay in the loop and be aware of what is happening.

While the independent control derived from the network of service provider relationships contributes to the risk management environment, it can present operational and relationship challenges. The extra resource required by a manager to integrate properly with a new service provider, possibly generating a duplicative set of procedures, can be demanding and with ultimate ownership of the relationships resting with the managed account, not the manager, some managers can feel more distanced.

What the network of managed account-owned service provider relationships are designed to deliver is in essence increased operational transparency and control.

The risk of operational fraud, style drift or simply underperforming strategies remain a key focus of hedge fund investors and managed accounts provide a more detailed and timely information flow direct to the managed account provider than is the case for a pooled fund.

Administrators and auditors communicate and co-ordinate directly with the platform provider as well as the managers. Managed account investors have direct daily access to all investment and cash activity on a position level. Data can be sourced from prime brokers, administrators or even the managers.

There is full transparency into all cash movements available on a daily basis and commonly the administrator reconciles cash on a daily basis. The books and records of the managed account can be reviewed at any time. There are no “secrets”. Expenses are controlled and managed by the platform provider, limiting a manager’s ability to “hide” expenses.

On the valuations front, direct feedback from service providers can prove to be very important, especially in instances where there is a large number of trade breaks, the manager is unable to assist in the reconciliation process or where the manager is not trading with the approved set of counterparties. This window will reflect the manager’s operational capabilities and will red flag issues which arise in practice but may not be detected during an operational due diligence visit. This feedback forms part of any allocation decision but may also benefit the manager if it eventually leads to improvements in their own infrastructure and they can piggyback off the administrator or the managed account platform provider’s experience.

Of course, accessing information and interpreting and acting on that information are two separate things. There is a potentially overwhelming amount of information.

Valuation is typical here. Many managers utilise several prime brokers and OTC counterparties, trade specialised markets, emerging markets and with new sophisticated products.

The more complicated the strategy, the more important it is to build good communication, be pro-active and build automated solutions. Any breakdown in the process will make the information output unreliable. Daily transparency is not inexpensive and can run at over 35 basic points for a high complexity manager. Therefore, a suitable cost benefit analysis should be considered, with regards to the cost, anticipated assets under management and the ability to obtain good, clean independent pricing.

It is critical to develop a plan of what data fits the platform provider’s risk management model and to build a scalable system which can process and store data according to the platform provider’s requirements. Monitoring techniques range from provider to provider but often include exposure limits, style drift, breaching risk limits and daily volatility. Prime brokers and third party providers offer tools to build systems but they also require an investment in people who have an appropriate skill set to review and understand complicated instruments and who can develop policies and procedures to support the process.

A detailed discussion of prime broker terms is beyond the scope of this article . Clearly an effective partnership between the prime broker (or prime brokers) to the managed account is an essential component of any robust managed account platform. By leveraging off its bulk buying power with the prime brokers, a sophisticated managed account owner can provide investors and managers with advantageous arrangements that many managers would probably not receive on their own. Such benefits may include:
• Reduced pricing,
• bespoke lock up agreements on margin and financing,
• enhanced mitigation of broker credit risk,
• favourable legal and credit terms in managed account documentation, and
• service upgrades.

To negotiate and execute prime brokerage arrangements at the right level, managed account owners must have developed intellectual capital in what is a competitive hiring space - dedicated teams with significant multi-disciplinary experience and market knowledge.

As the number and sophistication of trading strategies continues to grow, for users with the resources and know how to keep pace with the changes and who can “read” and understand the powerful data streams they furnish, managed accounts will continue to provide the means to go beyond blind pool investing.

N.B .This is an extract from a larger article which can be viewed in full on the AIMA website.

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