By Neil O'Hara
Doug Shaw, head of alternative investments at BlackRock in London, doesn't like to offer managed accounts to investors, and it's not hard to understand why. "If one raises money in the fund on the stated and transparent terms, there is something inherently discourteous if one then raises money for the same strategy in a managed account on different terms," he says. As a result, Shaw uses managed accounts sparingly in the firm's $20 billion portfolio of hedge fund strategies and strives to ensure that fund investors are treated fairly.
BlackRock's qualms notwithstanding, managed accounts became all the rage last year after hedge funds halted redemptions at the end of 2008. At that time, investors were desperate to get their money, but they couldn't—and they began to eye managers more skeptically, demanding to get a better handle on what they were investing in on a daily basis.
Managed accounts, which offered better liquidity and transparency, seemed a panacea, and platforms run by Deutsche Bank, Lyxor Asset Management and others that allow even smaller investors the option took off. In an effort to appease investors and raise money, a slew of bellwether hedge fund names—including Caxton Associates, Paulson & Co., Tudor Investment Corp., Winton Capital Management, Marathon Asset Management and Third Point—jumped on board.
But now that the furor has subsided, the downside of managed accounts is increasingly apparent. Should the markets turn rapidly, for example, managed account investors that can see positions on a daily basis could pull the plug before other investors are even aware anything is amiss.
Conflicts of interest between investors aren't the only drawback to managed accounts. Even though they promise transparency and liquidity, they can't protect investors from losses when strategies fail. Nor are they a substitute for risk management.
They are even less desirable to managers. Not only does complete transparency lift the veil on the secret formula that drives their excess returns, managers also have to absorb significant incremental operations, accounting and administrative costs to run managed accounts. Even if the managed account is in theory run pari passu with the hedge fund, it won't always have the same positions, particularly in less liquid securities. If new money comes into the fund, it may not be possible to buy more of a particular distressed debt issue at the current market price, and it's in no one's interest for the manager to chase the price up only to see it fall back once the extra bonds are on the books.
All of these issues spell trouble. "The regulators are bound to have a look at this over time," says Ken Phillips, chief executive officer of HedgeMark International, which specializes in the development and integration of managed account platforms. "The better hedge fund managers will refuse to give an asymmetrical benefit to the managed account holder. It's not fair to other investors if liquidity terms are not reasonably aligned."
The Securities and Exchange Commission has not weighed in on managed accounts, but at least one regulator—the Financial Services Authority, which regulates hedge funds in the U.K.—has taken a stance on side letters that is indicative of how it might view managed acounts.
Three years ago the FSA cracked down on side letters that gave investors in pooled vehicles better liquidity or a break on early redemption fees than that were not available to other investors nor disclosed. The FSA imposes an obligation on managers to treat clients fairly, a doctrine BlackRock's Shaw applauds. "I try to build as many fund terms as I can into the managed account agreement in order to square that circle," he says.
A growing number of hedge funds now accept managed accounts, but many managers still don't like them. "Managed accounts clearly push toward preferential treatment of large investors over small investors," says the founder of one multibillion-dollar hedge fund that refuses to take managed accounts as a matter of principle. "We want to be able to look a $1 million investor in the eye and tell them they are getting the same terms, returns and treatment as a $1 billion investor.
"Over time the accounts will end up with different returns, which leaves the manager vulnerable to accusations of preferential treatment among investors," he continues. The firm has fended off pressure from investors to accept managed accounts by offering greater transparency into the fund, and Shaw reminds those worried about liquidity that his firm never put up gates or halted redemptions during the financial crisis.
Managers that do accept managed accounts demand a hefty minimum for their trouble, often as high as $100 million. That rules out all but the largest institutional investors and funds of hedge funds: Even a $1 billion investor is likely to want 20 to 30 different funds in the portfolio.
As a result, smaller investors are in the lurch, notes Joel Katzman, the former head of JPMorgan Alternative Asset Management who invests on behalf of a family office. At that size, a managed account isn't economical for either Katzman or potential managers, so he has to invest in pooled vehicles. He thus tends to avoid managers who accept managed accounts alongside their flagship hedge fund.
Katzman says he doesn't mind if someone who has $50 million to $100 million to invest gets a break on fees and has better access to the manager than he does. But why should investors who have enough money to set up a managed account be able to get their money out faster? "If you need a certain liquidity to manage your fund, don't tell me you offer better liquidity to someone who gives you more money," Katzman says. "I get very touchy when investors are not treated equally."
Many managers run managed accounts alongside their hedge fund, so investors all have the same positions. If a manager has $1.5 billion in the pooled vehicle and a single $500 million managed account, the liquidation of $500 million will have the same effect on asset prices whether that money comes from the pool or the managed account. So if the managed account holder can bail out first, investors in the hedge fund take a bad mark at best—and may suffer permanent losses in a turbulent market or if the assets are illiquid by nature.
Managers could insist on identical lockup provisions in the agreement that governs the managed account, but in Katzman's experience they often don't. They may have a clause that allows them to scale back or postpone a withdrawal from the managed account if the manager believes it would adversely affect investors in the fund, which ought to provide some protection. In practice, Katzman argues that these clauses don't work as advertised because the broker or custodian is usually not party to the agreement. "If the client asks the broker to liquidate the account, the manager cannot stop it," he says. "If the broker doesn't follow his instructions, the client will sue the broker and, in all likelihood, win." The manager could bring an action against the investor after the fact for violating the investment management agreement, but suing a customer is bad for business—and the hedge fund investors may have already suffered irreversible damage.
The incremental costs a manager must incur skew the availability of managed accounts toward larger firms too. A recent study by TABB Group, a financial services research and consulting firm, found that while 69% of hedge fund managers who have more than $3 billion under management also run managed accounts, only 28% of those with less than $500 million in assets offer them. Matt Simon, a research analyst at TABB, cautions that the numbers may be overstated because many managers run just a few accounts to accommodate trophy investors .
TABB's study also revealed a gulf between managers who take managed accounts and those who don't. Large managers who already have them set the minimum size for a new account at $35 million on average, but it would take $125 million to induce managers who don't offer these accounts to get in the game. "Some managers are set against managed accounts," says Simon. "They feel separate accounts are inefficient and not scalable."
While only the largest investors qualify in their own right, smaller investors can still participate indirectly through funds of funds that focus on managed accounts—although they face another layer of fees (typically a 1% management fee and a 10% performance fee) on top of whatever the underlying managers charge. Or they can tap managed account platforms run by Lyxor, Deutsche Bank and others, which aggregate contributions and allocate the money to managed accounts run by hedge funds that have agreed to participate in their programs—again, at an incremental cost. These platforms typically offer better liquidity—weekly, in some cases—than the quarterly redemption window most hedge funds provide.
"They are an organized exercise to give small investors who go through platforms greater liquidity in exchange for higher fees," Katzman complains, "and they give bigger investors liquidity they shouldn't have through the pretext of a managed account."
Even though some investors prefer managers who don't accept managed accounts, others may take comfort in the presence of a large institutional account run alongside the pooled vehicle, according to Charles Stucke, chief investment officer at Chicago's Guggenheim Investment Advisors, which helps investors allocate money to hedge funds. "Investors know that somebody is getting full transparency into the entire book and managing risk on top of it," he says. "They like to tag along with larger credible investors that have robust due diligence processes."
The risk investors take when the manager accepts managed accounts escalates as the liquidity of the underlying assets declines. In activist strategies, in which managers accumulate illiquid block positions, a peremptory managed account withdrawal may not only impair performance at the pooled vehicle but could also threaten the entire strategy if the manager needs to maintain a threshold stake in order to influence corporate events, notes Stucke.
For managers who are struggling to raise money in their flagship hedge funds, the temptation to accede to demands for better liquidity in managed accounts and gloss over the conflicts of interest may be hard to resist. Top managers usually have no trouble attracting assets to their pooled vehicles, which raises the possibility of adverse selection if a managed account platform does not have access to the premier talent. "How are platforms going to attract the better managers if all they're offering is access to hot money?" asks HedgeMark's Phillips.
Attitudes among top managers appear to be changing, however. Lyxor now counts brand names like Caxton, Marathon, Paulson, Tudor and Winton among the 111 managers investors can access through its managed account platform. At more than $10 billion in assets, Lyxor has become one of the largest allocators to hedge fund managers.
The platform model allows investors to outsource due diligence, risk management and accounting, but superior liquidity is the major draw. "We try to provide the best liquidity the strategy can offer, whether it is weekly or monthly," says Nathanael Benzaken, managing director at Lyxor.
Andrew Rabinowitz, chief operating officer at $11 billion Marathan, notes that the portfolio it runs for Lyxor does not strictly track the credit performance or business of its flagship fund, which invests in distressed debt and special situations throughout the capital structure. Lyxor offers monthly liquidity, forcing Marathon to invest only the most liquid portion of the firm's strategy. "It's a trade-off," says Rabinowitz. "If the investor is looking for liquidity, then generally they have to give up some performance."
Benzaken notes that half the assets on Lyxor's platform come from institutional investors, which typically invest for the long term and don't need better liquidity. But another slug comes from funds of funds, which may take advantage of short or nonexistent notice periods to engage in opportunistic trading not available to investors in a pooled vehicle. "Investors on our platform can adjust their portfolios pretty quickly to optimize entry and exit points," Benzaken says. Yet an invitation to market timing not available through the pooled vehicle raises the possibility that incremental platform liquidity may in fact harm fund investors.
HedgeMark's Phillips argues that the potential damage to investors in the hedge fund is negligible for strategies that invest in liquid assets—long/short equity in large cap stocks or global macro, for example—because the market can absorb a liquidation with minimal impact on prices. It's a different story for illiquid assets like distressed debt, where the underlying instruments trade by appointment. To Katzman, though, it's the principle that matters: "A manager's attitude toward liquidity can be a barometer as to what kind of fiduciary he is."
Managed accounts won't protect investors against losses if their true concerns relate to flaws in the underlying investment strategy rather than the drawbacks of pooled investments. John Donohoe, chief executive officer of consultancy Carne Global Financial Services, has been approached by investors that made the switch to managed accounts before the financial crisis and wondered why they still incurred big losses.
"We looked at the investment guidelines and said, 'Sorry. The managers were within the parameters you gave them,'?" he says. "If you are going to use managed accounts, you need a risk management and investment diversification framework for them as well." The investor has to set position limits, sector concentration limits, leverage limits, a cap on illiquid assets—all the risk controls a hedge fund manager would apply to the fund portfolio.
Title to the assets in a managed account rests with the owner, who cedes control of the investment program to the hedge fund manager but retains responsibility for custody, accounting, financing and counterparty risk mitigation. "Only a handful of investors are sophisticated enough to put that ideal risk management in place," says Donohoe. "The rush to managed accounts is a reaction to hedge funds putting up gates. Investors take control of the assets, but that doesn't mean the portfolio has the liquidity they want."
Even advocates of managed accounts say that the increased transparency, liquidity and control they offer come at a price. Although management and incentive fees usually match those of the hedge fund, administrative expenses are higher because even a big managed account lacks the scale of the pooled vehicle. The account holder needs more infrastructure too. A daily report from each manager listing thousands of securities that are not grouped to show which long is paired to which short adds nothing unless the investor can interpret and analyze the data. Multiply that by 20 to 30 times in a diversified hedge fund portfolio, and the demand on investor resources becomes daunting. "Investors have been given the information and transparency, but do they know how to interpret it?" Donohoe asks.
Only institutional investors that have large allocations to hedge funds and the bigger funds of hedge funds can afford the necessary investment in people and technology to process all the data. Scott Perkins, executive managing director at Lighthouse Partners, a $5 billion fund of funds in Palm Beach Gardens, Fla., says his firm decided to switch to managed accounts five years ago, but the switch has been so complex and time-consuming that the firm still has about 50% of its assets in pooled funds. Perkins estimates that a fund of funds needs close to $2 billion in assets to get access to the top managers and support the infrastructure to handle everything from legal documentation to the data analysis a comprehensive managed account program requires.
In theory, the greatest benefit of transparency is the ability to quantify overlapping positions among different managers that can lead to excess concentration at the portfolio level even if each manager complies with specific investment guidelines. It brings into focus crowded trades, like the big bets on oil in early 2007. "You may have one guy who is long oil futures, another who is long small cap oil stocks, a third who is short the airlines and a fourth who is long the commodity currencies. They are all in the oil trade," says Richard Tomlinson, founder of Tomlinson Investment Consulting, which advises hedge fund investors on how to set up and run managed account programs.
Yet for all their nominal control, managed account holders do not have complete freedom to cut back their exposure if excess concentration does occur. Managers won't tolerate attempts to micromanage their portfolios, especially if they have not breached their investment mandate. Investors can pull out a portion of their money from accounts exposed to the concentrated risk, a tactic Tomlinson used himself earlier in his career when he ran a fund of managed accounts for Old Mutual Asset Management. They can also use an overlay—sell oil futures short or buy puts on oil, for example—that will offset part of the loss if the trade goes bad, or add a new manager whose strategy is negatively correlated to the crowded trade.
Another drawback from the manager's perspective is that all managed accounts are not created equal. Tomlinson points out that if the owner is a single institution, the manager develops a relationship with the underlying investor, which may help smooth things over when the manager hits a rough patch. Money that comes through a managed account platform places the manager at one remove from the investor, and the platform operator won't intercede when investors request a redemption. "It is a whole different ball game because the manager doesn't have the communication channel to investors," says Tomlinson. "Managers don't view accounts on platforms and proprietary institutional accounts the same way."
BlackRock chose to make one U.K. equity hedge strategy available on one managed account platform after several clients told Shaw they preferred to participate through a structure that allowed them to outsource risk management and operational due diligence rather than invest directly in the hedge fund. The liquidity on the platform is controlled by a daily trading volume limit at the security level rather than the specific dates and notice periods that apply to the fund, but in a highly liquid strategy Shaw felt the difference was not material. As he puts it, "The square wasn't quite a circle, but it would roll." AR