Hedge fund investors could obtain greater peace of mind through managed accounts. But there are significant infrastructure requirements for investors, funds and administrators, says Hans Hufschmid, CEO of GlobeOp
Managed accounts are used by institutional and private investors as an alternative to direct hedge fund investments. The key attraction is increased portfolio transparency and investor ability to retain control over assets and investment terms.
Interest in managed accounts is now driven by factors like the logic of independent valuations, the dissatisfaction with gates, lockups, side-pockets and similar redemption limitations imposed by hedge funds in 2008, and the lack of independent asset, position and cash verification at the core of Madoff-related events.
Hedge fund managers have not historically embraced managed account structures because they create additional complexity, but more managers are willing now to contemplate managed account options.
There are several key planning, structural and management elements that investors and fund managers should consider when establishing managed account relationships.
Managed accounts provide investors with greater control and access to cash and assets, compared to the commingled share ownership model of traditional hedge fund investing. Investors should, however, be clear that as a solution managed accounts typically require greater investor responsibility and involvement in the account infrastructure, administration and activity monitoring.
Five key elements
There are five key elements to managed accounts, the first of which is fund manager selection. If already active in hedge fund investment, the investor will be familiar with this process. However, unlike hedge fund managers, managed account managers (technically referred to as advisors) require power of attorney to deal on behalf of the investor's managed account. Limits of authority need to be clearly defined.
In addition, there may be investment rules to be defined if the managed account is not to be pari passu with the rest of the hedge fund(s) managed by the same investment manager. In any event, assets will remain legally allocated to the separate account in the investor’s name, rather than commingled with other fund shareholders.
Second, as the legal counterparty in a managed account, investors are responsible for establishing the legal and trading counterparty infrastructure and contracts. Negotiating these key trading contracts are typically the greatest challenge in establishing a managed account, due to the set-up time and complexity involved and the industry or trading domain knowledge required. These contracts provide the legal and strategic framework within which the account can trade, the respective financial liability of the investor and account advisor, and the security, custodial, derivatives counterparty and brokerage rates and fees. Experienced negotiators and legal advisors with domain knowledge can help the investor avoid pitfalls that can affect profitability longer term.
Given this complexity, investors may choose an asset manager specialised in managed accounts to build a portfolio that corresponds to specified investment objectives.
While these firms often assist the establishment of the necessary account contracts, investors increasingly insist on being active participants in the selection of the external administrator given the critical role data plays in monitoring performance.
The next three elements of managed accounts centre on middle and back office services, controls and monitoring, and manager monitoring.
The transparency and independence objectives, control elements and operational complexity of managed accounts require administration expertise and system underpinning. The administrator should demonstrate experience with managed accounts, provide a technology platform that is both scalable and flexible, and confirm an annual SAS 70 Type ll audit of processes and controls.
Risk analytics and reporting should be integrated on the same platform and based on the same security master and pricing models to reduce the risk of errors created by transferring data between systems. Across each and all of the investor’s managed accounts the administrator should deliver the daily reconciliations and independent verifications for, among others, cash balances, collateral payments, and custody movements.
To enable investors to slice and dice data and ensure investment activity remains within stated objectives, the administrator should offer daily P&L reports with drill-down accessibility for both individual and consolidated accounts.
From an operational risk perspective all reports and statements should be based on the same pricing sources and security master to ensure consistency.
Because traded assets are separately allocated to the managed account, the administrator needs to offer monitoring data and tools to both the investor and account manager – daily independent P&L and risk statements based on reconciled position-level data, independent valuations and risk analytics across all investor accounts.
Account and performance monitoring – the analysing of a rich data set – can be time-consuming, particularly for multiple accounts. Since 2008 investors are principally concerned about monitoring leverage, counterparty exposure and style drift. The administrator can serve the investor and account manager effectively with consolidated online data, such as portfolio risk reports and asset allocation.
It is possible for investors to control some of the infrastructure costs and increase efficiency. When investing with multiple managers or strategies, the managed account investor should look for a core area of consistency across their platform. They should control but not limit the selection of prime brokers – both from the perspective of counterparty risk management, and for their support in the ISDA and ISMA processes. The investor should, however, insist on working with a single administrator that can facilitate a shared, integrated set of trade processing pipes, counterparty reconciliation and position-based risk reports. This trend is already being driven by larger investors wanting more comfort around operational risk and efficiencies.
It is undisputed that managed accounts can make the life of a hedge fund manager more complicated – differing investor strategies and guidelines, additional reporting – but it this is simply a fact of life. Investor sentiment has changed dramatically due to the events of 2008 and for them there will be no return to less transparent relationships.
Automation can address some of the additional work required, but managed accounts are the latest example of a secular trend that has been in place for many years.
The variety of investor-specific guidelines across different investors wishing to pursue similar investment mandates can add complexity and inefficiency to the portfolio management process. Additional reporting confirming adherence to these investor-specific rules is also required.
For the account advisor, the managed account infrastructure and investor reporting responsibilities for each investor account typically includes daily, separate position reconciliation, cash break monitoring, and control or guideline adherence reports.
For both parties managed accounts offer the great advantage of forcing operational and risk rigor – ie, good process safeguards related to trade entry, reconciliations, daily P&L reports and risk analytics.
A great deal of recent investor interest in managed accounts stems from concerns raised about the independent verification of assets and access to these assets during events related to the Bernard Madoff hedge fund scandal. While investors do want trusting relationships with their asset managers, tighter due dilligence means they have also become acutely aware of the need to independently verify that assets are real and can be accessed directly.
©2009 Funds Europe