Hedge Funds and Managed Accounts: A Discussion

My friend and fellow blogger Yaser asked me the following question: "I would love to hear your opinion on Managed Accounts and whether they improve transparency and other pros/cons of HF investing." While I find it flattering and humorous that anyone would "love" to hear my opinion on anything, I think the question is deserving of a response, for what it is worth. Yaser also forwarded me the results of an August 2006 survey from Terrapinn Ltd. concerning managed accounts, and suggested I take a look at it as well. The results of this survey are predictable: many Institutional Investors don't invest in hedge funds due to lack of transparency; many would be more inclined to do so if there was greater transparency; and a significant number are considering investing in hedge funds via managed accounts in the future. Yeah, whatever. So what is the straight dope on managed accounts? Here it is.

So what is a managed account, exactly? A classic hedge fund managed account has the following characteristics:

• The investor owns actual assets via the managed account, not simply LP interests in a pool of assets;
• The hedge fund manager is an advisor to the managed account;
• The investor has full transparency into the assets being managed;
• The investor generally has liquidity superior to the LPs in the main fund;
• Running a managed account is an operational and logistical hassle for a hedge fund manager; and
• Most hedge fund managers will require a sizable capital commitment in order to accept a managed account.

This presumes, however, that a hedge fund manager is willing to run a managed account under any circumstance. Many top managers simply won't, or only run managed accounts for legacy investors for whom they do it as a courtesy (as they may have originally helped them get their start, etc.). Why are managed accounts viewed with such disdain by managers, while they are clearly desired by Institutional Investors? Principally, because:

• They are an operational pain, requiring discrete resources for their proper management which reduces returns;
• They often provide a window (read: transparency) into a portfolio and trading strategies that managers find undesirable;
• They often come along with preferential liquidity rights for their owners which managers don't want to give;
• They often create asymmetry with the main fund, as managed account holders may want portfolios run pursuant to their unique portfolio objectives and/or risk parameters; and
• They create unnecessary and unwanted complexity in to manager's operations when they simply are not needed.

There is a supply and demand imbalance for top hedge fund managers, where the demand for their product far outstrips supply. Therefore, there is absolutely no incentive for these managers to take on managed accounts. And they won't. So which managers are offering managed accounts? Not the top managers. Frequently emerging managers or those for whom asset gathering has been a problem. Remember the S&P investable hedge fund index? It failed. Managed account platforms run by big banks are challenging by their nature, because frequently the only funds willing to accept the rigid parameters of the program are, quite simply, not the best. Therefore, there is, to a degree, structural adverse selection when it comes to managed accounts. Those who are willing to run them are simply not the best, because they need to accept them to raise assets. Top managers don't, and want all their investors to be fund investors with homogeneous (and painfully rich) terms. This makes life easy.

So ultimately it is up to the Institutional Investor to vote with their feet:

1. Is gaining transparency worth the possibility of giving up returns? or
2. Is it best to simply avoid hedge funds altogether and accept that the asset class won't be available to me? or
3. Should I sacrifice my transparency guidelines on a small portion of my portfolio in order to gain exposure to top hedge fund managers in the hope of generating true alpha?

While 1 is clearly stupid, either 2 or 3 are perfectly reasonable and valid choices,  IMHO. But the punch line remains:

Those who think the flood of Institutional assets into the hedge fund space wanting greater transparency will force the use of managed accounts on top managers are on crack. It just won't happen.

I think transparency can be a beautiful thing - depending on the context. But for most high quality hedge fund managers (and for many investors as well), transparency is NOT considered a good thing, and it will be those most in need of assets (read: novices or B-type managers) who capitulate to such demands. Now is this any way to invest? Maybe if you are seeding new funds. Otherwise, choose another asset class.

Comments

[EC]

No problem, I am referring primarily to net performance of investment vehicles and am less concerned with technical classification. Like all of us they expose themselves to risk, take some compensation in return for their services, and serve up some net performance with some strings attached. Taking their structure as a whole-- operational, compensation and size primarily-- I am unsurprised with their performance.

To take classification to another level I personally compare my net performance to that of ETF's. They serve as very real benchmarks which are almost 100% transparent and liquid. They may fit a different "classification" but they are extremely relevant to pretty much anyone managing money.

Heck, I wouldn't be surprised that if some investors in FI get fed up, leave and invest in hedge funds and/or ETF's. There seems to be relevance here.

[Paxton]

If a FOHF creates a seperate fund for each of its institutional investors, through which the seperate fund invests into the underlying bevy of hedge funds--- would the seperate fund be considered a managed account?

If so, would that prevent the FOHF from considering IPO plans due to UK insider trading laws like Winton?

[Yaser Anwar]

EC- With all due respect I don't think value investing in itself is a HF strategy. Value, like growth or GARP, is an investing style.

But aren't event-driven, directional and relative-value HF strategies (each with their sub-strategies)?

Don't get me wrong, I think you're 100% right saying that they're a glorified marketing IM firm. They are no different than, say, Legg Mason in style and structure wise (the main difference being LM's record being better).

Pretty much every firm which does Private Banking is somewhat a managed account, in the sense there is close to full transparency. That said, the Private Banking firms, like FI, don't classify as HFs, hence irrelevant.

I hope I'm clear. If I'm wrong, please do tell! Maybe once Roger is back from his sabbatical he can help us out!

Thanks for the chat.

[EC]

Since when is value investing not a hedge fund strategy? Maybe I should close shop then, because that would imply my sorry ass shouldn't exist!

Maybe I'm looking at it wrong, but he is value investing using a wide array of managed accounts, with a big marketing department and a compensation package tilted towards AUM. And as surprise may have it, his fund is huge and he underperforms your typical run of the mill value investing benchmarks. Maybe I'm missing something that your incisive original mind has picked up on.
-EC

[Yaser Anwar]

EC- FI doesn't not implement HF strategies, nor is it registered/structured as a HF partnership. So your example in this post's context is irrelevant.

Just my $0.2

[Yaser Anwar]

Off-topic: Sir you should check out this blog http://suddendebt.blogspot.com/

pretty good.

[Yaser Anwar]

Great points as always but I've a concern:

1) The top managers you're eluding to sir are, well, not open to investors anymore. I'm referring to the creme of the crop- The SACs, Caxtons, RT (maybe only for their 100 bn fund?), Tudor, Atticus etc. So what is a rich guy like me (hypothetical example only!) who needs to get into a solid HF do?

Should I not accept the transparency just because it gives the illusion that a fund is weak/not good enough? I guess so. Then the choice for me would be to go to a top FoHF with A+ ratings and access to these guys.

I asked one of my Permal contacts what his thoughts in general were with regards to managed accounts. Long-story-Short, he mentioned the same points as you sir.

He said its sort of a plus for them because they can show that, alongside A ratings for their funds and solid performance, being one of the oldest in FoHF business they have access to the top funds. These top funds are super regulated within, hence investors should just invest with Permal.

Also, if a fund like Solengo isn't utilizing a managed account, then why should I (hypothetical ex: A trader with experience with good sell/buy-side firms) do so?

That said, investors will not want to feel left out. Hence they will end up chasing beta performance.

Maybe we should put a sign

BEWARE: BETA PERFORMANCE FOR ALPHA FEES!

At the end of the day, the HF industry, much like Wall St. in general, is a very creative industry. Someone somewhere will figure out a new marketing ploy to lure people in.

We're all gullible, can't help it! (In Nick Taylor style, need to pay mortgage, not just one but two three, maybe four? Especially if I was a NEW/LEND client! lol)

[EC]

Interesting example of this comes to mind- Ken Fisher, of Fisher Investments. 16,000 clients, all managed funds, no lock-up period. Manages $32B out of his house in California with 300 employees. Mediocre performance at best. The place is a glorified marketing machine, and their fee structure encourages that. He claims to follow Buffett but the way he runs the fund seems to run contrary to Buffett's principles.

I find it very interesting how strongly the structure of a fund (operational, incentive, legal, AUM) is as a predictive tool for returns-- somewhat for future returns, *definitely* for historical returns.