After the turmoil of 2008 and 2009, hedge fund investors have learned to dread the “four horsemen.”
That’s how Bernice Miedzinski, executive vice-president at Man Investments Canada characterizes the Bernie Madoff fraud and the Lehman Brothers collapse, which froze some hedge fund accounts, as well as the sub-prime meltdown, factors that along with falling markets, may have caused some hedge fund managers to suspend redemptions.
The antidote, indeed, the future of the hedge fund industry, lies in managed accounts, she argues, where the hedge fund manager runs the money, but all else is left to an independent advisor and third-party service providers. Still, Miedzinski cautions, “managed accounts are not panaceas.”
Managed accounts come in different forms, says Riva Waller, who heads Man’s managed accounts group in New York. She was presenting this week in Toronto at a seminar for institutional investors. The structure Man uses signs the hedge fund manager to an investment manager agreement. The managed account is an offshore corporation that owns the assets the manager runs, with Man serving as the risk manager or sub-advisor. In turn, Man engages the administrator, legal counsel, prime broker, valuation service provider, auditor and other professionals.
There are a number of advantages to this structure, especially in light of the Bernie Madoff fraud. The manager only makes trading decisions, and trades according to constraints laid out by the investment management agreement. The manager cannot invest incoming cash or set up service-provider relationships. The manager, in other words, cannot “basically do what they want to do” via an offering memorandum, she says.
Still, it can be complex to set up a managed account—Man has 72 of them. Some strategies may involve illiquid securities—distressed debt, for example—that can be hard to replicate. Some strategies may also require a certain minimum asset base; so may some prime brokers. Thus, a $5 million account may not be feasible, but a $50 million account would be workable. In addition, a manager may not like the added burden of disclosure, or have back-office systems that are compatible with Man’s requirements.
The upside
But there are benefits for institutional investors, particularly on the corporate governance side. The pension plan or endowment owns the assets and gets full risk transparency. The service providers are not part of the hedge fund manager’s shop — a recurring problem in a number of recent U.S. scandals. Risk limits are set by the investor, and liquidity lies in the market, not the manager. Investors can sell off positions according to market volume, not the manager’s constraints in preventing a flood of redemptions, and Man has fired managers who refused to sell liquid positions.
But, Waller says, “You don’t set up a managed account to get liquidity.” Instead, it’s to control the account. Liquidity depends on the type of instrument. Over-the-counter derivatives in credit strategies, for example, have less trading volume than a long/short equities strategy would.
That can involve another layer of complexity: Man has to have access to other managers who successfully wind down a portfolio, she notes.
The downside
But there can be drawbacks too. A managed account may not necessarily duplicate the results of the underlying fund. This slippage occurs because the managed account may not be able to invest in exactly the same assets as the underlying fund, or because the investor requires daily or weekly liquidity, essentially “stripping out” parts of a manager’s strategy. There are also more fees to manage data for risk analysis. And, a managed account might not be suitable for assets that are hard to price or are illiquid.
Man’s structure acts like a fund of hedge fund managed account. That can be useful in mustering the assets (Man has $10 billion) to drive discounts and in managing risk across multiple providers. For example, with the Lehman collapse, Man had to act to move assets to other prime brokers. Assets held through Lehman are still tied up in bankruptcy hearings. Margo Jensen, Man’s London-based head of prime brokerage and trading, notes that in the end, exposure to Lehman was reduced from $800 million to only $100 million, and Man will likely get $52 million back.
Other firms were not so lucky, and had to fold because they no longer had control over their assets. For its part, Man had to watch carefully over other prime brokers in the fraught fall of 2008, and reduced its exposure to one prime broker from $3.3 billion to $1.3 billion in nine days.
But that’s another side to managed accounts: securing the third-party service provider arrangements. Crucial, for example, is finding valuation service providers who understand the strategy and thus evaluated net asset values, instead of relying on the hedge fund manager’s word.
But the Lehman blow up has led to the establishment of third-party custodians who will hold securities that are less frequently traded — securities that are not traded daily, in which case the costs become prohibitive.
Risk?
Beyond considerations of operational risk with service providers, there is another dimension of risk management that managed account providers can employ. It’s managing the data, says Man’s risk management leader in Zurich, Adnan Chishti.
In Man’s platform, risk managers can take individual manager level data such as returns, drawdowns, and volatility to determine the drivers of return and risk—the factors that are often outside the hedge fund manager’s control, such as equity market cycles, interest rate regimes and commodity and currency trends.
His team monitors risk daily, using both third-party and in-house databases. The third-party sources give position transparency, such as when an Asian hedge manager moves into a gold ETF. That’s an alarm bell, but as Chishti puts it, most of this risk monitoring is part of a story line—not something for immediate action, but rather something to be taken into account in manager reviews. And, he warns, “position transparency is not risk transparency.”
The idea behind more robust analytics that go beyond what statistics a manager reports is to create better risk reporting that highlights the manager’s behaviour, the drivers of return and the sources of risk as well as the manager’s historically performance—the better to inform the client.
It’s data-intensive work, and Chishti concludes that “some people joke that risk management is data management—to a large extent, that’s true.”