All market participants have faced a tremendously challenging year. The magnitude of market movements has been unprecedented as has the volatility. As the correlation of asset classes moved to 1, and as the impact of deleveraging in a falling and illiquid market was painfully experienced, investors inevitably concerned themselves primarily with stabilizing their portfolios.
However, 2008 has brought more issues to the table than simply those of volatility and down-side protection. Clients have recognized a preference for greater control of their investments than typically experienced in commingled funds such that risks can be better mitigated and a greater scope for action can be enjoyed.
The circumstances of 2008 have re-introduced the traditionally more mundane risk considerations of:
• Counterparty risk
• Liquidity risk
• Redemption risk; and
• Information shortage risk
In many instances, these risks more than heightened the difficulties for investors. Within the hedge fund arena, the four above mentioned risks made a significant, negative impact on investors in several large commingled fund products. It is typically the case that the greater one of these risks is, the more it exacerbates other risks.
In a medium term investment area such as hedge funds, it is unnecessary and unhelpful that the lack of information for the end clients has in many instances resulted in the entire client base capitulating on account of redemption risk.
In the standard game-theory problem, each participant makes a rational calculation that no-one wishes to be left with the illiquid ‘rump’ portion of a portfolio and consequently all participants redeem. This investor version of musical chairs thus leads to a suboptimal outcome for all. As the experiences of 2008 are evaluated, long-term investors will want to re-think not only in what they invest, but also how they invest.
A segregated account is an individual portfolio of securities held at a custodian. Importantly, the client is still invested in the fund vehicle of the underlying hedge funds (as opposed to a “managed account”) and can still be anonymous vis-à-vis the hedge funds as these are bought/sold using a nominee name. The investment manager is then given the right to trade relevant securities on behalf of the client.
When re-thinking their investment method, long-term investors should consider the benefits of segregated account investing:
• Customised, complementary hedge fund exposure Through a comprehensive dialogue, the client’s portfolio is created such that it is designed to add-value in the context of the client’s overall portfolio. What is produced is not ‘standard’ but instead a dedicated investment solution. Individual clients will have individual concerns and requirements; in general, the elements that investors will most likely focus on are: risk appetite/tolerance, exposure preferences, liquidity requirements, and elimination of heightened indirect exposure.
• Portfolio evolution Clients benefit from holding a dynamic portfolio that evolves in response to market cycles and as part of overall portfolio progress. Importantly, this evolution of exposure always takes into account the clients’ individual requirements. As clients’ comfort with the investment style increases, they can take the opportunity to change the risk appetite within their portfolio, to create a core-satellite approach to hedge fund investing, and to truly integrate their long-only investments with their portfolio of hedge funds.
• Transparency Clients take confidence in knowing the exact names and types of exposure which comprise their portfolio. This is achieved by giving a detailed outline of each individual hedge fund position as well as detailed attribution and contribution analyses. To ensure even deeper knowledge and to inspire further confidence, clients can also benefit from meeting managers with whom their portfolio is invested.
• Investment decision-maker insights & education Client reporting for segregated accounts tends to be targeted to match the demands of the individual client and their stakeholders. The starting point for this is always to ensure that the client has direct access on a regular basis to an investment decision-maker. In addition, reporting materials are often constructed such that they are covering exactly the right level of detail. Naturally, this can range from high-level market commentary to in-depth quantitative and qualitative reviews. This interaction allows the client far greater possibility to appreciate the nuances of the hedge fund world and how to best approach the opportunity set afforded. Thus the information shortage risk can be considerably reduced, if not eliminated.
• Structural preferences As the investor-base for hedge funds has expanded to become global, there is a diminishing overlap between clients’ structural requirements, and consequently less benefit from a narrow commingled fund approach. Unique client requirements such as preferred service providers (with the potential to mitigate counterparty risk), annual dividend requirements, eliminating exposure to hedge funds with side-pockets, foreign exchange hedging, etc. can all be catered to within a segregated account format. Furthermore, the segregated account format can – depending on the set-up required – result in clients benefitting from a lower cost structure. In addition to the above, during the extreme stress periods of 2008, segregated account clients have benefitted from:
• No fund redemption risk Each client has been able to evaluate their portfolio purely from an investment perspective rather than from a ‘fear of being the last one in the line’ perspective. Segregated account clients can dictate their liquidity preferences at construction, and throughout have a full overview of the liquidity in their portfolio; a dialogue can be entered into as to the position at each hedge fund. Consequently, the liquidity risk can be controlled to a far greater extent.
• Tackling headline risk Segregated account clients have been better able to immediately address questions as to what is in the portfolio on account of the transparency and insight on names provided. Key features of leverage, liquidity, concentration, and directionality of each underlying hedge fund can be shared.
• Effecting change Segregated account clients are able to work in partnership with the investment manager in terms of implementing changes in their portfolio during stress periods. In some instances, this can lead to higher cash levels than usual during turbulent times; in other instances, it can lead to a more consolidated list of high quality managers, moving away from a more diversified portfolio.