Accelerated investor interest in managed accounts is now driven by:
• the logic of independent valuation
• investor dissatisfaction with gates, lock-ups, side-pockets and similar redemption limitations imposed by hedge funds in 2008
• 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. With most fund management companies now in capital-raising mode, more managers are willing to contemplate managed account options.
Based on GlobeOp’s experience serving more than 100 funds and investors as managed account clients, 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 (institutional and private) 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 in return for greater control over the account. The five key elements of managed accounts are illustrated in Figure 1.
The first step – fund manager selection – parallels that of the traditional hedge fund investing model. Manager selection criteria will still include, among others, investment strategies, risk profile, performance record, industry reputation, due diligence and references. 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. It means 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. In broad terms, setting up a managed account requires a set of trading contracts as outlined in Figure 2.
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.
Specific investment objectives
Given the detail and complexity outlined above, investors may decide to engage an assetmanagement firm specialised in managed accounts to build a portfolio that corresponds to specified investment objectives. While these firms often assist in manager selection and 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 quality and accessible data plays in the investor’s monitoring of fund performance.
The transparency and independence objectives, control design elements and operational complexity of managed accounts require significant 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 II 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 from one system to another. Across each and all of the investor’s managed accounts the administrator should deliver the following daily reconciliations and independent verifications:
• cash balances
• collateral payments and reconciliations
• custody movements
• securities settlement and balances verification
• wire transfer confirmations.
To enable investors to slice and dice data and ensure investment activity remains within the stated objectives, the administrator should offer daily P&L reports with drill-down accessibility for both individual and consolidated accounts, including:
• total and individual P&L
• aggregated accounts by position, regions, currency and securities exposure
• data delivered at various levels of transparency
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.
Monitoring is time consuming
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 both the investor and account manager effectively by offering consolidated online data such as:
• Independent, position-level reports and reconciliations
• Portfolio risk reports
• Limit reports
• Counterparty exposure risk reports
• Portfolio valuations
• Performance attribution
• Asset allocation
It is possible for investors to control some of the infrastructure costs and increase efficiency. When investing with multiple managers – be it multiple strategies or multiple asset management companies – 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.
Managed account advisor considerations
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 itis a fact of life today. 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. As the hedge fund industry continues to improve its standards, it will increasingly attract and be driven by institutions, for whom operational excellence, transparency and effective reporting checks and balances are essential investment criteria.
The variety of investor-specific guidelines across different investors wishing to pursue similar investment mandates – strategies, investment guidelines, asset allocation or counterparty rules and limits – 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
• P&L and portfolio valuation statements
• Position-reconciled risk analytics based on t
• Control or guideline adherence reports
• Weekly, daily or monthly operational reporting.
Trust but verify
For both parties managed accounts offer the great advantage of forcing operational and risk rigor – i.e., 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 and access to assets following the events surrounding the Madoff fraud. While investors do want trusting relationships with their asset managers, they have become acutely aware of the need to independently verify that assets are real and can be accessed directly.
Ron Tannenbaum is Co-Founder of GlobeOp Financial Services, a leading, independent financial technology specialist. Established in 2000, GlobeOp provides automated, integrated middle- and back-office, services. Clients include hedge funds and asset management firms representing approximately some 1,150 funds and $106 billion in assets under administration.