Managed Accounts

Are they the answer to hedge fund problems?

LOIS PELTZ

Managed accounts are not for all investors – or all managers. Some investors complain that the minimums are very high, the extra fees and costs are not warranted, and they would not know what to do with all the transparency provided, especially with regard to complex instruments. Some large managers are not on managed account platforms or are not compelled to set up a managed account; this could result from any of the following: the managers are closed to new investment and do not need additional assets; they are unwilling to give transparency; managers use a black box trading system; they are concerned with a possible flow of position information to the proprietary trading desk of the owner or the sponsor; or, the managers want to control the inflow and outflow of assets.

Yet, managed accounts are a promising route that will help reduce operational risks. From an investor’s point of view, are managed accounts/platforms the answer to hedge fund collapses, defaults, and other problems? In such cases as Amaranth, Bayou, and Beacon Hill, would investors have been protected under a managed account/platform format?

* Amaranth

In September 2006, Connecticut-based Amaranth Advisors lost 65%, or more than $6 billion, due to losses in natural gas trades. At its peak, assets were $9 billion. The hedge fund is now liquidating.

* Bayou

The Bayou funds collapsed in August 2005 when it was discovered that Samuel Israel and Dan Marino had attempted to recoup mounting losses by investing Bayou assets in what he believed to be securities offering exceptionally high yields. About $100 million of Bayou assets were invested in these private securities. Israel and Dan Marino pleaded guilty to their own fraud. The fund filed for Chapter 11 bankruptcy relief in May of 2006.

* Beacon Hill

In 2004, Beacon Hill and its principals agreed to pay $4.4 million to settle regulatory allegations that it defrauded investors. Investors lost $300 million in 2002 as the net asset value, when eventually restated, fell 54%. Beacon Hill had been charged with misrepresenting and manipulating its valuation procedure for its hedge funds.The misrepresentations had to do with the methodology Beacon Hill used for calculating the net asset value for its hedge funds, the hedging and trading strategies used for the purportedly market neutral funds, and the value and performance of the funds. Central to Beacon Hill’s fraud, according to the SEC, was the manipulative conduct that allowed Beacon Hill to report steady growth and to hide losses in the hedge funds through 2002.In answering the question on whether managed accounts/platforms are the answer to investors’ hedge fund disasters, one must first clarify the definition of a managed account; it is a vague term that may include considerable territory. Distinctions need to be made between a managed account, a managed account platform, an advanced fund of funds, and indices.

With managed accounts, investors enjoy benefits such as generally lower expenses, dynamic allocation, more frequent valuation, better liquidity, transparency, ability to close an account quickly if a problem develops, better risk monitoring and management, and freedom from being placed in a position where litigation is required to recover money should a problem arise.

Still, not all managed accounts are created the same. The level of protection offered by a managed account depends on the nature of the specific platform, as well as the infrastructure supporting the trading activity and the way that activity is monitored. Complexity of trading strategies, comprehension of risks, frequency of position assessment, ability to monitor, and ability to value are all complicating factors.

Another key factor is the way the managed account platform is designed. “If done properly, the accounts will be segregated,” say veteran managed account experts. The platform needs to have the ability to cut the relationship with the manager at any time. Also important is the content of the investment guidelines/mandates and how they are actually controlled. Independent pricing, independent NAV calculations, and independent reporting are critical. There should also be an upfront agreement on who the counterparties are, what the trading limits are, which instruments can be traded, and the roles and responsibilities of both prime brokers and administrators.

As it turned out, Beacon Hill was on the Lyxor platform. Lyxor liquidated it as problems occurred.”If there is a breach of investment guidelines, we have the right to terminate the advisor agreement. If we want to liquidate the fund, we are free to do so. We did that once with a fund managed by Beacon Hill. The managed accounts are Lyxor funds,” says Alain Dubois, chairman of the board of Lyxor Asset Management.

“The manager committed fraud in his fund but couldn’t commit fraud in our fund because managers don’t have control over the assets. We had time to unplug the managed account quickly enough to limit the loss compared to the loss in the fund. We took two weeks to liquidate the fund in an orderly manner and return money to investors.Investors are still stuck with Beacon Hill four years later with a loss that is approaching 65 to 70%. That is another advantage of a managed account – we were able to get out quickly and limited the loss.”

According to an executive at a large US-managed account platform, the first check on a hedge fund manager in their platform is whether the assets are as stated. Platforms that do extensive risk monitoring get positions from third parties, such as administrators and prime brokers. If the fund is reporting it has $500 million and the risk monitoring units are only getting $100 million from the prime brokers, questions can be asked. There could be explanations for differences, but it is an issue that needs to be reconciled. Otherwise, it is a red flag warning. As a result, Bayou could have been spotted on their platform, according to this executive.

The Amaranth collapse is a good illustration of a disaster that might have been averted if the fund had assumed a managed account platform; had such a platform been in place, problems such as a large natural gas concentration and style drift may have been spotted by the risk management units.

“There was massive style drift; it started as a multi-strategy fund and became an energy fund. It went from a diversified strategy to a highly concentrated and leveraged portfolio. Both elements would have been caught by the Lyxor team before the blowup,” says Lyxor’s Dubois. “We are providing sort-of a third party risk control and risk assessment.”

Outlook

Estimates of assets in hedge fund managed account platforms range between $50 and $100 billion, with more probability given to the lower end of that range.

Since the Amaranth collapse in September, a number of managed account-type platforms are reporting an increase in calls from investors since the platform offer transparency and risk management. A sharp upward trajectory of demand is expected, with a good percentage of that coming from institutional investors.

There are not many platform providers at the moment. Veteran industry observers predict that, in a few years, there may be 6 to 10 players due to the significant investment that is required. The players that are best placed to develop this area are banks because a bank can build on its equities and its team, can sell capital guarantee products, and can have good control of the underlying.

Lois Peltz is the president and CEO of Infovest21, an information provider in the alternative investment arena.