Investors’ enthusiasm for the fund of hedge funds (FoHF) business model was significantly damaged by the financial crisis of 2008. However, as an industry, lessons have been learned and improvements made, notably to address the need to provide improved governance, greater transparency and better risk control. The most effective way to achieve this has been to reconfigure the business model and offer multi-manager solutions via managed account platforms, thus creating a new acronym, FoMA (fund of managed accounts). As a result, we have observed that investors have returned in search of diversified exposure to hedge funds, a trend that has gathered momentum through the first half of this year. The focus of this article is to examine the FoMA structure and explore the similarities and differences between it and the traditional FoHF model, as well as the merits and limitations associated with each.
Understanding the model
Both FoHFs and FoMAs act as collective investment schemes, pooling investor money and investing it across a number of hedge fund managers and strategies. FoHFs invest directly into a number of hedge funds. In contrast, a FoMA invests into several managed accounts, each typically replicating the investment strategy of an existing hedge fund. A FoMA can either invest solely in the managed accounts of a single platform provider or be multi-platform, investing in the managed accounts of various platforms. The managed account platform provider acts as the investment manager and has responsibility for the operation and governance of the account while the hedge fund manager is retained as the trading advisor to implement the trading and investment of the managed account.
Investors’ quest for transparency
In response to significant investor and regulatory pressure, the majority of hedge fund managers are now far more transparent than they were prior to the financial crisis. Investors, including FoHFs, demand access to and detailed reporting from their hedge fund managers. Managed account platforms have invested significantly in risk and other reporting technology to provide this. Single-platform FoMA operators who are part of a managed account platform have the additional advantage of full position-level reporting which allows daily consolidated risk analysis, something which a FoHF or a multi-platform FoMA would find extremely hard to achieve. While individual portfolio details are not usually available to the end investor, FoMA reporting can be tailored to provide detailed consolidated portfolio-level analyses to the end investor.
The interests of hedge fund managers and their investors are not always aligned. A conflict between the hedge fund’s desire to attract assets and generate fees can lead managers to take on increased risk and drift beyond the stated investment mandate and their core competencies. Often a hedge fund’s offering documents are very broadly worded with few, if any, investment restrictions, thereby allowing the manager broad investment discretion. A responsible FoHF manager will mitigate this risk by remaining in close contact with the underlying managers and by seeking regular updates and explanations as to the fund’s performance, positioning and risk exposures. The investment guidelines, trading limits and investment restrictions for managed accounts are detailed in the trading advisory agreement and monitored daily by the platform manager. The platform manager, who has full position-level transparency, monitors each trading advisor to ensure it continues to adhere to the stated investment objectives and that the portfolios are managed within their risk limits and investment restrictions.
An advantage of a FoMA from a portfolio management perspective is that, with full portfolio transparency, a more granular, position-level analysis based on homogenous reporting may be performed, notably through a consolidated exposure analysis, to determine the true extent of diversification. Investing in multiple funds or strategies does not always translate into true factor diversification as, at any given time, managers may have similar and converging biases. By receiving a more granular picture with a quicker refreshment rate of data, FoMA managers are able to make portfolio changes in a more timely manner, based on a near real-time picture of portfolio attributes.
Investing via a hedge fund or traditional FoHF is an investment in a commingled vehicle with multiple investors. Each investor owns a share in the performance of the fund in a one-size-fits-all solution, where customization of overall mandate or underlying hedge fund manager for one investor is not possible.
In contrast, within FoMA structures it is possible both to customize the underlying hedge fund manager mandates and the overall FoMA mandate to an individual investor’s specific allocation requirements. The ability to provide bespoke solutions is an important edge for investors who, for example, might have significant investment restrictions or a desire to target a specific opportunity.
A disadvantage of a FoMA from a portfolio management perspective is that setting up a new manager on a platform can be a lengthy process, particularly if multiple counterparties are involved. Furthermore, there are some hedge funds who are unwilling to launch a managed account or who require a prohibitively large minimum investment in order to replicate the trading strategy. Finally, while a managed account’s well-defined investment mandate and accompanying risk limits reduce the chance of a blow-up, a consequence of this could be a tracking error, as the managed account may not fully replicate the reference hedge fund strategy.
Hedge funds who employ leveraged liquid strategies do not typically use cash efficiently. The amount of cash required to satisfy margin requirements is generally significantly lower than the amount of cash held by the hedge fund. By investing only the amount necessary to fund historical margin usage, plus a cushion, an investor can gain the same level of exposure to a strategy and retain control over excess cash. While some hedge fund managers operate funds that are notionally funded and available to FoHFs, the position transparency afforded to managed account providers means that notionally funded accounts can be provided in a much safer environment.
Understanding true liquidity
Following the financial crisis, FoHFs, in common with many hedge fund investors, discovered that several of the funds in which they were invested turned out to be far less liquid than they had been led to believe and, certainly, far less liquid than the redemption terms had indicated. Exceptional market conditions definitely played their part. However, there is no doubt that some hedge funds invested in illiquid securities to an extent beyond that which their investors either knew or expected. The transparency now demanded by FoHF investors helps to reduce the chance of any material changes in the liquidity profile going unnoticed. A FoMA, as a result of having full portfolio transparency, can closely monitor the true liquidity of the portfolio. In addition, the managed account provider is generally in a position to intervene and instruct the liquidation of any given portfolio in the best interests of the investors. This improvement in the quality of liquidity is of great comfort to investors, as it ensures that their interests are prioritized ahead of the hedge fund manager. It is far less likely that a FoMA would gate or suspend redemptions as a result of the true liquidity of the underlying investments not being fully understood.
The misappropriation of assets and the misrepresentation of investment performance are the two most significant fraud risks associated with investing in hedge funds. FoHFs mitigate these risks by performing detailed investment and operational due diligence pre and post investment. FoMAs have a greatly reduced risk of fraud as the trading advisors (the hedge fund managers) only have a limited mandate to trade the assets of that managed account. They are unable to move cash, except between approved accounts in the name of the managed account, or to determine valuations. Control over the assetsremains with the managed account platform operator who monitors the account daily.
Additionally, FoHFs pay special attention to the quality and reputation of the service providers and in particular to the services the administrator is contracted to provide and the extent to which, if any, the hedge fund manager is involved in the pricing process. Managed account platform providers generally use well-established, reputable service providers and typically use the same service providers across their entire platform, thus obtaining significant economies of scale.
A common criticism of both FoHFs and FoMAs is their additional cost or layers of fees. Additional fees are, of course, unavoidable, this being the cost of the service provided. That said, costs have steadily come down, particularly for large institutional investors. Service providers have been squeezed with administrators, registrars, auditors and custodians all being put under pressure to lower their fees. FoHF and FoMA providers have also pressured hedge fund managers to discount their standard management fee and occasionally their performance fee. Managed account platform operators in particular have been successful in negotiating reduced management fees and, increasingly, performance fees, helping to offset part of the additional cost incurred by investors.
Aligning the investor objectives with the investment model
There are clearly advantages and drawbacks to both the FoHF and FoMA investment models and, ultimately, it is up to the investor to evaluate which best suits their investment objectives and philosophy. Those who put emphasis on transparency and independent risk analysis will likely favour investment via FoMAs. In addition, since a managed account platform operator provides middle and back-office resources, their use can facilitate access by FoMAs to small and start-up managers whose limited operational capabilities would typically not satisfy a FoHF’s due diligence and would therefore be excluded from investment. Investors who prefer unrestricted access to the entire hedge fund universe may favour the traditional FoHF route. Of course, there is a third option available: a hybrid between the two can also be constructed whereby managed accounts are utilized where available and direct hedge fund investments made where a particular strategy is not available as a managed account.
The evolution of the FoHF model over the last few years represents a step forward in offering a better mix of options to end investors wishing to access hedge funds in a multi-manager format.
Sean Coleman is responsible for performing operational due diligence for the Sciens Fund of Funds and Sciens Managed Account Platform businesses. With seven years at Sciens and over 12 years in the hedge fund sector, Coleman has extensive industry experience, having previously worked for Close Fund Services, PFPC and BISYS. Alex Allen is a senior portfolio manager at Sciens, with 16 years’ industry experience. His primary responsibilities include research, portfolio construction and management. Prior to joining Sciens, Allen was a co-founder and chief investment officer of Eddington Capital Management Limited, a London-based fund of hedge funds company established in 2003. He managed Eddington’s two top-performing flagship products, including the Eddington Macro Opportunities Fund which won the InvestHedge ‘Best New Fund’ award, after generating a 25% gain in 2008.
Sciens Capital Management is an independent alternative asset manager with approximately $5.3 billion (as of 31 March 2014) in assets through its funds of hedge funds, managed accounts, advisory, private equity and real assets offerings. Sciens offers customized single client and multi-investor funds constructed using either the FoHF or FoMA models.
The Evolution of the Fund of Hedge Funds Model
The advent of FoMAs improves investor choice
SEAN COLEMAN and ALEX ALLEN, SCIENS CAPITAL MANAGEMENT
Originally published in the July/August 2014 issue