Hedge Funds in the ‘Post-Mingled’ Era
The trials of small and large hedge funds are mounting. Many have seen assets hemorrhage from outflows, fund launches have stalled, and closures have increased since 2016. One solution might be for the hedge fund industry to modify its current practices to more resemble what investors seem to want: separately managed accounts.
The typical explanation for the popularity of managed accounts is that they appeal to the investor-centric, governance-focused mindset that has taken hold in the aftermath of the financial crisis. Managed accounts are hardly a new idea in asset management – they predate the rise of commingled funds. But their appeal did increase after some large hedge-fund investors found themselves gated into funds holding illiquid assets around 2008.
Furthermore, the last decade saw the rise of “outcome-based investing,” where investors large and small have sought to tailor their portfolios to meet concrete goals or liabilities. At the same time, investors like family offices, high net worth individuals, foundations and endowments and large registered investment advisors all adopted the policies and methods of large corporate and public pensions. It used to be that only a large university endowment would ask for a managed account. Now requests come from all quarters.
Change seems likely, and it’s coming to the entire alternatives space. For regulatory reasons, CTAs have often employed their strategies in managed account formats. But now investors are increasingly seeking these arrangements from hedge funds and managers in private equity and private debt.
So far, the industry is resistant, and while managed accounts and managed account platforms have grown quickly since the financial crisis, most assets remain in commingled funds. Earlier this year, the law firm Seward & Kissel LLP analyzed the public filings for more than 200 U.S. hedge fund managers and found that “the vast majority (69%) of both equity and other advisers did not advise separately managed accounts.”
It may be that they have balked at the operational burdens. Managers with separate accounts must provide bespoke performance and risk reporting, split trades among brokers, allocate trades to accounts with different cost bases, track customization requests for risk or environmental, social and governance issues, and more.
All of these add to costs, despite recent advances in fund administration technology. It doesn’t help that investors who want to negotiate terms are also likely to ask for fee concessions. Managed accounts can mean higher expenses and fewer revenues, which is a tough spot for smaller funds with strained margins.
Performance reporting also becomes difficult in a managed account world. Composite return streams are generally problematic, given that the underlying accounts may be customized and have different start dates, as well as different trade allocations or costs. In the long-only world, managers can create composite track records compliant with the Global Investment Performance Standards (GIPS) published by the CFA Institute, but those standards do not yet exist for alternative strategies.
Nevertheless, swelling numbers show that more investors feel managed accounts’ benefits outweigh their challenges. Assets of managed account platforms, which aggregate the administration of multiple accounts for asset managers, have grown to $112 billion at the end of 2018 from $41 billion in 2010. These platforms account for just a fraction of the managed account universe, but they are large businesses. Man FRM’s AUM exceeds $19 billion over more than 400 accounts. Lighthouse Partners, K2 Advisors, Prelude Capital and PAAMCO Prisma all employ various types of managed account structures to deploy capital. Prominent users of these services include investors like university endowment DUMAC and public pensions like MassPRIM and Texas Teachers.
This isn’t exactly the long-term trend that most fund management firms would want the industry to follow. However, now, with investors demanding what Enso Financial Analytics has termed “TLC” (Transparency, Liquidity and Control), managers have little choice.
In 2018, Credit Suisse’s prime brokerage surveyed 200 investors representing $765 billion in assets and found that a quarter of all their alternative investment flows were through separately managed accounts.
JPMorgan’s 2019 Institutional Investor survey reveals massive use of managed accounts by key alternatives investors, with consultants directing 50% of client assets and funds of funds deploying 43% of new assets through these channels. Overall, 36% of the JPMorgan survey respondents used separate accounts in 2018. Endowments and foundations, funds of funds, family offices and pensions all told JPMorgan they plan to increase their separate account investments this year.
Meanwhile, HFM data showed $144 billion in hedge fund outflows for 2018. eVestment reported that the industry experienced outflows of $44 billion through June 2019, with no end in sight. Managed accounts might be a lone bright spot that heretofore resistant managers might be wise to consider.
In the absence of standardized performance reporting for managed accounts, the traditional hedge fund might still find a vital role to play as marketing collateral. The fund represents the manager’s core strategy. Its track record is what investors scrutinize while they decide what customizations they’ll want for their own accounts. But it’s the firms that embrace managed accounts that have the best chance of raising assets in an increasingly tough environment.
The author is a hedge-fund industry source who wishes to remain anonymous.
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