Accessing Hedge Funds Through Managed Accounts: The Future Is Now by KPMG
Executive Summary
The hedge fund industry is in the midst of change, with institutional investors becoming an increasing proportion of assets under management. In a recent survey of managers, the majority of respondents believed that pension funds will be their primary source of capital by 2020. With this, the ways in which hedge fund investments are accessed is evolving significantly.
Key to this is a focus on improving transparency and customization. Investors require improved transparency to better their understanding of the investments made by hedge fund managers on their behalf, and to better assess their liquidity. Customization, both in investment mandate and commercial terms, is increasingly sought to ensure hedge fund allocations better complement investors’ wider portfolios.
Managed accounts are key to this evolution within the hedge fund industry. They increase transparency and give investors more control, which allows better assessment of performance and liquidity. Such structures also enable investors to work with managers to develop more optimal, customized hedge fund solutions.
Operational costs (both setup and ongoing) are a key consideration in the use of managed accounts. Infrastructure providers are playing a key role in managing costs, as the industry evolves. These third- party service providers enable operational costs to be reduced and for a wider range of investors to access the benefits of managed accounts. As their offerings develop further, both investors and managers stand to increasingly benefit.
With the increasing prominence of institutional investors and their demand for customized solutions, we expect managed accounts to continue to increase in popularity and become a crucial component of the hedge fund industry.
Managed Accounts Are The Future
The 2015 KPMG/AIMA/MFA Global Hedge Fund Survey highlights the material changes that the hedge fund industry is currently in the midst of. This includes improving operational effectiveness, increasing alignment of interests and delivering value to investors. Amongst this, the development of more customized products for investors is a key focus. This discussion paper considers if the use of managed accounts represents the future for hedge fund investing. Its focus is on how hedge fund investing is accessed. It does not seek to assess the future investment performance prospects for hedge funds, which is the topic of far-reaching debate elsewhere.
A managed account gives the investor transparency on the underlying portfolio of investments, and the ability to take control of the portfolio from the hedge fund manager should it be required. Further, the custom nature of managed accounts gives scope for the investor to negotiate both investment and commercial terms (e.g. investment guidelines and fees). Greater operational requirements are the flip side of the increased flexibility offered by managed accounts, with investors needing to address aspects such as account setup and appointment of third- party service providers.
This paper seeks to discuss the increasing use of managed accounts across the hedge fund industry in general. It is noted, for example, that not all hedge funds are opaque in terms of their underlying investments and that certain hedge fund managers will not offer investors managed accounts.
Managers are moving towards customized product offerings with almost half (47 percent) of all fund managers reporting that they already offer a fund of one or managed account solution, and 21 percent saying they plan to offer these solutions within the next 5 years.
~ 2015 KPMG/AIMA/MFA Global Hedge Fund Survey
Definition Of Managed Accounts
We define managed accounts as segregated accounts that are owned and controlled by the investor, with investment decision-making delegated to an appointed hedge fund manager — their structure is conceptually the same as a segregated portfolio within equity and bond investing. This paper focuses on managed accounts at the hedge fund level (i.e. where the underlying investments in instruments and securities are made). The term ‘managed account’ can also be featured at the portfolio of hedge funds level, where a fund of hedge funds manager constructs a custom portfolio (the managed account) of underlying hedge funds — commingled funds and/or managed accounts. While a number of the areas discussed in this paper are relevant to this type of managed account, it is not its primary consideration.
The paper also focuses on the use of managed accounts by investors on the ‘buy side’, where the investor drives the setup of the mandate and includes a discussion of operational support providers to institutional investors that utilize managed accounts. These ‘infrastructure providers’ are typically third-party firms who are agnostic to the hedge fund manager and the institutional investor, and they focus on supporting the operational needs of investors to effectively and efficiently run managed accounts within a diversified investment program.
The Development Of Managed Accounts
While managed accounts existed previously, they have risen in prominence following the 2008 financial crisis. This has been driven by investor demand, with their ability to address issues such as transparency and liquidity being key.
Traditionally, an investor would invest in the commingled fund set up by the hedge fund manager. This would either be a direct investment in the commingled fund, or an indirect investment with the investor first investing in a fund of hedge funds (FoHF) that then invests a proportion of its assets in the underlying commingled hedge funds. Both transparency and liquidity issues with this approach came to the fore in the fallout of the financial crisis. In addition, hedge fund investors were also exposed to the risk of the financial weaknesses or irrational redemption behavior of co-investors in commingled funds.
With stress across financial markets, investors experienced the drawbacks of limited transparency in the underlying holdings of hedge funds. This resulted in liquidity issues, which had knock-on effects throughout the hedge fund industry — from the underlying assets invested in, to the liquidity restrictions imposed at both the hedge fund and FoHF level (e.g. gates and side pockets). This was further compounded by a number of fraudulent acts that had been undertaken within hedge fund structures and were also exposed at the time — for example, Bernard Madoff.
Overall, this led to increased demand from investors for greater transparency, liquidity and asset segregation, in order for them to better understand the investments hedge funds were making. In addition, it also led institutional investors to demand greater control over their hedge fund investments and not be subject to the liquidity provisions and co-investor risk of commingled structures. This has been further supported by the increasing prominence of institutional investors in hedge funds (e.g. pension funds), which now account for around two-thirds of total hedge fund assets. These investors have increased demand for greater transparency and customized investment mandates, as well as putting pressure on fees.
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