My friend and fellow blogger Yaser asked me the following question: "I would love to hear your opinion on Managed Accounts and whether they improve transparency and other pros/cons of HF investing." While I find it flattering and humorous that anyone would "love" to hear my opinion on anything, I think the question is deserving of a response, for what it is worth.
Yaser also forwarded me the results of an August 2006 survey from Terrapinn Ltd. concerning managed accounts, and suggested I take a look at it as well. The results of this survey are predictable: many Institutional Investors don't invest in hedge funds due to lack of transparency; many would be more inclined to do so if there was greater transparency; and a significant number are considering investing in hedge funds via managed accounts in the future. Yeah, whatever. So what is the straight dope on managed accounts? Here it is.
So what is a managed account, exactly? A classic hedge fund managed account has the following characteristics:
- The investor owns actual assets via the managed account, not simply LP interests in a pool of assets;
- The hedge fund manager is an advisor to the managed account;
- The investor has full transparency into the assets being managed;
- The investor generally has liquidity superior to the LPs in the main fund;
- Running a managed account is an operational and logistical hassle for a hedge fund manager; and
- Most hedge fund managers will require a sizable capital commitment in order to accept a managed account.
This presumes, however, that a hedge fund manager is willing to run a managed account under any circumstance. Many top managers simply won't, or only run managed accounts for legacy investors for whom they do it as a courtesy (as they may have originally helped them get their start, etc.). Why are managed accounts viewed with such disdain by managers, while they are clearly desired by Institutional Investors? Principally, because:
- They are an operational pain, requiring discrete resources for their proper management which reduces returns;
- They often provide a window (read: transparency) into a portfolio and trading strategies that managers find undesirable;
- They often come along with preferential liquidity rights for their owners which managers don't want to give;
- They often create asymmetry with the main fund, as managed account holders may want portfolios run pursuant to their unique portfolio objectives and/or risk parameters; and
- They create unnecessary and unwanted complexity in to manager's operations when they simply are not needed.
There is a supply and demand imbalance for top hedge fund managers, where the demand for their product far outstrips supply. Therefore, there is absolutely no incentive for these managers to take on managed accounts. And they won't. So which managers are offering managed accounts? Not the top managers. Frequently emerging managers or those for whom asset gathering has been a problem. Remember the S&P investable hedge fund index? It failed. Managed account platforms run by big banks are challenging by their nature, because frequently the only funds willing to accept the rigid parameters of the program are, quite simply, not the best.
Therefore there is, to a degree, structural adverse selection when it comes to managed accounts. Those who are willing to run them are simply not the best, because they need to accept them to raise assets. Top managers don't, and want all their investors to be fund investors with homogeneous (and painfully rich) terms. This makes life easy.
So ultimately it is up to the Institutional Investor to vote with their feet:
- Is gaining transparency worth the possibility of giving up returns? or
- Is it best to simply avoid hedge funds altogether and accept that the asset class won't be available to me? or
- Should I sacrifice my transparency guidelines on a small portion of my portfolio in order to gain exposure to top hedge fund managers in the hope of generating true alpha?
While 1 is clearly stupid, either 2 or 3 are perfectly reasonable and valid choices, in my humble opinion. But the punch line remains:
Those who think the flood of Institutional assets into the hedge fund space wanting greater transparency will force the use of managed accounts on top managers are on crack. It just won't happen.
I think transparency can be a beautiful thing - depending on the context. But for most high quality hedge fund managers (and for many investors as well), transparency is NOT considered a good thing, and it will be those most in need of assets (read: novices or B-type managers) who capitulate to such demands. Now is this any way to invest? Maybe if you are seeding new funds. Otherwise, choose another asset class.