Divide and rule?

MSS Capital's head of structuring in EMEA, Caelim Parkes examines the benefits and drawbacks of managed accounts, in answering why at least a portion of one's hedge fund assets should be managed in segregated accounts

Hedge fund indices provide the ideal stepping-stone for those new to alternative investments and specifically into the opaque world of hedge fund investing, as well as market practioners, interested in efficient portfolio theory and the benefits of diversification, which are achieved through allocations to hedge fund strategies.

The end-users of hedge fund index products (retail or institutional) have equitable requirements: to be exposed to a variety of return-enhancing, risk-diversifying investment techniques and to be kept safe from the perceived investment and operational risks associated with investing in hedge funds.

the safety net

Managed accounts give the end-user of hedge fund index products the safety net that their investment is managed appropriately. Institutional investors indicate the areas of most concern to them when investing in hedge funds are lack of regulation, risk control and the lack of transparency.

Transparency is an essential component among any risk managers' tools for red flagging possible issues and monitoring style drift, according to the KPMG study, Hedge Funds: A Capititalist Reshaping Global Investments.

Portfolio transparency is not easily obtained and, when it is, the skill set required to convert the data into useful parameters is essential.

Managers are seldom forthcoming with position details for the investor (institution or individual) for fear of the front-running of their positions by investment bank trading desks or exposing their risky short positions to competitors. Had investors adequate information on the positions held by Long Term Capital, Amaranth or Mother Rock, to name a few, would they have redeemed earlier or chosen to invest in other funds where leverage was less highly used and had lower position concentration?

Managed accounts attempt to go some way in alleviating both retail and institutional fears of the hedge fund 'unknown' - and to make 'what if' scenarios more accessible.

no straightjacket

They should not restrict or inhibit the hedge fund manager from trading the portfolio as they intend, according to started objectives and risk management parameters, in the markets of their choice in the search for 'alpha'.

Although, they should provide a legal framework for consistent delivery of positions and valuations to a source not in a position to use the information to front-run, they should allow for independent valuation of the assets, provide the course of action which would be implemented when a hedge fund manager strays from an agreed instrument trading list or risk management parameter (style drift perhaps, or something more serious) and place this legal framework in a jurisdiction which has acceptable and enforceable legislation.

It is the access to the transparency, independent valuations and implantation of the legal framework which makes an index based on managed accounts a very attractive option for the investor, retail, instutional or regulator, who concern themselves with the safe guarding of their investments.

Any index product aims to deliver on a set of clearly defined objectives which should be available publicly. FTSE for instance, has the objective of its index to measure the open, investable, liquid hedge fund managers who are statistically representative of their strategy and governed by a publicly available rule structure.

For FTSE to deliver on its promise, it uses the managed account platform managed by MSS Capital to deliver those promises and set of objectives.

safety in numbers

It is the managed account structure that allows the platform manager, such as MSS, to collect data, via the platform administrator, safe in the knowledge that the data has been reconciled and valued independently, and aggregate thousands of positions (which, in isolation, are not that useful) through its risk management system GARAS, into manageable streams of information.

The data in its simplest form examines basic risk management parameters such as leverage, concentration, permitted instrument lists, counterparty exposures and so forth to make sure that (1) the manager is doing what he or she has set out to do as per the prospectus and (2) that there is no style drift and hence the FTSE promise with regard to measure the risk and return of certain hedge fund strategies, is being adhered to.

Further to the risk management and style drift benefits which exist, are a number of secondary items, which are nevertheless equally as important.

Individual managed accounts (as opposed to using one managed for several hedge fund managers), allow for the segration of assets at the manager level.

Should an event occur, contagion is restricted to the individual managed account and cross subsidising would be limited. Enhanced liquidity is available at times whereby the platform manager may instruct the prime broker of a hedge fund manager to liquidate a portfolio, or do an in specie transfer should the manager continue to breach his or her legal requirements (transparency) or a risk management breach occurs.

reporting excellence

Enhanced and detailed client reporting is a derived benefit from the managed account structure.

FTSE is able to publish daily index changes in the Financial Times.

The platform manager is in a position to report in market events and the possible impact on the portfolio by being able to value at any given time the exposure to the collateralised debt obligation (CDO) market, as well implementing exposure screening and scenario analysis on the impact of interest rate curve changes on the portfolio as required by certain regulatory environments, such as Sweden. There are two areas in which we believe indices such as FTSE's Hedge Fund Index, which are based on managed account platforms will have a real advantage in the investable hedge fund space.

These are in the development of products for retail and insurance distribution through Ucits fund wrappers and in the production of Basel II compliant reports which will result in significant cost savings for institutions adhering to the new Basel II cost of capital calculations, as currently seen in Japan.

pros and cons

The counter-argument to the benefits of using managed accounts to drive investable hedge fund indices, is the extra layer of costs which a managed account assumes.

However, given the enhanced benefits and investment experience they deliver, these are worth the margin cost.

As some investors have indicated, you may not put all of your assets into managed accounts-based products, but as an insurance policy against single manager events, it is very sensible to balance your exposure with both direct and managed account products.

A further argument, that not all of the best hedge fund managers offer managed accounts and hence are not available for selection into an index based on managed accounts, has changed substantially in the last three years. MSS has seen the growth of managed accounts across the board, due to the demand from institutional investors such as pension funds and insurance companies and regulatory bodies such as the Comisión Nacional del Mercado de Valores (CNMV), in Spain.

This is illustrated by hedge fund managers who are included in the FTSE Hedge Index (Winton, Kinetics, Okomus and Theorema).

Managed account platforms allow index providers to deliver on their hedge fund promise. They provide the safety net through transparency, risk management and style drift analysis and provide structured product providors with an asset which can fit a variety of products.