white paper on managed accounts

June 2015

Peter Dom and Bas Nagtzaam

Managed accounts: The solution to the trend of institutionalization in hedge fund investing?

White paper managed accounts June 2015 2

1. Introduction

2. Industry Institutionalization Trends 2.1 Development hedge-fund industry

2.2 Impact institutionalization

3. Possible investment structures

4. Managed accounts further explained 4.1 Definition of managed accounts

4.2 Managed-account structure

4.3 Operational set op

4.4 Legal, regulatory and tax set up

4.5 Available managed account product structures

4.6 The positive aspects of managed accounts

4.7 Disadvantages of managed accounts

5. Suppliers of managed accounts 5.1 Background and company profile

5.2 Product/service offering

6. Implementation of managed accounts

7. Conclusion

8. About AF Advisors

Content

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The hedge fund industry has changed dramatically over the last decade. Hedge fund assets have tripled as investing in hedge funds has become more mainstream and institutional investors have increased their allocations to hedge funds.

As a result of the increasing importance of institutional investors to the hedge fund space, more stringent requirements are forced upon hedge fund managers, especially with regard to transparency and control of assets. The trend of institutionalization will continue with the expected growth of institutional assets. This will impact the products and services offered by hedge funds. Next to institutionalization, the sector is currently dealing with a wave of new regulations.

In this paper we describe the different possible investment structures for hedge fund investments and how they relate to changing investors requirements and new regulations. We focus on the possible solution of managed accounts to fulfill the institutional investor requirements and describe the advantages, challenges and practical aspects of implementing a managed account.

This paper provides insights for institutional investors and financial institutions investing (or considering investing) in hedge funds. The paper seeks to bring a clear and balanced view on the various investment vehicles for hedge funds with a particular focus on managed accounts. Finally, we will answer the question whether managed accounts are the right answer to the trend of institutionalization of hedge fund investing.

1. Introduction


2.1 Development hedge fund industryThe global hedge fund industry showed a strong growth over the last decade. The assets under management(AuM) have grown to a record $ 2.36 trillion as of June 20141. As such, hedge funds respresent about 1% of global financial assets.

Increased allocation towards single manager hedge funds by institutional investors has been the primary driver of this growth in assets. Recent research showed that institutional investors account for 62 percent of the industry’s AuM.2 Hedge funds appeal to a broad range of investors though. Within the category institutional investors, foundations are the largest investors in hedge funds: 19% of institutional hedge funds investments are held by foundations. Fund of hedge funds and private sector pension funds are also significant investors in hedge funds, as Figure 2 and 3 show.

2. Industry institutionalization trends

1 Estimations by Eurekahedge and Barclay Hedge.2 Goldman Sachs Annual Global Hedge Fund Investor Survey 2013.

0,00

0,50

1,00

1,50

2,00

2,50

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Figure 1: AuM ($, trillion) in hedge funds (1997 - 2014) excluding Fund of Fund investments

Source: Barclay Hedge

Foundations 19% Family O�ces 7%

Fund of Hedge Funds 16% Asset Managers 4%

Private Sector Pension Funds 15% Insurance Companies 4%

Endownment Plans 12% Investment Companies 1%

Public Pension Funds 9% Sovereign Wealth Funds 1%

Wealth Managers 8% Others 4%

Figure 2: Total hedge fund assets per institutional investor type

Source: Preqin Global Hedge Fund Report 2014


Recent surveys of the hedge fund industry indicate that the total AuM of the hedge fund industry are expected to continue to grow3. The increase of the capital invested by institutional investors will be the key driver behind the expected growth4. In the current market environment characterized by low interest rates, low credit spreads and high equity valuation institutional investors are searching for yield in alternative asset classes including hedge funds, as both fixed income and equity markets may face headwinds going forward. As the institutional investors will remain the most important investors for hedge funds, the trend of institutionalization of hedge funds investing will continue and will impact the key product characteristics.

Figure 4 depicts the key issues the hedge fund industry is currently facing according to institutional investors. Achieving performance on a long term basis is essential for institutional investors. The introduction of new regulation frameworks such as the the Alternative Investment Fund Managers Directive has also lead to significant changes in the hedge fund sector. Another important change in the industry is the increase of the alignment of interest between hedge fund managers and investors through fee mechanisms. Investors are paying more attention to the management and performance fees of hedge fund managers. Finally, investors are increasingly requiring transparency with respect to their hedge fund investments. In the subsequent paragraphs these key issues will be discussed in more detail.

Figure 3: Hedge fund assets per institutional investor type over time

Public Pensio

n Funds

Sovereig

n Wealth

Funds

2009

2010

2011

2012

20130%

5%

10%

15%

20%

25%

Endowments

Fam

ily O

�ce

s/Foundatio

ns

Insu

rance

Companies

Private

Sector P

ension Fu

nds

7,5% 9,9%

18,9% 19,5%

2,5%

6,9%

3 Deutsche Bank Alternative Investment Survey 2014.4 Goldman Sachs Twelfth Annual Global Hedge Fund Investor Survey 2013.

Source: Preqin Special Report November 2014


2.2 Impact of institutionalizationThe institutionalization of the hedge fund industry has impact on the following aspects:– Performance– Risk management– Control– Liquidity– Transparency– Fees– Hedge fund beta– Alignment of interest– Compliance and regulation

PerformanceA major concern of institutional clients is that hedge funds may deliver beta returns whereas the reason to invest in hedge funds is to achieve absolute uncorrelated returns. Institutional clients are not willing to payhedge fund managers relatively high fees to deliver just beta returns. Despite the on average fairly disappointing and sometimes market corelated returns, the expected growth of institutional assets in hedge fundsindicate that institutional clients still believe in the ability of hedge funds to generate absolute return. Acrossinvestor type and geographies, the majority (61%) is expecting a return between 6% and 10%, while 35% expect to have a return of 11% to 15%. In four years, the percentage of investors targeting double digit returns for their hedge fund portfolio has dropped from 52% to 37%.5 Hedge funds now have to live up to both the ambitious expectations of institutional investors and the expectation of largely uncorrelated returns.

Risk managementRisk considerations have always been a component of hedge fund investing. In recent years however, institutional investors have paid increased attention to market risk, liquidity risk, counterparty risk and operational risk.

While some years ago it was acceptable to experience periods of negative returns, institutional investors no longer seem to have patience to wait for market dynamics to change. As a consequence institutional investors

5 Credit Suisse Global Survey of Hedge Fund Investor Appetite and Activity 2013.

Figure 4: Key issues facing the hedge fund industry

0% 5% 10% 15% 20% 25% 30% 35% 40%

Other

Economic Environment

Liquidity

Correlation

Investment Opportunities

Volatility

Transparency

Fees

Regulation

Performance

Source: Deutsche Bank Alternative Investment Survey 2014


require a greater understanding of their investments and associated risks. In order to keep up with market standards and expectations with respect to governance, investment committees, boards and regulators are increasingly seeking more extensive and sophisticated risk reporting. As a result institutional investors require risk data and reporting that is both current and accurate on portfolio and hedge fund levels.

Especially since the onset of the financial crisis counterparty has risk received increased attention. Institutional clients desire a frequently updated integrated view of their total counterparty risk. This means that the investments in external hedge funds need to be included in their internal counterparty risk reports.

Finally, institutional investors must take operational risk into consideration. Hedge funds often invest in illiquid instruments and complex OTC contracts, requiring skilled and experienced fund operations staff. Researchshows that operational risk is of great importance as the majority of the hedge fund blow-ups are caused by operational failures or weaknesses.6 Institutional investors are aware of the importance of these risks. In fact, ‘operational robustness’ is now perceived as one of the most important factors influencing the allocation decision.7

ControlControl issues can be split into two related considerations – issues regarding control and governance over the underlying assets and issues surrounding conflicts of interest. A number of fraudulent cases like Madoff and blow-ups of hedge fund managers have all raised serious questions about the level of control investors have over their investments. In addition there is an inherent risk of conflict of interest between the manager and the investor. The source of this conflict lies in the objective of the hedge fund manager to attract assets and generate fees. Managers can increase risk in their portfolio (e.g. leverage, extreme bets, deviations of the investment style) in order to boost the performance. Institutional investors want to mitigate the risk of conflict of interest and require more control over their investments. Pension institutions in particular have very high standards regarding governance and asset control in traditional asset allocations and are increasingly applying equivalent standards to their hedge fund investments.

6 Capco white paper ‘Understanding and Mitigating Operational Risk in Hedge Funds Investments’ March 2003.7 Goldman Sachs Annual Global Hedge Fund Investor Survey 2013.


LiquidityOver the last years there has been a clear shift in preference for greater liquidity. Although there is substantial difference in the outcome of research, the majority of investors are currently invested in funds with at least monthly liquidity.8 It should be noted that long-term investors like pension funds have differentrequirements regarding liquidity and can generally accept lower liquidity.

While ongoing liquidity terms in hedge funds are improving, the majority of institutional investors still accept some lock-up period. Pension funds, insurance companies and endowments generally accept longer lock-up periods than other institutional investors because they benefit from a capital base that allows them to apply a longer term view. There are substantial differences in investor opinions about lock-up periods per region. US institutional investors are more willing to accept longer lock-up periods and gating provisions while European institutional investors strongly prefer that the liquidity of the fund matches the liquidity of the underlying investments.9

TransparencyTransparency continues to be an important issue for institutional investors. The level of transparency of hedge funds has generally improved throughout the years, but institutional investors’ requirements are pushingthis trend further. Institutional investors often require full position transparency and detailed portfolio reports. Institutional investors require this level of transparency in order to monitor the manager, to monitor sources of performance and to facilitate risk management. One aspect that is often overlooked is the importance of the quality of data. The added value of transparency in terms of sophisticated risk managementand performance measurement is only valid if the quality of the data provided is both accurate and reliable.

FeesNowadays, institutional investors have more bargaining power to achieve better results in setting the level of fees. As a result the typical ‘2 and 20’ model has been abandoned to a large extent. The increased flows of institutional assets, disappointing performance of hedge funds over the course of recent years andthe increased cost consciousness of institutional investors are the main reasons for institutional investors to continue to push back on fees. The arguments used by investors to (re)negotiate fees include less favorable liquidity terms, lock-ups, early stage investments and finally poor or beta related performance.10

Figure 5: Single strategy hedge fund liquidity terms 2008 and 2014

2008

31%

45%

8%

11%5%

Monthly or Less

Quarterly

Semi-Annual

Annual

More than Annual

2014

81%

29%

2% 2%

Source: Goldman Sachs Global Hedge Fund Investor Survey 2014

8 Deutsche Bank Alternative Investment Survey 2014.9 Goldman Sachs Twelfth Annual Global Hedge Fund Investor Survey 2013.10 2013 Credit Suisse Global Survey of Hedge Fund Investor Appetite and Activity, and DB 10th annual Alternative Investment Survey.


Hedge fund betaIncreasing focus on cost, coupled with a notion that hedge funds may be nearing an alpha generating capacity constraint as an industry, has led investors to consider adding ‘hedge fund beta’ to their portfolio. Currently, several institutional investors are pioneering on this investment frontier. Essentially, hedge fund beta can be replicated either top-down or bottom-up. The top-down approach encompasses running backward-looking regressions of historical hedge fund index returns on various capital market risk factors (e.g., stock indices, bond indices, commodities, stock volatility). If the regression analysis showed a high explanatory power it is said to have ‘replicated’ hedge fund returns. In practice however, backward-looking regressions appeared to have only a limited amount of predictive power. As a result, top-down approaches have been surpassed in popularity by bottom-up approaches. This approach starts by attempting to understand the underlying securities and trading patterns of various hedge fund strategies. If the core of certain hedge fund strategies have little-to-no discretion in what and how they trade, the bottom-up approach replicates the actual hedge fund strategy using a similar set of systematic trading rules. As such, the bottom-up replication product is akin to an actual hedge fund manager using a rules-based, quantitative approach to trading the underlying securities associated with a particular hedge fund strategy. The bottom-up approach is also referred to as ‘alternative beta’ or ‘alternative risk premia.’

Aligment of interestInstitutional investments are a driving force behind the increased focus on alignment of interest between hedge fund managers and investors. Institutional investors’ main focus with respect to creating alignment is on economic terms. They increasingly expect that management fees should not generate profits for the hedge fund manager but rather should be set at a level to cover reasonable operating expenses of a hedge fund manager’s business and investment process. To this end, managers are required to be transparent about their costs and managers should provide investors with sufficient information regarding their operating expenses and break-even asset levels, so that investors can assess the appropriateness of the management fees being charged. Performance fees should include proper use of high water marks and hurdles. The need for a proper long-term incentive for the manager to maximize value over a typical investment period of 6 to 10 years became particularly acute after the recent financial crisis.

Figure 6: The average management fee and performance fee paid by asset owners investing in hedge funds

16.0

16.5

17.0

17.5

18.0

18.5

1.45 1.50 1.55 1.60 1.65 1.70 1.75 1.80

Aver

age

Perf

orm

ance

Fee

(%)

Average Management Fee (%)

Pension Fund: 1.5 / 17.7

Endowment/Foundation: 1.58 / 16.31

Private Bank/Wealth Manager: 1.74 / 16.6

Asset manager/Fund of funds: 1.68 / 18.24

All Respondents: 1.69 / 18.21

Family O�ce: 1.69 / 17,76

Source: Deutsche Bank Alternative Investment Survey 2014


Figure 7: Illustration of the abundance of new hedge fund regulations

Performance fees typically crystallize annually. This has lead to situations in which an investment in a hedge fund has produced a profit for the hedge fund manager but not for the investor. After serious drawdowns in 2008, numerous long-term investors realized that, as a result of the timing of profit splits, the hedge fund manager was the only one with an actual profit arising from the investor’s allocation to the fund.

As a result, performance fee mechanisms that provide true alignment between hedge fund manager and investors, i.e. with clawbacks over multiple years, are becoming increasingly in vogue. The clawback provision allows investors to reclaim earlier charged performance fees. However, many of the clawback arrangements currently in place in the US, could lead to the consequence of fund managers being taxed on deferred income. In other words, they have to produce a cash flow now, while the performance fee cash flow occurs at a later stage. This has been mitigated by the introduction of a performance fee in the form of a stock appreciation right. Instead of being paid a (deferred) performance fee in cash, the hedge fund manager is granted an option on the value of his hedge fund. This mechanism effectively allows the incentive fee to accrue over the life of the allocation which creates a long-term co-investment between investor en fund manager.

Apart from performance fee retained within the fund, institutional investors also expect senior investment professionals from hedge fund management organizations to have a significant amount of their net worth invested in the hedge fund.

Compliance and regulation:As regulators have been focusing their attention on hedge funds since the financial crisis, regulation has become the second-largest challenge hedge fund managers are currently facing in the industry.. As of July 2014, any hedge fund, private equity fund or real estate fund wishing to market or manage its fund in the European Union needs authorization under the Alternative Investment Fund Managers directive (AIFMD). As a result, many previously exempt hedge fund bodies have been included in the scope of regulators.


11 2014 Preqin Investor Outlook: Hedge Funds.

The objective of AIFMD is to introduce a common regulatory framework for previously unregulated funds in the EU to increase investor protection and to enable better monitoring of systemic risk issues by obliging hedge fund managers to provide extensive information to regulators. Funds that are regulated under UCITS are excluded from the scope of this regulatory framework.

AIFMD requires hedge fund managers to obtain authorization, live up to ongoing operation requirements and comply with transparency and reporting requirements.. The directive is pushing hedge fund managers to improve their risk management and to use externals for valuating their portfolios. An aspect of AIFMD which challenges established practices in the hedge fund sector is the potential restriction of remuneration through bonus deferrals and clawback provisions. In addition, the AIFMD also enables competent authorities to intervene and et limits on leverage when deemed necessary with respect for the stability and integrity of the financial system.

The majority of hedge funds are based in the US but when they are marketed to investors in the EU, they are in scope of AIFMD. At the moment, nearly 50% of the largest managers with asset under management of $ 5 billion or more had thought about exiting markets because of increased regulations.11 In addition, smaller hedge fund are likely to spend more on regulatory compliance, both as a percentage of assets under management and relative to operating costs, than larger managers.

Institutional investors are certainly more aware of the risks they are taking by investing in traditional or alternative funds and will seek to avoid negative publicity or difficult questions from stakeholders such as boards and underlying (pension) clients. Investors require their managers to be on top of the new regulation standards as well as to quickly anticipate any further upcoming changes. Factors that an investor will consider when evaluating the preparedness of a given manager to handle and anticipate these changes include an evaluation of the legal compliance and operational resources of the manager.


Investors may gain exposure to hedge fund strategies through several different types of vehicles.

The most common ways to invest in hedge funds include:1. Direct fund investement: The investor invests directly in hedge funds. These hedge funds are set up and

managed by the hedge fund manager. The hedge fund manager is the entity that has control over the fund and the assets. The hedge fund manager determines the governance structure of the hedge fund, the level of transparency provided towards investors and selects the fund’s service providers. The liquidity terms of the hedge fund are defined by and generally in favor of the hedge fund/manager (typical hedge fund liquidity terms are monthly or even quarterly with long notice periods). Hedge fund fees consist of a management and performance fee, and fees for service providers (e.g. administrator, custodian, transfer agent, legal advisor, and accountant) and other costs such as marketing and organizational expenses. The majority of the hedge funds is set up in lightly regulated domiciles like the Cayman Islands, Jersey or B.V.I. Recently, a number of hedge fund managers have issued mutual funds regulated under the US 1940 Investment Company Act.

2. Fund of hedge funds: A fund of hedge funds is a fund that invests in several different hedge funds to

provide better diversification. The manager of the funds of hedge funds is responsible for manager selection, portfolio construction and portfolio management. Ultimate control over the assets is exercised by the underlying hedge fund managers. While offering investors the advantages of greater diversification and manager selection expertise, the disadvantages include limited transparency, liquidity constraints and additional costs. As the assets are held by the underlying manager, transparency is limited at the fund of hedge fund level. The liquidity of the fund of hedge fund is linked to, and might be constrained by, the liquidity of the underlying hedge funds. Fund of hedge funds have a double layer of costs as both the fund of hedge fund and the underlying hedge funds will each charge management and/or performance fees, service providers fees and other costs. Similar to hedge funds, fund of hedge funds are often set up in lightly regulated domiciles like the Cayman Islands, Jersey or B.V.I.

3. Possible investment structures

Figure 8: Illustration of different types of hedge fund vehicles

Manager Platform Provider

Client

HedgeFund/FoHF

DedicatedManagedAccount

CommingledManagedAccount

Fund of One

Fund governance:Platform

Investment policy governance:Platform/Manager (Client as shareholder)

Service provider governance:Platform

Asset control:Platform

Transparency:Partial transparent (with delays and notalways with full holding transparency)

Fund governance:Client/independent

Investment policy governance:Client/Platform/Manager

Service provider governance:Platform/Client

Asset control:Client/Platform

Transparency:Full transparency

Fund governance:Manager/Client

Investment policy governance:Client/Manager

Service provider governance:Manager

Asset control:Manager

Transparency:Dependent on manager and nouniformity

Fund governance:Manager

Investment policy governance:Manager (Client as shareholder)

Service provider governance:Manager

Asset control:Manager

Transparency:Limited


3. Fund-of-one: This is a dedicated fund that is set up by the hedge fund manager at the request of a large investor to manage the investor’s assets pari-passu with the reference hedge fund. The manager retains ownership and the control over assets and maintains the relationships with the market counterparties and service providers. A fund-of-one is set up as a separate vehicle effectively segregating the assets from the other assets of the manager. Large investors will be able to customize the fund on certain aspects like investment guidelines, transparency and governance (by appointing one or more directors of the fund). For these investors it should also be possible to negotiate lower management fees as the fund-of-one is not competing with the reference hedge fund of the manager. The fees of the service providers should remain comparable to those of the reference fund. The fund can be set up in the investor’s domicile of choice.

4. Managed account: A managed account is an investment structure that is set up and governed by either the managed account provider, the client, or the independent board of directors (hereafter called ‘sponsor’) to manage the assets pari-passu with the reference hedge fund. Typically the managed account will be set up as a separate vehicle enabling the ring-fencing of the assets. The managed account can be fully customized to the sponsor’s specific needs and restrictions. The hedge fund manager will only be involved in portfolio management without having any control over the assets or the operating model. All operational aspects are handled by service providers that are chosen by the sponsor of the managed account. Similar to the fund- of-one, the sponsor will be able to negotiate reduced management fees for a sizable dedicated managed account. The costs of service providers will be charged to the fund (account) but can be kept relatively low as the fees can be negotiated on the basis of the sponsor’s total AuM. The fund (account) can be set up in the sponsor’s domicile of choice.


4.1 Definition of managed accountsAlthough managed accounts have been in use for more than a decade, there is still confusion about the concept of a managed account for hedge funds. This confusion may stem from the terminology because the managed account structure is similar to the segregated mandates given to the traditional long-only managers by institutional investors. For managed accounts, as with segregated mandates, the manager acts as investment advisor to a portfolio of assets that is tailored to the client needs and operates within the client’s framework of service providers.

To provide greater clarity about the concept of managed accounts for hedge funds, the following definition will be used:

4.2 Managed account structureManaged accounts can be structured in many ways and can be customized to the needs of the sponsor.The diagram below shows a typical managed account structure, the parties involved and their main tasks.

4. Managed accounts further explained

A managed account for hedge funds is an investment structure:– That is governed by either the managed account provider, the investor, or the independent board of

directors (the ‘sponsor’).– Where the assets are typically managed pari-passu with the reference hedge fund.– That is tailored to the specific needs and restrictions of the sponsor.– Where the hedge fund manager’s role is limited to executing the trading strategy– Where certain operational tasks such as valuation and accounting are carried out by independent third

party providers that are chosen by the sponsor.– Where the sponsor is responsible for the operational oversight of the managed account (e.g. risk

management, monitoring investment limits, cash management, reporting, legal, compliance, tax).


Figure 9: Typical managed account structure, including involved entities and activities

Hedge FundManager

Managed Account(company, Trust, LP)

Service Providers &Market

Counterparties

Investor

Governance

Legal, TaxCompliance

Risk Mgt

Reporting

Operations

Operational Risk

Trading strategyreplication

TradingAdvisoryAgreement

ServiceAgreements

Auditor

Prime Brokers

Administrator

Registrar & TransferAgent

Legal Advisors

Secretary

OTC Counterparties

Risk Management

Operational Controls

Reporting

PerformanceMonitoring

InvestmentManager

HF portfoliomanagement

AssetControl

TradingAdvisor

Board of directors / manager,general partner

Legal, Tax,Compliance

Monitoring TradingAdvisor

contractual fund)

Managed account providerInvestment Management Agreement

Management company (if applicable)

(AIFM in the EU)

Custodian/Depositary in the EU

Explanation:– Managed account: For each managed account a separate legal structure is incorporated. This incorporation

requires regulatory approval or notification. As each managed account is a separate legal entity, the assets are ring-fenced and there is no risk of contamination across managed accounts. The party that governs the managed account varies by structure – a company structure will have a board of directors, a trust structure will have a manager and an LP will have a general partner. The governing body is responsible for, amongst other things, the appointment of the trading advisor, service providers and market counterparties.

– Trading advisor: The hedge fund manager is appointed as the trading advisor to manage the assets of the managed account within a set of agreed upon investment guidelines as set out in an Trading Advisory Agreement (TAA). The TAA is the key legal document that governs the relationship between the managed account and the trading advisor. In Table 1 the key elements of a TAA are summarized. The trading advisor typically needs to be approved by the regulator: in the US as a Registered Investment Advisor and in the EU under Mifid or AIFMD regulations.

– Investment manager: The party that is appointed as investment manager of the managed account will perform the daily operations of the managed account (subject to the specific requirements of the investor/ sponsor). In most situations the managed account provider will be acting as investment manager of the managed accounts, as only large investors will be able to act as investment manager themselves. A managed account provider acting as investment manager typically needs to be approved by the regulator: in the US as a Registered Investment Advisor and in the EU under AIFMD regulations.


Typically the investment manager is providing the following services (not limited to):- Trading advisor monitoring: Monitoring the daily process.- Risk Management: Stress testing, calculation of risk data, report investments guidelines breaches

and coordinate corrective actions as necessary.- Operational tasks: Cash management, checks on valuations and trade errors, monitoring of the subscription and redemption process and monitoring service providers and market counterparties.- Performance Measurement: Performance reporting and analysis of the managed account,

the reference fund and any tracking error.- Reporting: Making available periodical managed accounts and risk reports- Legal, Tax and Compliance: Negotiate and draft legal agreements, perform legal proceedings,

tax filing, and legal compliance.

– Custodian/Depositary: The custodian, typically combined with a depositary function under EU AIFMD, ensures that the issue, repurchase, redemption, sale, and cancellation of shares are carried out in accordance with the prospectus and any other applicable legal documents (articles of association, trust deed). In addition, the custodian/depositary is also responsible for the safekeeping of the assets. Under AIFMD the depositary function includes supervising the managed account’s investment activities and cash flows.

The custodian may also be required to conduct the annual shareholder reporting and to confirm the managed account’s accordance with its prospectus and the applicable regulations.

The custodian is allowed to delegate the whole or any part of its custodial functions to a third party, provided that the liability of the custodian regarding the safe keeping of the assets will not be affected. The custodian must exercise care and diligence in choosing and appointing a third party as a safe-keeping agent and must maintain an appropriate level of supervision over the safe-keeping agent. The depositary function, as required by AIFMD, cannot be delegated.

Table 1: Overview of key elements of the Trading Advisory Agreement

Investment related aspects Investment guidelines:• Approved markets, sectors and instruments• Concentration limits• Liquidity of underlying investments• Leverage limits• Exposures

Business aspects • Capacity• Management & performance fee• Liquidity of the MAC• Most Favoured Nations (MFN) clause

Legal aspects • Termination• Liability & indemnity• Reps & warranties• Confidentiality

Operational aspects • Description of roles and responsibilities • Insurance• Ongoing due diligence

• Trading process and IT


– Registrar and Transfer Agent (RTA): The Registrar and Transfer Agent has responsibilities that include the processing of subscription and redemption orders, maintaining the shareholder register, carrying out anti-money laundering checks and sending notices, reports (including the interim and annual reports), financial statements and other documentation to the shareholders.

– Prime brokers, clearers, and OTC counterparties (market counterparties): Each managed account will normally have the same market counterparties as the reference fund. In order to mitigate counterparty risk each managed account should have at least two prime brokers and a number of OTC counterparties. Each managed account will execute its own agreement with such prime broker, clearer or OTC counterparty.

– Administrator: An independent administrator will (in most cases) be appointed for the administration and accounting valuation. The administrator is often also responsible for collateral management.

– Registered Auditors: A chartered auditor is appointed to produce and approve the annual report of each managed account.

– Legal advisors: Legal counsel will be appointed to provide legal services to the managed account.

– Secretary: A company secretary can be appointed to provide a registered office for the managed account, to prepare (board) meetings, to maintain minutes of those meetings and to ensure that required filings with the regulator are made.

4.3 Operational set upThe operational set up of a managed account is designed in such a way that the trading advisor is able to trade for the managed account and the investment manager is able to perform its oversight function. Although the operational set-up may vary per managed account provider, the typical set up is illustrated in Figure 10.

Figure 10: Operational structure, including cash and securities flows

ClientCash A/C

Transfer AgentCash A/C

FundTreasury Securities A/C

FundCash A/C

Prime Broker A Securities A/C

Prime Broker ACash A/C

Prime Broker BSecurities A/C

Prime Broker BCash A/C

OTC CounterpartyCash A/C

Executing Brokers & OtherMarket Counterparties

Money MarketCounterparties

Cash sweep for

investments

Allocation to primebrokers &OTC counterparties

Securities & OTCtrading

Cash allocation to

Aggregation of managedaccount orders

Clientcustody account

Transfer Agentcustody account

Fundcustody account

Prime Brokercustody account


4.4 Legal, regulatory and tax set-upThe managed account can be tailored to the institutional investor’s requirements regarding legislative framework, domicile and regulation, legal arrangements, taxation, and local support of service providers.

DomicileTraditionally managed accounts were set up in more lightly regulated offshore domiciles like Cayman, Bermuda and Jersey. In the recent years institutional investors often demand properly regulated hedge funds domiciled in an onshore location with strong regulatory governance. The demand for better regulatory oversight stems from regulatory developments but is also based on self-regulation of investors. Anticipating on this client demand, several managed account platform providers have moved their platform to onshore domiciles.

The most popular domiciles to set up European onshore managed accounts are Luxembourg and Ireland. Where Luxembourg is the logical choice for plain vanilla mutual funds or UCITS funds, Ireland has the preference for non-UCITS hedge funds. Although the regulation and legal vehicles are quite similar, hedge fund managers tend to have a slight preference for Ireland.

Most US managed accounts are still domiciled offshore in the Cayman Islands, but onshore structures in Delaware – or equivalent onshore juridictions – are gaining more traction.

Regulatory frameworkThe EU regulatory framework available for managed accounts can be divided in UCITS and AIFMD. In the US the Dodd-Frank Act introduced hedge fund supervision by the SEC, whereas the majority of hedge fund used to operate under an exemption. Broadly speaking, UCITS is fund-focused regulation, providing only some requirements for fund managers, while AIFMD is mainly targeting the fund manager’s organization. The introduction of the AIFMD largely ended the existence of unregulated funds in Europe.

UCITS hedge funds have witnessed significant growth since 2007 as managers have continued to attract investment interest from insurance companies, pension funds and other institutional investors. Important drivers for this growth are investor’s restrictions on investing in non-UCITS funds and the robust regulation of UCITS (e.g., diversification requirements, liquidity, transparency). In reaction to this trend several managed account platform providers have set up UCITS managed account platforms.

Large institutional investors, especially from outside Europe, have, however, little to no interest in UCITS managed accounts. Generally, the added value of UCITS compared to a managed account in an onshore domicile is questionable. As the liquidity, transparency and advanced risk management are already intrinsic to managed accounts, and proper regulation and governance are intrinsic to onshore domiciles, UCITS seems morea marketing gimmick than that it actually adds value. The regulation can even be detrimental as UCITS limits the usage of total return swaps and provides stringent requirements to quality of collateral.


Irish and Luxembourg AIF structuresThe most popular fund structures for institutional investors are a Qualifying Investor Fund (QIF) in case of Ireland and a Specialized Investment Fund (SIF) when the domicile is Luxembourg. Both fund structures typically qualify as AIF (alternative investment fund) and are suitable for a variety of hedge fund strategies as the investment restrictions are limited (no borrowing or leverage limits) and the fund structure is reserved to professional investors.

As the US does currently not have a regulatory regime equivalent to the AIFMD, US-based managed account structures typically have no regulatory investment strategy constraints as compared to a QIF or SIF.

Legal vehicleTypically there are two main legal vehicles used to set up managed accounts – a corporate vehicle and a trust or contractual fund.

Corporate vehiclesThe Investment Company is the most common legal vehicle used for managed accounts. In Luxembourg the SICAV is the preferred choice, whereas US-based managed accounts typically opt for an LLC. Recently, the Irish Collective Asset Management Vehicle (ICAV) came into full operation.

Each company, comprising one managed account, is managed and controlled by its board of directors (SICAV, ICAV) or by a managing member (LLC). The board of directors or managing member is allowed to delegate certain duties to third parties (e.g. investment management duties, administration functions), but remains responsible for ensuring that the company is managed in the best interests of the shareholders. This legal structure can easily accommodate specific client needs on control and ownership, as independent or affiliated directors can be appointed to the board of directors.

Unit Trust/contractual fundA Unit Trust is frequently used for managed accounts that are sold to US, Japanese, and UK investors. A Unit Trust is constituted by a trust deed made between the trustee and the manager. The trust deed defines the rules of the fund and the rights of the unit holders. A Unit Trust is not a separate legal entity and therefore the trustee acts as legal owner of the fund’s assets on behalf of the investors.

Figure 11: Comparison of regulatory requirements of different vehicles in Ireland and Luxembourg

Ireland

QIF

Luxembourg

• Minimum EUR100,000investment

• No investment limits

• Short selling permitted

• 24 hour authorisation

• Complex incentive fees

• Broad range of permissiblestrategies

• Individual investor: minimumEUR125,000 investment

• Risk spreading limit of 30%only. Minimal restrictions

• Short selling permitted

• No lead time to authorisation.Must �le within 1 monthfollowing creation.

• Broad range of permissiblestrategies

SIF


A contractual fund, like a unit trust, is a collective investment undertaking which is constituted as an unincorporated body established by a management company. The unitholders, by contractual arrangement, participate and share in the property of the collective investment undertaking. This structure is frequently used for European investors.

For all of the above vehicles it is possible to structure a fund as an umbrella fund. Umbrella funds are often used for managed account structures as it is the most cost efficient structure while segregation of liability between the sub funds is (in most jurisdictions) arranged by law. Many managed account providers or institutional investors still prefer to have stand-alone funds because a theoretical risk remains that there will be contamination between the sub funds as the segregation has not been tested in US courts. In addition, the funds may also provide for the establishment of different classes of shares or units within a fund or, inthe case of an umbrella fund, within each sub-fund of the fund.

TaxAll of the above investment vehicles are exempt from tax on their income and gains and no withholding tax is levied on income distributed to its investors (except when the EU savings directive is applicable). In Luxembourg there is an annual subscription tax of 0.01% of the net asset value for institutional funds (exemptions are applicable for pension funds and investments in other funds that are already been subject to subscription tax). Investment companies are generally not tax transparent and are qualified as “per se” corporate entities for US tax purposes, making it impossible to be treated as partnership for these purposes (“check the box”). Unit trusts and contractual funds can be structured as tax transparent and, as such, can be looked through for U.S. tax purposes.

Selection legal structureThe investor and managed account provider have to decide what the best structure is for all intents and purposes and should therefore take the following aspects into account:– Desired domicile, regulatory oversight and framework– Tax considerations– Ability to provide for control or influence of the sponsor or investor– Familiarity of the end investor with the legal structure– Type of investments and applicable investment restrictions

Figure 12: AF Advisors Investment Structure Selection Framework

Selection ofInvestment

Strategy

Requirementsof Targeted

Clients

Proper FundGovernance

FiscallyOptimized

Low OperationalCosts & Complexity

Fund Terms AttractiveFor Clients

Fund Terms EnableExecution of Strategy

Control over theinvested cash

Transparent reportingon returns, risk & costs

Alignment of fund withclient ’s �scal situation

No costly operationalmistakes

Low operational fees tooptimize returns

No costly operationalmistakes

Low operational fees tooptimize returns

Flexibility to change ifmarkets change

Taking advantage of taxreclaims

Adherence to agreedinvestment restrictions

Good liquidity terms

Liquidity matchinvestments & fund

Appropriate fees

Appropriate transparentfees

Freedom to pursueinvestment strategies

Control over the termsof the fund


4.5 Available managed account product structuresIn the earlier paragraphs the managed account concept, the legal structure and the operational set up have been described. There are a number of ways to invest in managed accounts. Generally the following managed accounts product structures are available: – Commingled managed account– Fund of managed accounts– Dedicated managed account– Structured managed account

Commingled managed accountThis is a managed account that is set up by a managed account platform provider who is offering a range of individual managed accounts covering multiple hedge fund strategies to institutional investors and high net worth individuals. The managed account provider acts as investment manager of the managed account and is responsible to control and operationally manage the managed account for the benefit of the investor. As all the investors invest in the same managed accounts the investments of the investors are effectively commingled.

Fund of managed accountsIn this structure the investor invests in a fund that is set up by the fund of hedge fund manager. The fund of hedge fund manager is managing a portfolio of managed accounts that are either controlled by the fund of hedge fund manager or by a managed account platform provider. The investor can profit from the portfolio management and the manager selection capabilities of the fund of hedge fund manager in combination with the advantages of managed accounts.

Dedicated managed accountDedicated managed accounts are set up for a single investor either by the investor or a managed account provider. There are essentially three types of dedicated managed account structures:1. A dedicated managed account structure where a managed account provider is acting as investment

manager and has the full fiduciary responsibility for the managed accounts. Some activities can be excluded from outsourcing to the managed account provider and be carried out by the investor. Customization is possible but to a limited extent as the managed account provider is ultimately responsible and therefore liable for the managed accounts. With this structure the investor is using the expertise and economies of scale of the managed account provider while limiting its liability.

2. A dedicated managed account structure where the investor is acting as investment manager and has the full fiduciary responsibility for the managed accounts. The investor can either set up and manage the managed account completely by itself, or can use a managed account provider to set up and perform certain tasks for the management of the managed accounts. In case the managed account provider performs certain duties like onboarding of new managers or operational support, the investor remains responsible and is involved in all processes. This structure gives the investor ultimate control and opportunities to customize the features of the managed account to their requirements. In reality there will be very few investors that are able to set up and manage managed accounts completely themselves.

3. A dedicated managed account structure that is a hybrid structure of option one and two. In this structure the investor is having a formal role in the governance of the managed account structure (e.g., as sub advisor or by delivering one or more directors of the board). The investor enters into a service agreement with the managed account provider to set up and perform certain tasks relating to the operational management of the managed accounts. The managed account provider will be acting as investment manager. Because the investor has a formal role in the governance structure, significant control over the managed accounts can be realized while the platform provider has effectively the main fiduciary responsibility for the operational management of the managed accounts. It must be noted that more involvement of the investor in the governance and operational management will also bring more potential liabilities.


The picture below details the difference between the three types of dedicated managed account structures:

Structured managed accountWith a structured managed account the investor is investing in a product (e.g. principal protected note, option, certificate, total return swap) where the underlying investments are one or more indices that reflect the performance of the relevant managed account. The client effectively has exposure to managed accounts and is therefore benefitting from the advantages of (daily) liquidity, transparency and active risk managementof managed accounts, but holds no shares or units of the managed account itself. Structured managed account products are only possible for liquid hedge fund strategies like CTAs, Global Macro, FX and Commodity. An important aspect to take into account is the possible credit risk this structure entails. Depending on the specific product type and the underlying investments, the investor can profit from offered features such as capital protection or unfunded investments. With the last product structure the investor can realize exposure to managed accounts without necessarily exchanging any initial capital.

4.6 The positive aspects of managed accountsKey beneficial features of managed accounts that have contributed to the popularity of this segment are:

A. Improved governance and asset controlA managed account is governed by a managed account provider, client or (independent) board of directors instead of a hedge fund manager. The hedge fund manager’s role is limited to manage the assets pari-passu with the reference hedge fund without having any control over the assets and operating model. The segregation of the key roles and responsibilities of managed accounts results in the following advantages for the investor:– Elimination of conflicts of interests: The segregation of the trading responsibility from the fund

management and custodial responsibility, potential conflicts of interest are eliminated. Managers are no longer involved in for example the decision making regarding approving NAVs, suspensions of NAVs, and valuations of underlying positions.

Figure 13: Illustration of differences between three types of dedicated managed account structures

Manager Platform Provider

Client

DedicatedMAC

Clientin the lead

Fund governance:Platform/Independent

Investment policy governance:Platform/Client/Manager


Asset control:Platform/Client

Fund governance:Client/independent




DedicatedMAC

Platformprovider

in the lead

Option 1.

Option 2.

HybridDedicated

MAC

Client andplatformprovider

in the lead

Fund governance:Client/Platform




Option 3.


– Reduction of operational risk due to independent control and oversight on the hedge fund manager: An independent party or the investor is responsible for tasks such as operationally managing the managed account (risk management, monitoring investment limits, cash management, reporting, legal, compliance, tax) and performing additional controls on NAV’s transactions. The additional checks and balances will reduce the operational risk to a large extent.

– Reduction of the risk of fraud: In the typical managed account structure the manager is not allowed to execute cash transactions. The platform provider or the investor are monitoring the operations of the fund closely. This reduces the risk of fraud. In case of fraud, the board of directors or the management company can decide to take control of the underlying portfolio by revoking the trading authorization and terminating the investment management agreement with the manager. Consequently the board of directors can decide to liquidate the portfolio or appoint another manager to temporarily manage the fund and/or liquidate all positions.

– Customization based on the requirements of the investor/platform provider: Investors and managed account platform providers are able to customize their managed accounts by:

- Defining customized investment arrangements and restrictions: In general this will limit the risk profile of the investment and will reduce the chance of potential style drift. The possible downside is that the investment restrictions can significantly limit a manager’s ability to generate returns. Whilst the manager has large investment discretion for his own fund the restrictions could result in a tracking error for the managed accounts.

- Using the SRI policy of the investor or platform provider: With managed accounts it is possible to negotiate with the manager to use its exclusion list and or voting policy.

- Selecting service providers: The investor or managed account provider can select his own set of service providers (administrators, prime brokers etc.) and can create a uniform operational set up that is applicable for all the managed accounts.

- Tuning the fund related aspects like legal structure, domicile etc. towards their needs.

It should be noted that the improved governance and asset control cannot prevent that in most managed account structures there is still an agency problem in relation to the managed account provider and the service providers. Compared to the lack of control and influence in commingled hedge funds though, a managed account structure has less governance issues.

B. Greater degree of transparencyManaged accounts provide significantly more transparency than hedge funds. While hedge funds offer monthly or quarterly transparency, most managed accounts offer weekly or daily transparency. This allows investors to execute the required detailed level of risk management ( e.g., VaR, risk factor sensitivities, stress tests, and leverage) on the individual hedge fund portfolio as well as on the aggregate hedge fund investments. It also allows the investor/the platform provider to monitor the manager and/or aggregated portfolio on a daily basis regarding for example the P&L, style drift, and instruments used. Furthermore, the transparency will be useful for the portfolio construction of fund of hedge funds. It is important to note that the transparency and risk management will only add value when the data is accurate and correctly labelled, and the risk system is correctly calibrated. Otherwise the transparency will not serve a useful purpose.

Institutional investors want to know and understand their investments and risks. The advantage and necessity of more transparency can be best explained by giving a real example of the transparency of the net equity exposure in case of monthly, weekly and daily transparency of a hedge fund (Figure 14).


Top left: monthly net equity exposures by an European L/S fundTop right: monthly reported (1 month delay) net exposures by an European L/S fund – current market standardBottom left: weekly reported (without delay) net exposures by an European L/S fundBottom right: daily reported (without delay) net exposures by an European L/S fund

Source: Lyxor

Figure 14 clearly show what relevant information the investor is missing in the current market standard hedge fund reports. Compared to weekly or daily transparency the investor is completely unaware of intra-month market exposures and has to trust the hedge fund manager is not taking unacceptable bets.

Solvency IIAs a result of Solvency II regulation, hedge fund investments are marked as ‘other/level II equities’ with the consequence that investors essentially have to hold capital worth 49% of any investment in hedge funds. The transparency offered by managed accounts makes it however possible for insurance companies to perform a reliable risk-return analysis that is needed to develop an internal model to calculate alternative and possibly lower capital charges. Research showed that a capital charge of no more than 25% is deemed to be appropriate for a well-diversified hedge fund allocation.12 In addition the aggregated portfolio and risk transparency of managed accounts will enable insurance companies to meet the stringent regulatory reporting requirements of Solvency II.

C. Uniform operational set up A platform provider or investor is able to set up its own operational set up for managed accounts. This means that the managed accounts will have a universal operational set up and arrangements with all hedge fund managers and

Figure 14: Illustration of the benefits of timely and more frequent transparency

12 EDHEC Solvency II: A unique opportunity for hedge fund strategies EDHEC January 2012, Mathieu Vaissié.


service providers, the same pricing policy and the same SLA. This will generate substantial advantages in terms of:– Fee reduction due to economies of scale: The investor/the managed account provider is able to negotiate

reduced fees with the service providers, as the contracts will be based on total AuM of all managed accounts. – Limitation of operational risk: As mentioned, the operational risk is one of the major factors of risk with

hedge fund investments. It is therefore important to carefully monitor the operations of the manager and the service providers being used. When investing in multiple hedge funds, this is a rather difficult task because there will be multiple service providers, contracts, legal arrangements (which will also be difficult to retrieve), pricing policies etc. The result is that the level and quality of operational risk management, that is needed to mitigate risk, is sub-optimal.

– More efficient and effective monitoring of the service providers: As there will be fewer service providers involved, the operations team at the side of the investor/managed account provider will have fewer on-site visits, relationships, performance indicators and SLA’s to manage. Finally, the focused approach towards the service providers will contribute to improving the services provided by the service providers.

D. Liquidity enhancements Liquidity should be approached in two ways:1. Normal conditions.2. Emergency situations.

Normal conditionsThe investor/platform provider has the ability to agree upon customized liquidity terms. Where retail investors require more liquidity (daily or weekly subscription and redemption), institutional investors generally have a more long-term view and are willing to give up liquidity or accept lock-ups in return for other benefits.

Emergency conditionsAs the investor/platform providers control the fund, they are able to replace the manager and liquidate the underlying investments in emergency situations. This important feature of managed accounts is protecting the investor against, or limiting the consequences of, fraud or bankruptcy of the manager and/or market counterparties. The actual liquidity is ultimately determined by the liquidity of the underlying assets and for some highly illiquid and complex strategies it can take substantial time to unwind the positions. Some managed accounts provide for redemption in kind so that forced sales of illiquid portions at high discounts can be prevented, but this will only be a feasible option for large institutional investors.

E. Management fee reduction Depending on the structure, managed accounts can potentially benefit from lower management and/or performance fees. The management and performance fees of the underlying manager in a commingled managed account are generally equal to the fees of the reference fund, while dedicated managed accounts can negotiate more attractive fees from the manager. The manager is often willing to accept lower management and or performance fees due to the size of the assets, the profile of the investor(s), and other terms such as liquidity and capacity.

4.7 Disadvantages of managed accountsAs is the case with every investment structure, managed accounts do have certain disadvantages and limitations that should be taken into consideration. In articles and papers that are available in the market, the mistakeoften made is to bring up limitations or disadvantages that are not applicable to all managed account product structures. Higher operational costs is for example a frequently mentioned disadvantage. This is however only applicable to a dedicated managed account and not to a commingled managed account. One should therefore


be cautious to generally label specific structure related disadvantages to managed accounts in general. Taking the above into account the following general limitations and/or disadvantages of managed accounts can be distinguished:– Tracking error– Additional costs– Increased responsibility and liability– Negative selection bias– Not suitable for all strategies

Tracking errorAn important potential downside of managed accounts is the risk of a tracking error between the managed account and the reference fund. The objective of the managed account is to replicate the performance of the reference hedge fund, but a tracking error can arise due to:– Different investment restrictions (e.g., allowed instruments, leverage, concentration, liquidity limits, SRI

policy).– Different fee levels for service providers and market counterparties.– Different level of management and/or performance fees.– Building up exposure to very illiquid instruments. It can take several months to construct the same portfolio

as the reference fund.– Different pricing or valuation policies.– Operational issues at the managed account (e.g., settlements issues, administrative errors).– Different cash management policy.

It is important to closely monitor the tracking error and understand what is causing it so that the managed account provider/the investor is able to promptly react on it.

Additional costsWhen reviewing the cost structure of managed accounts, one should distinguish investment structure related costs and costs at the side of the investor. Unless an investor is setting up a self-managed dedicated managed account, the managed account provider will charge a (platform) fee to the investment structure. On the other hand, the managed account provider is able to negotiate reduced fees with the service providers (administrator, custodian, transfer agent) and usually charges lower ‘other operational costs’ (e.g. organizational and marketing expenses).

For commingled managed accounts this amounts to a total expense ratio that is generally higher than the reference fund. Due to the focus on costs by the institutional investors there is a pressure for lower fees. As a result some of the managed account platform providers are applying a different fee model for large institutional investors. In this new fee model the management and performance fee of the managed account are effectively at the same level as the reference fund. This is accomplished by negotiating a kick back fee with the manager that is equivalent to the platform fee. A crucial point in this respect is that there is full transparency on the level of kick back fees, otherwise this will dilute the added value of transparency of managed accounts.

A dedicated managed account will enable the investor to negotiate lower management and/or performance fees. Depending on the AuM and complexity of the managed accounts being used, the total expense ratio of a dedicated managed account will in most cases be lower than an investment in the reference hedge fund.

Regarding dedicated managed accounts, the internal costs of the investor are an important aspect to takeinto consideration. The resources (labour and financial capital) that are required to invest in managed accounts depend on the selected structure, and in case of a dedicated managed account, how the managed account


is structured, governed and operationally managed. If the investor wants to be substantially involved in the due diligence, the legal negotiations with managers, service providers and market counterparties, sufficient resources are needed for the project-based onboarding of new managers as well as for ongoing operational tasks.

The frequently used claim that managed accounts are more expensive than direct investments in hedge funds is difficult to either confirm or reject. The cost level generally depends on the chosen product structure, the AuM, the complexity of the managed accounts and the managed account providers being used.

Increased responsibility and liabilityA disadvantage that is mentioned by investors is that investing in managed accounts creates an additional liability. Due to the transparency and extensive risk management, the investor is able to closely monitor the manager and should therefore in certain circumstances act based on the available (risk) information. If the investor/managed account provider is not acting, the investor/managed account provider can potentially be liable for this. Another example of the transfer of liability is related to the customization in case of a dedicated managed account (e.g. service providers used, investment restrictions etc.). Despite the fact that there is indeed a transfer of liability from the manager to the investor/managed account provider, this should not be the convincing argument to refrain from investing in managed accounts. First of all the answer to the question who is ultimately liable depends on the structure of the managed accounts. There are structures possible where the main liability remains with the managed account provider. Secondly, with the hedge fund industry getting more mature the transparency and enhanced risk management will become the industry standard, so the institutional investors have the fiduciary responsibility to closely monitor and actively manage their hedge fund investments.

Negative selection biasAlthough there is a trend that more and more hedge fund managers are opening up managed accounts, there are still managers not willing to do so. Reasons might be that the manager is satisfied with the assets under management or considers the operational burden of running a managed account to be too big (implementing positions across numerous accounts, adhering to tailored guidelines and monitoring numerous accounts).

Because there are managers that are not willing to set up managed accounts, this might trigger the idea of negative selection bias. The negative selection bias means that the managers that are offering managed accounts are of lower quality and have lower performance. Although this line of thinking is supported in some research papers13, there is no academic evidence for a negative selection bias. On the contrary, there is academic research available that shows no significant differences in performance between hedge funds that offer managed accounts and hedge fund that do not.14 Nevertheless, investors might be disappointedif it appears that the funds they want to invest in are not available through a managed account solution.

Managed accounts are not suitable for all hedge fund strategiesSome hedge fund strategies are not suitable to run through a managed account structure. This is applicable for some very illiquid strategies which trade instruments that are difficult to valuate, difficult to allocate over more accounts, are complex from risk management perspective as well as strategies that invest in SPVs, and cannot offer full transparency. Generally the more liquid hedge fund strategies are better suitable and more frequently used for managed accounts.

13 April 2013 Towers Watson Hedge Fund Investing Opportunities and Challenges. 14 Is There a Cost to transparency? Rajesh K. Aggarwal and Philippe Jorion, 2011.


5. Suppliers of managed accounts

Similar to the frequently misused term of managed accounts, there are various parties that unjustly claimto be a managed account provider. There are substantial differences in the product offering and capabilities of the platforms as well as the background and profile of the companies offering the managed accounts. Before investing in a managed account the investor should carefully assess what managed account providers meet the requirements of the investor.

As the market of managed accounts is growing, the number of providers of managed accounts is growing accordingly. As the competition is fierce and new managed account providers are entering the managed accounts market space it is likely that the top 10 will be somewhat reshuffled in 2014.

In Table 2 the top 10 managed account platform providers are presented.

Source: HFMweek

Over the course of 2014 total managed account assets declined with 1,1%, but this is fully attributable to the removal Alpametrix from the ranking, as discussed in subsequent chapter. In 2013 Alphametrix accounted for USD 7 billion or about 12% of assets managed through managed accounts. Excluding Alphametrix, managed account assets increased with about 10% in 2014 as compared to 2013.

AlphametrixJust a few years ago, AlphaMetrix seemed quite successful in attracting managed account assets: according to HFM week its assets peaked at $ 6.9 billion In 2012 however, the firm suffered from cash flow problems and made public that they had not been investing the management fee rebates from the managers for their investors, but that they were retaining these fees for themselves. The Commodity Future Trading Commission (CFTC) started an investigation and sued Alphametrix for at least $ 2.8 million of fees that belonged to clients. As a result of those developments, Alphametrix now is defunct.

Many hedge fund investors through Alphametrix appeared not to have done proper due diligence on the firm. The business model of Alphametrix was relying heavily on manager kickbacks - a typical red flag. Another red flag could have been the very capital-intensive conference and event business, with the aim to to introduce investors to hedge fund managers. Next to this, AlphaMetrix did not have an open architecture with respect to administrators, mainly using its affiliate Alphametrix360. The use of an independent administrator would make a fraud like this less possible, as it seems that Alphametrix360 falsified investor statements to some extent.

Table 2: Top 10 managed accounts in 2014

Managed Account Platform AuM (Bn, USD) 2011 growth AuM Number of funds

Deutsche Bank 12.4 15% 223

Lyxor Asset Management 11.8 9% 121

Man Group 8.0 -11% 80

AlphaMetrix 6.9 8% 150

Lighthouse Partners 4.8 27% 90

Goldman Sachs 3.5 44% 54

HFR Asset Management 3.1 0% 78

UBS 2.5 92% 30

Innocap 2.4 13% 48

Amundi 2.3 26% 31

Q1 2014AuMMAP

Q12013AuMMAP

-1.1% decline

70.2 bn USD

69.4 bn USD

Managed Account Platform AuM (Bn, USD) 2013 growth AuM Number of accounts

Lyxor Asset Management 12 5% 96

InfraHedge 11.5 51% n.a.

Deutsche Bank 10.1 -8% 200

FRM (Man Group) 8.3 -10% 68

Permal 8.2 24% 86

Lighthouse Partners 6.3 15% 95

Amundi 5.3 23% 31

Morgan Stanley 2.9 50% 30

Innocap 2.7 16% 31

Goldman Sachs 2.1 1% 22


5.1 Background and company profileManaged account providers can be categorized as follows:– Managed account providers being part of a banking group– Managed account providers being part of an independent asset management company– Managed account providers being part of an asset servicing company– Managed account providers that are built out of a fund of hedge funds organization

BanksSome of the first managed account platforms were started by managed account providers that are part ofa banking group, either as part of their investment banking business line or within other or separate business lines. These platforms are generally large in terms of AuM and number of managers on the platform. Initially the focus was on distribution of commingled managed accounts but currently they all offer and service large dedicated managed accounts. A substantial balance sheet supports the managed account business and provides a long-term commitment to the business as well as potential financial back up if needed. The recent financial crisis showed however that the stability of banks is limited and that they can come under serious pressure potentially impacting the continuity of the managed account capability. In addition, some banks offer structured products on the managed account that might impact the liquidity and could potentially result in a conflict of interest. By now all managed account providers backed by banks are offering a multiple prime brokerage model effectively eliminating another point of potential conflict of interests.

Asset managersOther managed account providers are independent asset managers offering (amongst others) managed accounts for hedge funds. By being completely independent, the potential conflicts of interest are limited. Only when the managed account provider is managing proprietary single-strategy hedge funds in combination with offering managed accounts is there a potential conflict of interest. The asset management license is useful for operating managed accounts because this will allow the managed account provider to perform certain additional tasks/responsibilities that are restricted to asset managers. A point to take into consideration is that some of the independent asset managers could have a limited balance sheet and consequential buffer to absorb liabilities or large investments into the platform. Asset servicing companyAnother group of managed account providers is linked to asset servicing companies, i.e. administrators or custodians. The business model does not incorporate some of the potential conflicts of interests that banks and asset managers might have, while the managed account provider can profit from the operational infrastructure and capabilities (such as risk tooling) of the asset servicing company. A potential conflict of interest that remains, however, in the case that the affiliated companies will be acting as administrator/custodian of the managed accounts. Typically the managed account providers in this segment focus on investors that want to invest in dedicated managed accounts.

Fund of hedge fundsThe last category of managed account providers that can be distinguished are fund of hedge funds that initially invested in dedicated managed accounts set up by themselves and over time have opened up the managed accounts to other investors. Some of these managed account providers are now also offering general managed account services. Fund of hedge funds are asset managers that are often completely independent. There isa conflict of interests with the fund of hedge funds target group, as they are to a large extent competitors. Another issue to take into consideration is whether the managed account provider is able to make a long-term commitment and has the required budget and resources to maintain a (dedicated) managed account platform that meets the high demands of investors.


5.2 Product/service offeringThe industry has reached a maturity phase where the top ten managed accounts players offer all main hedge fund strategies. As expected in the business cycle, managed accounts currently are in fierce competition and pricing pressure occurs. Some managed account providers try to create a competitive advantage by focusing on niches like small or emerging managers or specializing in certain structures or strategies.There are managed account providers that focus on more illiquid strategies like credits, merger arbitrage and distressed strategies. Illiquid strategies are more demanding for the managed account providers (risk management, operations/administration) and therefore it is important to investigate how much experience a managed account provider has with these types of strategies.

There is a substantial difference in the products and services offered by managed account providers. The problem for the investor is that most of the managed account providers are using the same superficial marketing terms like ‘all strategies, full transparency, full customization, thorough due diligence, very liquid, active risk management’. The investor should assess potential managed account providers in detail to value their key capabilities, their client portfolio, risk management capabilities, structural risks, operational oversight, due diligence capabilities and process.

Risk management is another area where there are substantial differences between the managed account providers. Some managed account providers offer standardized risk reporting (e.g., VaR, sector exposures, and leverage), while others offer extensive risk management functions like risk factor analysis, stress tests, historical and forward looking scenario analysis. The level of customization of the risk and risk reporting function differs also substantially and are important factors to look at before selecting a managed account provider.


6. Implementation of managed accounts

A commonly used argument against managed accounts is that the implementation is difficult, time consuming and therefore expensive. These concerns are relevant, although steps can be taken to mitigate the costs and complexity of a managed account implementation.

The following process steps can be defined for the implementation of managed accounts:1. Define requirements2. Select investment structure3. Design managed account structure (in case of a dedicated managed account)4. Select managed account provider5. Set up and launch of managed accounts (in case of a dedicated managed account)

1. Define requirementsThe first step that should be taken by the investor is to define the requirements with respect to governance, control, legal structure and operational set-up. Many investors allocate a lot of time to hedge fund research and selection, but less to what the requirements are regarding governance, control, legal structure and operational set up and controls regarding the managed accounts. The investor should define requirements on all of these (key) elements of the investment structure. This will also reduce the risk of a lengthier and therefore more costly implementation process.

2. Select investment structureOnce the requirements are defined, the next step is to assess to what extent the possible investments structure meet the defined requirements. Based on this assessment the investor can make a balanced decision what investment structure fits to their needs best: a commingled managed account, a dedicated managed account,a hybrid structure or a structured managed account.

3. Design managed account structureIn case of a dedicated managed account the investor has to design a managed structure taking into account:– The desired level of control and transparency (e.g., over the assets, the (fund) structure, service providers,

and operations).– The (perceived) fiduciary responsibility of the client in the managed account solution.– The risk appetite (more influence creates more responsibility and therefore more potential risk).– The total expense ratio of the investment structure.– The availability of resources (budget and people).– The required time and costs involved.

The design of the managed account structure will at minimum need to consist of:– Legal structure of the managed account.– Governance of the managed account structure.– Detailed overview of roles and responsibilities of all parties involved.

4. Select managed account providerFor the selection of a managed account provider a distinction has to be made between commingled and dedicated managed accounts.

Commingled managed account providerWhen selecting a commingled managed account provider the selection process is similar to the selection of hedge fund investment and should at least focus on the following elements:– Reputation– Creditworthiness of the managed account provider and its parent company


– Governance of the managed account provider as well as the individual managed accounts– Operational set up (administrators, custodian, operational oversight, cash management)– Coverage of strategies– Risk management– Reporting

Dedicated managed account provider:Most investors will not be able to set up and manage a dedicated managed account structure by itself because they lack the required scale and expertise. Usually the first step is therefore to select the best possible managed account provider. As dedicated managed accounts are customized and set up by the managed account provider in close cooperation with the investor, a more strategic relationship is required and therefore a thorough selection process should be put in place.

An RFI or RFP (depending on the complexity of the structure and required services) needs to be made and sent to a number of platform providers. This document should incorporate all the defined requirements (includingthe legal structure, the governance model, and the description of roles and responsibilities). The replies on the RFI or RFP of the managed account providers need to be carefully evaluated and rated based on a scoring model. The next step is to decide on a short list. Those managed account providers should ideally be visited for on-site due diligence. On paper a managed account provider can look very robust and professional, but the on-site visit gives valuable information about the teams, systems and procedures in real life situation. After the on-site visit, a final selection of the top two or three needs to be made and subsequently the negotiations have to be started. Once the negotiations are finished the managed account provider can be finally selected. The next step that should be initiated immediately (and ideally should be completed within a very short timeframe) is the closing of the contracts and service level agreements between the investor and the managed account provider.

5. Set up and launch managed accountsFor dedicated managed accounts a new investment structure has to be set up. Although the actual lead-time to launch a managed account will vary per managed account, a lead-time of 3 months for a new manager can be used as a rule of thumb. The negotiation of the IMA and the investment guidelines with the manager usually take substantial time. Initially market counterparty agreements have to be (re)negotiated. With smaller and emerging managers the operational set up requires extra consideration, as this will need quite some attention from the manager’s side to comply with the operational requirements of the managed account provider.


Figure 15 illustrates the process and the general timeline of the onboarding of a manager for a dedicated managed account.

To conclude, the difficulty and time required to implement a managed account depend on the structure of the managed account. If the investor chooses to invest in a commingled managed account, the implementation is to a large extent similar to a commingled fund investment and is fairly simple and efficient. If the investor chooses a dedicated managed account supported by a managed account provider, the difficulty, required time and resources to implement depend on the level of customization and fiduciary responsibility the investor wants to have. Greater customization in terms of processes and responsibilities generally leads to a more complex and time-consuming implementation. The implementation of a dedicated managed account that is set up and managed by the investor itself will, depending on the capability of the investor to set up and operate hedge funds, be the most complex and time consuming implementation.

Figure 15: Dedicated managed account implementation timelines

Requirements

Project timeline

Managed account structure

Selection managed account provider

Onboarding managers

Month 1. Month 2. Month 3.

Legal negotiations manager, agreements, prospectus, investment restrictions

Operational set up

Due diligence (investment + operational), background check

Boardmeeting

Filing

Assessment required set up(instruments, counterparties)

Launch


7. Conclusion

In this paper the different possible investment structures for hedge fund investments, and managed accounts in particular, have been assessed. Based on this assessment, the central question whether managed accounts are the right answer to the trend of institutionalization in hedge fund investments, can in general be answered positively. Managed accounts can offer the key characteristics that institutional investors demand for all their hedge fund investments. Managed accounts deliver improved governance and control over the assets as well as a high degree of transparency that enables advanced risk management, strong operational oversight, and possible lower capital charges under Solvency II. The costs of a managed account are an important point to take into consideration, but due to competition between managed account providers and the willingness ofhedge fund managers to accept lower management fees, this will not automatically be a showstopper for using managed accounts. Other issues to take into consideration are the fact that not all strategies and managers are available through managed accounts and a possible tracking error in relation to the performance of the reference fund.

Due to the demand of investors and regulators for more transparency, control and properly governed hedge fund investments, managed accounts will in most cases be the preferred solution for institutional investors. In order to be certain that managed accounts are the best solution, an individual assessment needs to be made of the requirements of the investor regarding their hedge fund investments, which should at least address the following topics:– The desired level of control and transparency (over the assets, the (fund) structure, service providers,

operations).– The (perceived) fiduciary responsibility of the investor.– The risk appetite of the investor (more influence is creating more responsibility and therefore more

potential risk).– The total expense ratio of the investment structure.– The availability of resources (budget and people).


8. About AF Advisors

AF Advisors is an independent research and consultancy firm servicing the investment management industry. In the evolving financial environment we enable financial institutions and institutional investors to achieve their strategic goals by offering specialized services in structuring and organizational changes.

We provide our clients a strategic advantage by offering a combination of extensive experience and in-depth product and market knowledge. AF Advisors is able to cover the whole value chain of product structuring, legal and fiscal affairs, compliance, risk management, operations and business development. This breadth of knowledge and depth of experience means that AF Advisors is not only able to provide clients with intelligent, commercial and practical advice but is also able to support implementation. This will ensure that our advice will not remain a theoretical exercise, but will work and adds value in practice.

One of our key focus areas is the structuring of managed accounts for hedge funds. Although the level of more understanding and knowledge about managed accounts is increasing there are still many misconceptions and undifferentiated views on managed accounts in the market. This is also the case with some consultants. This can be explained by the fact that those consultants have theoretical knowledge on managed accounts, but have in many cases never designed and/or implemented a managed account structure. AF Advisors has the unique combination of the theoretical knowledge and operational experience in designing and implementing a large number of managed accounts.

AF Advisors has advised and assisted the second largest Dutch pension fund service provider PGGM with the structuring and implementation of one of the largest and award winning (Financial News Award for Most Pioneering European Institutional Investor in Hedge Funds 2011 and 2012) dedicated managed account platforms in the world. In 2014 and 2015 AF Advisors performed a similar assignment for one of the largest public pensions plans in the US.

AF Advisors has in-depth knowledge, is in close contact with all the major managed account providers in the market and has developed a proprietary database containing all key characteristics of the managed account platforms.

AF Advisors is able to support clients in the following areas:

Managed account structuring:

Design of managed account structure based on specific requirements of the client.

Advice on most suitable governance structure.

Provide a business case for the proposed managed account structure.

Selection of the best possible managed account platform provider:

Develop and execute a RFI and/or RFP.

Perform due diligence on the managed account platform provider.

Support the negotiations with the managed account platform provider.

Implementation of the preferred managed account structure:

Support or lead the onboarding process of the first batch of managers.

Embed the managed accounts investments in the organization of the client.

Hand over all activities and ongoing operational tasks to the relevant departments.

Important informationIn preparing this publication, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to us or otherwise reviewed by us. AF Advisors believes the content of this paper to be reliable, but cannot guarantee the exactness and completeness of this document. We do not assume any liability in the case of incorrectly reported or incomplete information.

Contact details:+31 (0)10 412 96 16+31 (0)6 202 69 [email protected]

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