Fx Quant > Managed Accounts vs. Hedge Funds
I. Traditional Hedge Fund (HF) Structure
A hedge fund is an investment company that is generally structured as a limited partnership (LP) or limited liability company (LLC) (‘the partnership’). Investors purchase shares or interests in these companies to earn a rate of return on the invested capital. The hedge fund manager is usually LP’s general partner. The partnership would have at least one prime brokerage account relationship, and this account would be wholly owned by the investors of the partnership. The prime brokerage account should be maintained at an independent prime broker and the prime broker should be reputable.
The net returns are realized by the hedge fund investors, or the partners of the fund. The hedge fund manager generally sends a performance update to the partners on a monthly or quarterly basis. Most hedge funds do not disclose the full details of the investments in the partnership. The administrator prepares monthly statements for each investor and reconciles the activity with the prime broker. The independent auditor reviews the work performed by the administrator, verifies the support documentation, independently revalues the securities in the prime brokerage account, and selects individual transactions for detailed testing, among other things. The investor would receive an independent statement at the end of the year, generally fiscal year end, which validates the value of the hedge fund investment.
Issues with the Traditional Hedge Fund Structure
Issues with the traditional hedge fund structure can be separated into:
- lack of transparency,
- liquidity issues,
- pricing issues and
- potential tax issues.
The fraud or service provider issue is easily highlighted through situations that have been reported in the marketplace. The hedge fund named XXXX did not have an independent auditor and did not have an independent prime broker. The hedge fund named YYYY did not have an independent auditor and the prime broker that was presented to the investors was not in fact the actual prime broker. These issues could have been avoided by having independent auditors and independent prime brokers.
For hedge funds, complete transparency is unheard of. The transparency issue is highlighted when a hedge fund named ZZZZ makes an unusually large investment in one company. The investment amount in this one company was in excess of the investment guidelines that was presented to investors and not having transparency into the underlying investments.
The liquidity issue is that an investor has notice periods and redemption periods before redeeming the investment. There are hedge funds that offer quarterly liquidity but most hedge funds have at least one year lock ups. Investors are charged an early termination fee, and that fee is generally excessive relative to any value lost due to the early liquidation.
Hedge funds do not offer the convenience of daily mark-to-market asset pricing. In fact, some of the more exotic hedge funds trade securities that are quite difficult to price; in the most extreme circumstances, hedge funds actually have priced their own portfolios, which inevitably has led to pricing issues.
The potential tax issues arise when non deductible expenses are incurred by the fund, and these expenses are not tax deductible to the partners.
II. Managed Accounts (MA)
The investor owns actual assets via the managed account, not simply LP (limited partnership) interests in a pool of assets. Since the investment would generally be done through a partnership to take advantage of the tax benefits, the investor would be the general partner of the partnership and the investment advisor would be a limited partner.
The investment adviser is generally granted the right to make investment decisions on behalf of the account (usually based on LPOA – Limited Power of Attorney authorization) and only the investor would have the right to transfer funds out of the separately managed account. Limiting the right to move cash improves the controls against potential fraud in the account.
Since the owner of the managed account (the investor) can terminate the trading authority of investment adviser at any time, the separately managed account investment offers daily liquidity.
Benefits of Managed Acounts
The managed account offers:
- better liquidity terms,
- lower expenses,
- full transparency and
- daily (sometimes in real time) validation of the investment value.
The managed account inherently offers daily liquidity to the investor. This inherent feature exists because the owner of the managed account (‘the investor’) can terminate the trading authority of the trading manager at any time and liquidate his account in a matter of hours.
When the investor is effectively the owner of the managed account, the investor can decide on whether or not to incur the additional cost of an audit and whether the services of an administrator are needed. The investment advisor will likely continue to use the same execution venue for all trading activity and the separately managed account will likely benefit from the existing execution rates of the investment advisor. Generally, prime brokers charge commissions based upon the total value of the account and the transaction activity.
Most execution tools in the marketplace have allocation tools (e.g. Oanda’s PAMM - Percent Allocation Management Module), and the allocations are performed automatically. The investment adviser / account manager would have to perform an additional operations check to ensure that all of the allocated trades have cleared. The investor should periodically review the listing of trade breaks to minimize costly trade errors.
The investor will have full transparency into the investments and will receive daily and monthly statements from the broker. The statements will include current (mark-to-market) valuation for all of the investments.
Because virtually all of the transactions in a managed account are priced either by an exchange or in the foreign exchange market, it is quite simple to mark-to-market any given account at the end of each trading day.
The majority of hedge fund failures have been due to fraud and operational issues rather than poor investment decisions. The managed account structure offers investors benefits of liquidity, transparency, fraud controls, and controls over cash movements over the traditional hedge fund investment structure.
Much of the information above was sourced from a paper written by John Cunningham of WR Capital Management.