Amid volatile financial markets, it can be easy for institutional investors and hedge fund managers to focus on their differences rather than on what they share.
Institutions are looking for transparency, accountability, an appropriate level of liquidity and alignment of interests, while managers are hoping to remain viable, stable businesses. More fundamental than these disparate objectives, though, is what we all have in common: our core mission as fiduciaries. We have all been entrusted, by the same ultimate beneficiaries, with capital that must be treated with the utmost care and thoughtfulness. When an institutional client invests with a manager, they are becoming partners in the same critical undertaking: building a better future for beneficiaries over the long term.
For some in the industry, such relationships have not always felt like partnerships following 2008. Certain managers turned out to have provided less than full disclosure about their activities, while others did not make adequate provision for the liquidity demands of investors. Some investors, meanwhile, were forced to withdraw even from high-performing funds because of short-term capital needs and a rapid reassessment of hedge fund risk/reward. Since then, institutions increasingly have sought to minimize their downside by maximizing control, transparency and aligning liquidity with that of the underlying holdings. They also have worked to increase manager accountability through encouraging improvements in the corporate governance of investment vehicles and a longer-term-aligned fee structure. These priorities often have been portrayed as inevitably spurring conflict between investors and managers.
More enlightened managers, however, understand that discussions about transparency, control, liquidity, fees, structure and similar issues need not be adversarial. Relationships are not zero-sum games, where one party wins only at the other's expense. The more closely interests are aligned, the more clearly manager strategies match investor objectives and the more information is shared within the bounds of confidentiality and efficiency, the better off everyone will be.
Consider separately managed hedge fund accounts as one useful example. Although they entail certain additional costs and logistical requirements for both investor and manager, large institutions have been choosing them more often over commingled hedge funds. Because each account remains in the institution's name, control and visibility of the assets are clearly maximized, and liquidity and fees can be set more thoughtfully as well. These are just the obvious advantages, though. Rather than just a defense against 2008-style problems, managed accounts can also present opportunities for extremely constructive deepening of the investor-manager relationship.
Managed accounts provide greater customization of investment guidelines to achieve the institution's overall strategy. Sophisticated investors can benefit from accounts that vary in strategy mix, concentration levels and other parameters from the same manager's commingled funds.
Managed accounts offer more options for alignment of interests between investor and hedge fund manager. For example, if both are focused on long-term performance, as they should be, such accounts can calculate performance fees not annually but over multiyear lockup periods. In addition, managers may be willing to lower their annual management fee in exchange for a greater share of the returns they generate.
Managed accounts improve the very nature of the investor-manager relationship, allowing a true strategic collaboration between them. Ideally, managers should provide not just a service but an overall solution closely focused on clients' fundamental investment needs. The precise tailoring made possible by managed accounts — and, no less important, the close consultation they require — can lead us toward that too seldom realized ideal.
In some cases, managed accounts can form the basis for a more extensive strategic partnership between investor and manager. Elements of this partnership can include consultation on the investor's overall portfolio, dynamic discussion of individual holdings or trends within that portfolio, mutually beneficial co-investment opportunities, and even training of the investor's personnel.
Separately managed accounts give investors control over the governance of the structure through which they invest and the counterparties with whom they interact. This can involve selecting service providers — such as administrators, custodians and pricing agents — and defining much of the operating structure — such as trading counterparties and cash management — to meet their particular needs and fiduciary requirements more fully.
To be sure, not every collaborative hedge fund effort needs a separately managed account. Investors can and should expect openness and consultation even from the managers of commingled funds. But managed accounts and related vehicles, for those with the scale and sophistication to take advantage of them, can offer invaluable ways to seize the high, and common, ground.
Investment management is a business, but not a business like most others. Because the dreams and security of so many people rely on institutions and the managers they select, we cannot view funds and accounts as mere products to be bought and sold like breakfast cereal. Manager and client should work together with their shared ends in mind — not only in setting investment guidelines, but also in designing all other aspects of what will hopefully be relationships that flourish over many years.
John Bader is chief investment officer of Halcyon Asset Management LLC, New York. Douglas Clark is head of manager selection at BT Pension Scheme Management, London.
