SMAs for Hedge Funds: Customized Solutions or Just A Huge Side Letter?

How can hedge fund managers profitably answer the growing demand for liquidity, transparency, and increased control on the part of investors?

That question sparked a lively panel discussion moderated by SS&C Advent’s Katherine Pearce, vice president of Product Management and Solutions Consulting, at GAIM Ops West. The panel comprised of a mix of investment, legal, and compliance officers from leading US hedge funds.

In the early days of hedge funds, investors were happy to cede control and put their trust in the manager’s discretion, so long as the returns outperformed the market. That all changed with both the massive influx of institutional capital (with its tighter governance standards) and with the financial crisis of 2008 (10 years on, its impact still reverberating).

All the panelists agreed that their firms were seeing the interest – or, more accurately, feeling the pressure – from investors for liquid alternatives and increased transparency.  Although titled “Meeting investor demand with customized and hybrid structures,” the discussion quickly turned to the growing use of separately managed accounts (SMAs) and “funds of one.” These are vehicles that follow the principles of hedge fund investing but are tailored to a single client rather than a pool of investors. The distinction between them is asset ownership: In an SMA, the investor owns the assets directly, while in a fund of one, the assets are owned by the fund.

Offering SMAs to investors is growing in importance as a competitive necessity among hedge funds in the post-Madoff era. And they may indeed provide investors with greater transparency and liquidity. However, they cause operational headaches for hedge fund managers. Unlike traditional asset managers or RIAs, who have built their businesses around SMAs, hedge funds generally lack the infrastructure to support a scalable SMA offering.  Challenges also arise from the perspective of capital deployment – one panelist characterized an SMA as “just a huge side letter,” meaning the client agreement contains caveats as to how the money can be invested.

The panel discussed a number of concerns for hedge fund managers addressing the increased client appetite for SMAs:

• An SMA is often structured to move in parallel with a pooled master fund but generally cannot use leverage and is constrained by other restrictions. As a result, returns will start deviating immediately from those of the master fund.  
• Fees may also mirror a master account, meaning they are billed at a designated point in the life of the fund. If the investor has the option to reduce the size of the fund or even discontinue it before that time, how does that affect collection of fees?
• Offering SMAs will require new operational processes. They will involve new counterparties. They will create unfamiliar trading and back office issues. They require new ways of tracking, new layers of policies and procedures, and specialized training.
• Reporting systems must adapt to client expectations for more customization and detail.
• Setting up an SMA will require a new legal entity structure. The hope is this legal structure is easily replicable because the cost and effort is significant.
• Firms will face new compliance requirements and procedures, including adherence to investment restrictions and more stringent oversight of personal account trading within the firm. 
• If a firm’s strength is in illiquid investments, it may be successful on the sales front in bringing money in but runs the risk of an operational meltdown. The less liquid the asset class, the less an SMA makes sense.

The verdict? SMAs are here to stay, but hedge fund managers must decide if the additional client assets are worth the added operational and servicing expenses. A fund of one may be an attractive option for hedge fund managers, but for many firms, it is a question of whether they can scale their SMA offering to make economic sense. That’s where a solution like Geneva can make a big difference, with its flexibility to support virtually any type of fund structure and built-in investor accounting capabilities. To find out how hedge fund are using Geneva to diversify their product offerings, read this case study or contact us.