It used to be that only the largest institutional investors could get a hedge fund to agree to run its strategy in a separate account designed just for them. But with a more difficult environment for hedge funds these days, small and mid-size investors are asking and getting special treatment as well, several hedge fund advisers say.
“It’s a function of the capital raising environment for hedge funds,” says Eric Costa, head of hedge fund research at investment consultant Cambridge Associates. “In the last three years, you haven’t seen a ton of flows into hedge funds. To raise capital, funds have to be flexible with things like managed accounts.”
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John Frede, manager of alternative investments research at 50 South Capital, a registered investment adviser and subsidiary of Northern Trust Corporation in Chicago, says large institutions have been customizing portfolios using separate accounts for the last four to six years. Investors in part wanted to reduce the risk of being in a commingled fund, with the attendant danger of being subject to other investors withdrawing their assets during times of market stress and forcing managers to sell securities at losses. But only recently have smaller institutions been able to demand the same.
Separate accounts are not just a risk mitigation strategy, however. They also offer investors and consultants the ability to customize their hedge fund allocations. For example, some investors may want less exposure to fixed income in general, or limited exposure to investment-grade bonds, because of concerns about rising interest rates. Frede says custom programs typically required $100 million or more in assets. Now smaller institutions can do it for $50 to $75 million, and even $30 to $40 million in some cases.
“As institutions become more sophisticated, they want a more flexible portfolio that can change over time,” says Frede. He adds that smaller and mid-size institutions often don’t need the quarterly redemptions that hedge funds offer, so they can use less liquid strategies as well as co-investments in custom programs.
Stuart Blair, director of research for Canterbury Consulting, which advises on $18 billion for endowments, foundations, family offices and high-net-worth investors, agrees that hedge funds are willing to do separate accounts for smaller clients. He says unlike investing through commingled hedge funds, which are “one size, fits all,” institutions get to customize a strategy around their risk tolerance, for instance. In addition, clients get to define the level of transparency that they want.
“Good luck in getting that from the hedge funds themselves,” says Blair.
Investors can also often get lower fees. “It’s a favorable environment to be a hedge fund allocator,” Frede adds. “Everything is negotiable.”