A Daily Dealing Fund of Hedge Funds - Is It A Dream

a presentation by David P. M. Blair
at the Hedge 2006 Conference, London
17th October 2006

There has been much discussion in the past year or so about the potential demise of the Hedge Fund, but given the continual growth in the number of Hedge Funds, these predictions appear to have been somewhat exaggerated.

Funds of Hedge Funds versus Multi-Strategy Funds

Another topic of discussion has been the battle for institutional monies waged between the advocates of Funds of Hedge Funds (FoFs) on the one hand and the Multi-Strategy Funds on the other.

Funds of Hedge Funds

It appears that the main objection to FoFs, apart from the higher fee levels, is the lack of both liquidity and transparency.  For example the Manager of a FoF can only redeem after a liquidation event occurs (i.e. bad performance; style drift; or whatever), which persuades the FoF Manager to sell, but it may be several weeks after that event before he can actually redeem his position, for several reasons, including, perhaps, long notice periods or delays in getting the NAV, or whatever.

So why are there so many large  US$1 billion or more  FoFs
It is my opinion that the driver behind the attraction of FoFs is that, by their very nature, Hedge Funds are often subject to capacity constraints.  It is still quite rare to find a single strategy funds with US$1 billion or even US$500 million assets under management.  As a result, institutional Investors, whose minimum investment in a fund may be as low as US$50 million, but often is US$100 million or more, cannot invest in many single Hedge Funds.  This is because many Institutions are prohibited, for example, from making an investment that represents more than 5% of the assets of the fund target.

Furthermore, a pension fund with several billion dollars of assets may only want to allocate 5% of their portfolio to Hedge Funds, which is the blanket description for funds covering numerous specialised strategies.  It is often not practical, let alone economic, to devote the resources  human or financial  that would be necessary to set up a Hedge Fund research department, which could conscientiously and efficiently review the hundreds of Hedge Funds in the market.  It is, therefore, often much more attractive for many pension plans and other institutions to carry out a beauty parade of FoFs and select one or two which they think are properly managed and, effectively, consider the management overlay fee in a FoF as the cost of outsourcing their in-house research department to the FoF Manager.  Thus, a FoF provides a diversified portfolio of Hedge Funds, often including some underlying funds that are otherwise closed to new Investors, as well as independent research into a wide spectrum of Hedge Fund products, into which an institution can invest without breeching their own investment restrictions.

Multi-Strategy Funds

Of course, in the context of diversification and eliminating the in-house Hedge Fund research department, multi-strategy funds offer a similar product to the Fund of Funds.  One of the main attractions, however, seems to be the fact that by keeping the management of the various strategies in-house, Investors avoid the FoF overlay fee, but this doesnt solve the problem of adding or changing a strategy or sacking a Manager.  Furthermore, we cannot ignore the obvious conflicts within the management group of the Multi-Strategy Fund, because, often, the individual strategy Managers  the trading managers, if you like  are partners, or have equity in the Fund Manager.  As a result, often, changing or adding strategies to meet market demand is not as simple as turning on a tap  it is more like trying to turn round a super tanker and it will often take longer for a Multi-Strategy Fund to change the weighting of different strategies, Managers and/or disciplines, that it does for a FoF.

Multi-Managed Account Platforms

An increasingly popular alternative is a fund operating as a multi-managed account platform, which gives the Fund Manager full transparency and liquidity, albeit with a FOF type overlay fee structure.  However one major disadvantage of having a series of managed accounts is the potential of cross collateral risk.  This is the risk that one account manager may go bananas and lose more money than he has been allocated.  This would most probably mean that the Fund Manager would have to, either take money from one or more of his other managed accounts to pay the short fall, or have to pay the losses out of his own pocket.

Solution

This can be avoided by using what may seem, at first sight, a complex master-feeder fund structure, which can be designed to give the Manager the limited liability protection offered by a fund, combined with the transparency, liquidity and flexibility that a managed account platform provides.  Of course, the higher FoF type fee structure applies  but there is a cost for everything.Institutional Client

Last year Custom House was approached by a large North American Institution, that was running a multi-manager, managed account programme, in-house, which they wanted to re-organise, as a fund structure, both to create a marketable product and to get the platform off their balance sheet.

The challenge was to provide a fund structure that not only had all the available security and immunity from that cross collateral risk, which is inherent within managed accounts, but also had the transparency, liquidity and flexibility of a full managed account programme, such as I have already described.

On the face of it, this appeared to be a clear example of Having your cake and eating it.

Structure - Concept

In the event we structured a Maltese domiciled Master-Feeder Fund, which offered Investors monthly liquidity, in what was, in effect  indeed was in fact  a Fund of Hedge Funds, but which also offered the Manager the same flexibility, transparency and liquidity provided by a portfolio of managed accounts, with not just limited risk, but also without any cross collateral risk.

Although the structure appears to be quite complex, as you will see, it is in essence a simple straightforward structure.  What we established was two Maltese SICAVs in a classic Master Feeder Fund structure, with the Master Fund being a segregated cell fund company, that has the ability to issue a large number of segregated cells - each with the desired liquidity and transparency and risk portfolio.

Structure - Actual

As you can see from this slide, Investors buy a particular class of share in the Feeder Fund, each of which represents a specific Sub-Fund.

That Sub-Fund invests down into all, or some, of the 28 segregated cells/Sub-Funds of the Master Fund.  The choice is entirely the Investors  although that does mean that any Investor who wants their own portfolio will need to invest a substantial or economic sum of money to justify creating their own Sub-Fund in the Feeder.

With regard to the Master Fund, you can see that each Sub-Fund is the sole responsibility of the selected trading manager or trader.

When we launched the structure last December, the Master Fund utilised 28 of some 35 or so authorised segregated cells, although today, it has reduced this to 26 cells, as the Manager has removed or replaced some of the original underlying Managers.

Each cell contains a specific managed account, organised as a segregated Sub-Fund, the assets of which are ring-fenced, so that no one Sub-Fund of the Master Fund can contaminate any other cell, or Sub-Fund, should it lose more money than the relevant Sub-Fund actually has in assets.

At the risk of being repetitive, but just to clarify this point: with a single managed account, the Investor has unlimited liability, and of course, with a multi-manager managed account programme, if one trading manager loses more than 100% of the assets allocated to that trading manager, then the Investors will have to meet the margin calls and cover those losses.  And, as I have already said, inevitably these monies will have to be taken away from one, or all, of the other managed accounts, or from the Investors own resources.

The segregated cell structure eliminates this risk, because a creditor of a specific Sub-Fund (which is more likely to be the prime broker, or other counter-party of the Sub-Fund), will only be able to claim against the segregated assets of the relevant fund, and no further.

So, as I have already explained, the Master Fund was designed as an umbrella fund with several Sub-Funds, each dedicated to a single trading manager.  The contracts, or investment advisory agreements, with each trading manager provides the overall Manager of the fund company with the right, on a daily basis, to increase or decrease the capital invested or indeed close the account of the relevant Sub-Fund, which, in effect, has all the characteristics of a managed account, because, in order to provide flexibility to the Manager, each Sub-Fund of the Master Fund has daily liquidity.

The Feeder Fund, of course, represents the Investors and, in our clients case, the Feeder Fund itself has several Sub-Funds representing Investors with different objectives.  For instance, the proprietary desk of the Institution wished to be invested in a weighted allocation between all of the trading managers  i.e. across the board of all of the segregated Sub-Funds of the Master Fund, whereas, other Investors might have different objectives  for example  one Investor specifically did not wish to invest with any CTAs, because that Investor had already made its allocation to CTA Managers, elsewhere.

We calculate the NAV on a daily basis for each of the Feeder Funds, as well as each of the Sub-Funds of the Master Fund.  This enables the institution to maintain a tight control of that performance, although the Feeder Funds only offer Investors liquidity on a monthly basis.

Administration

Obviously, the actual day-to-day administration is, to say the least, quite complex.  The Institution requires two things from Custom House:

    *  Firstly, Custom House provides a trade capture and reconciliation blotter each morning.  This is a report that captures and reconciles all trades carried out on behalf of each of the sub funds of the Master Fund on the previous day.  We established a team of about 10, who capture and reconcile all the transactions carried out by the various trading managers.  These amount to between 1,500  2,000 trades per day, which are executed through several different prime brokers and, indeed, with some trading managers, through three, four, or more such prime brokers.
    *  This report is delivered to the Manager of the fund between 10.30a.m. and 11.00 a.m. each day (Dublin time), which means that it hits the desk of the Manager very early (before 5.00am) each morning.  The report, which is fed electronically into the Managers systems, enables the Manager to carry out all of their risk analysis, such as, producing their VAR (Value at Risk) reports, and feed the data into any other risk management tools that they wish to use.
    *  Secondly, once we have completed and despatched the trade capture and reconciliation report, we start working on the production of the NAVs of each of the segregated Sub-Funds of the Master Fund, and each of the Sub-Funds of the Feeder Fund.  We aim to have all of these NAVs delivered to the Manager, out of our Chicago office by 5.00p.m. Chicago time, on the same day.

The reconciliation is, at present, all done in Dublin, because of the time advantage we have by carrying out this work whilst the client in North America is asleep.  The NAV calculations are currently partially done in Dublin and partially in Chicago, but it is intended that in the near future, all of the NAVs will be calculated in Chicago  although that may change, as I will explain in a moment.Cost Of Such A Service

It goes without saying, that providing such a service is expensive, and therefore to achieve economies of scale, a fund structure such as this one must start with substantial assets  in this case the Master Feeder Fund was launched with total assets of circa US$1.8 billion.

It must be admitted that taking on this account presented several major challenges for Custom House and it took quite a long time  for example, we ran in parallel for almost four months -  before we were comfortable with the process, but we still finished in four months, having allowed ourselves six.  There have also been some pricing problems with some esoteric derivates, but these problems have been solved, as they always are, with the pricing policy being clearly defined in the offering document and by outsourcing this task to one of the specialist firms in this area, like Sungard Reech.

I have often been asked why we dont produce our own pricing models for the more esoteric instruments and my response is that Custom House will not develop its own pricing models or offer that service for several reasons:

    * Firstly, I think it is an unnecessary risk for the administrator to take on when only being compensated with a few Basis Points;
    * Secondly, we are seeking independent valuations and that means independent of both the Manager and ourselves; and
    * Thirdly, it seems rather pointless to reinvent the wheel, when companies like Sungard Reech and their peers are already providing this service to a large number of institutions around the world.

It can readily be understood that taking on such a client as this one has dramatically changed Custom Houses image in the Hedge Fund Administration market, as indeed I would suggest that it has also established Malta in the Hedge Fund market, but we have not become complacent.  We are constantly trying to improve our service.  This may be by automating tasks and functions that had hiterto been manual, or outsourcing hard to value pricing problems.

A couple of years ago, we introduced CHARIOT, our password protected web-reporting platform, which has been very well received by our clients.

Currently, we are investigating the advantages of setting up an office in Singapore.  On the face of it, you might imagine that this move is designed purely to enable us to target Hedge Funds run by investment managers based in South East Asia and, indeed, that was the original concept.  However, as we have developed our product offering for the multi-manager, daily dealing, Hedge Fund platform, we have realised that, by opening an office in Singapore, we can extend and improve this offering substantially.  What we expect to happen will be that, for North American managed account funds, such as those I have been discussing, the initial operations in Singapore will be the trade capture and reconciliation function.  Because of the time differences, we would expect that most of the transactions carried out by the trading managers will be captured and will be reconciled by our Singapore office before we get into the office in Dublin in the morning.  Singapore will then send the files to both ourselves and to the Managers of the Funds in United States by 2:00 or 3:00 oclock in the morning, New York time.

Our Dublin office will then be in the position to calculate and issue the NAVs by 12:00 noon New York time, which will be a very satisfactory result for our clients.

Obviously, by having offices in Dublin, Chicago and Singapore, we do have a 24-hour service and that has obvious advantages and if you extrapolate the Singapore/ Dublin feed to the US Managers, it can be seen that a reconciliation department in Chicago could capture all the trades and reconcile all the positions for a European daily dealing fund and forward that information onto Singapore when they wake up in the morning.  Singapore could then produce the NAVs and forward that on to us here and to the clients in Europe before lunch.  Similarly, we in Dublin could do the trade capture and reconciliation of funds managed by South East Asian Managers.  That information could be forwarded to the Manager and Chicago before Chicago wakes.  Chicago could then produce the NAVs by afternoon in Chicago, which is before Singapore awakens.

This ability to take advantage of communications technology and the robust, flexible, fully automated and fully integrated system that we have in the PFS PAXUS system will put us in good stead and will, we feel, make it possible for the larger daily dealing Hedge Fund to become commonplace.

Thank you.