Dedicated Managed Account	Commingled Hedge Fund
Notional funding: account funded with required margin plus a buffer amount	Full cash funding required to subscribe
$100 exposure	$100 exposure
$60 required by prime broker $20 buffer for margining $20 capital savings, which can be deployed in other assets to achieve higher return profile	$100 required by prime broker Using leverage, hedge fund invests a lower amount Hedge fund retains control of excess cash

A Dedicated Managed Account (DMA) with notional funding allows the investor to invest only what the manager requires, meaning the allocator could borrow less from the treasury or use the excess capital to fund another investment.

Further, an allocator can achieve materially greater capital efficiency by investing in multiple notionally funded DMAs in a single legal entity. The diversification achieved through a larger and more varied asset pool will typically lower the margin requirement and free up additional capital.

Strong equity returns increase downside risk

Most large allocators have significant exposure to equity markets. Many allocators are considering hedging equity beta downside given all-time market highs and current macro volatility risks. For large investors like pension funds, sovereign wealth funds and endowments whose balance sheets tend to have material exposure to equity beta, the impact of an equity market drawdown could be significant. As we saw in 2020 when COVID-19 created a substantial market shift, many allocators found themselves challenged to meet their investment targets and funding obligations.

In recent years, many large allocators have implemented Risk Mitigating Strategies (RMS) programs to hedge or “offset” equity growth risk in their portfolios. In other words, these programs are intended to generate positive returns when equities decline. RMS programs invest in strategies that are expected to be negatively correlated to equity risk premium. RMS programs generally utilize three strategy components, which include:

• Long Treasury Duration,
• Trend Following/Capture,
• Alternative Risk Premia.

These investments are generally intended to have a similar level of volatility to equities so that they can effectively offset equity beta losses in times of stress. Several large pension funds use Dedicated Managed Accounts to implement RMS programs more efficiently. There are many benefits to using DMAs for these purposes including:

• Asset control: Assets in a DMA are segregated from other investors and ultimately controlled by the allocator. As a result, the risk of having redemptions suspended or gated is removed.
• Customization: DMAs allow the allocator to negotiate a custom investment strategy with the hedge fund manager that meets its specific investment and risk objectives while also implementing investment guidelines which can be monitored daily to ensure that program parameters are being respected.
• Cash efficiency: DMAs can be notionally funded meaning that the desired level of exposure can be achieved without fully funding the investment with cash.
• Rebalancing flexibility: DMAs allow for more flexible and dynamic rebalancing intra-month versus month-end or quarter-end timeframes required in commingled fund structure. This feature is particularly valuable for an RMS program in the event of outsized fund manager performance and in times of market volatility.
• Daily transparency: DMAs allow for daily performance and risk transparency as well as position-level drill down. The frequency and granularity of this actionable data should allow the allocator to better and more efficiently manage the RMS program from both an investment and risk perspective.

Losing alpha to fees

Allocators are increasingly struggling with the high fees charged by hedge funds, which can extend beyond 2&20 to 3&30 for some multi-strategy hedge funds. The cost of acquiring talent and running these funds is substantial, and often certain manager expenses including employee compensation are passed on to investors. Investors are paying substantial fees and expenses but typically have little transparency into the details of these charges.

The focus on fees is intensified given the current interest rate environment. With a steeper hurdle to jump, the hedge fund has a harder time outperforming the inherent cash benchmark, and fees erode the alpha even further. Sophisticated allocators managing large pools of money (such as pensions, endowments and sovereign wealth funds) are increasingly looking at options to invest their capital in a more efficient manner and reduce the high fees and expenses associated with certain pod shops.

One option is to bring investing in house, but that requires creating a whole infrastructure and recruiting and paying for talent. Another option is to use a Dedicated Managed Account Platform (DMAP) to create your own multi-manager vehicle using third party managers. This approach allows the allocator to build a custom product that can focus on a specific strategy, for example, or to allocate to managers that provide broader exposure to different regions, sectors or strategies in a more capital efficient model. Using a DMA, collateral can be managed more effectively with notional funding and cross margining and netting across all the managers in the legal entity. This type of structure is being used by many of Innocap’s clients as it offers enhanced capital efficiency and allows for easier onboarding, rebalancing and capital deployment.

Optimally implementing a portable alpha program

Finding assets that have demonstrated little to no correlation to the markets can be a powerful strategy for allocators seeking outperformance. Separating the portfolio into beta (to achieve a target index exposure) and alpha (to realize excess returns) not only improves asset diversification but can also unlock portfolio capital since the beta can be used as collateral to improve capital efficiency. This concept is commonly referred to as portable alpha.

Portable alpha reached its peak in 2008. By some estimates, approximately 25% of the largest pension funds were deploying a portable alpha strategy.* However, the Great Financial Crisis exposed flaws with the way these programs were implemented and correlation shifts combined with the illiquidity of the investments resulted in significant losses to portfolios and a shift away from portable alpha. By deploying these strategies through investments into commingled hedge funds for the alpha exposure and thereby limiting the liquidity, transparency and tools for risk management, these structures were set up to fail.

Portable alpha has once again regained popularity. Many lessons were learned from 2008 including that finding true alpha, deploying proper risk management and implementing through structures that allow investors to manage liquidity and rebalance their portfolios are essential to a successful program. DMAs address the key failures seen in 2008 and provide an efficient solution for implementing these structures.

The benefits of using DMAs include:

• Control and flexibility of the DMA structure allows for rebalancing of the portfolio at any interval.
• Allows for custom terms and liquidity to align with program objectives.
• Daily transparency can be used to monitor changes in correlations.
• The DMA structure can be notionally funded maximizing capital efficiency.
• Beta component can be used as collateral within the structure further increasing capital efficiency.
• Multiple managers can be combined into a single structure diversifying the alpha exposure.

*Institutional Investor – Easy Money: The Temptation of Portable Alpha Strategies, Imogen Rose-Smith, February 10, 2010

The liquidity challenge in volatile markets

Market volatility is likely to continue given geopolitical and market conditions and the potential impact of a new administration in the United States, creating opportunity in the liquid markets. As a result, many allocators want the flexibility to take advantage of changing market conditions more rapidly and the transparency to more effectively understand their market exposure. The lack of position-level transparency in traditional hedge fund structures can make this challenging and limit the allocator’s options.

We saw this in 2020, when allocators struggled with rapidly changing market conditions in the early days of COVID-19. Those who had managed account structures had greater visibility into their investments, and more flexibility in adjusting positions to rebalance their portfolio. Many allocators notionally fund their DMAs which makes it easier to extract excess cash which can be opportunistically deployed during periods of market volatility.

Using a DMA gives allocators the option to house each manager in its own standalone legal entity or employ a multi-manager structure. The latter offers significant benefits as allocators can achieve cross-margining, more easily deploy capital between managers, shift exposure, or add new managers to capture opportunities.

In Summary

While DMAs offers substantial benefits to allocators during all market conditions, those benefits become even more evident in times of volatility or stress. Managed accounts enable a dynamic approach to portfolio management, from notional funding to the ability to customize a strategy, adjust investment guidelines or redeploy capital more effectively. Allocators have more control over their investments in the search for outperformance and can keep more of the alpha by negotiating customized and lower fee structures.

With over US$80 billion on the platform, Innocap is the world’s leading provider of DMA services. Powered by our purpose-built technology and team of experienced fund professionals, we provide institutional allocators with a superior way to structure, access and monitor their investments through DMAs. Our platform services allow them to customize their investment solutions, achieve asset control, increase transparency, and enhance operational alpha over their alternative portfolios.