Separate Accounts as a Source of Hedge Fund Alpha

April 2010

This paper examines how separately managed accounts can serve as an additional source of hedge fund alpha for institutional investors. A separately managed account custodies an investor’s assets with a firm that is independent of the hedge fund manager, giving the investor legal control of the assets and full transparency of the holdings. The paper argues that this structure adds returns over and above the traditional sources of hedge fund performance, because it enables both asset protection and disciplined risk management. Asset protection guards against fraud and the everyday conflicts of interest between manager and investor, while transparency lets an investor set and monitor investment guidelines, value positions independently, control leverage, and manage exposures across the whole portfolio. The liquidity of a separate account also helps an investor rebalance and hold positions through periods of stress, when commingled funds may restrict redemptions. The analysis is written for institutional allocators, OCIOs, and consultants, and it frames its conclusions as analytical perspective grounded in more than a decade of experience.

What This Paper Examines

• How separate accounts can add a source of alpha beyond hedge fund beta, asset allocation, and manager selection.
• How independent custody protects assets against fraud and principal-agent conflicts.
• How transparency supports investment guidelines, independent valuation, and leverage control.
• How portfolio-level risk management, including overlay hedges and rebalancing, is enabled by transparency and liquidity.
• Why the benefits of separate accounts tend to be largest during periods of market stress.

Key Findings

• Separate accounts can add a distinct, incremental source of alpha. Beyond the traditional sources of hedge fund return, the account structure itself can contribute performance through asset protection and better risk management, rather than by changing how the traditional sources are attributed.
• Independent custody structurally reduces fraud and conflict-of-interest risk. Separating trading authority from custody means a manager cannot report fictitious assets. It also helps investors identify and avoid the everyday conflicts, such as biased valuations of illiquid positions, that arise in the manager-investor relationship.
• Transparency turns information into better risk management. Position visibility lets an investor set and monitor investment guidelines, value holdings independently, and limit leverage and concentration, which tends to reduce severe drawdowns rather than only volatility.
• Liquidity supports rebalancing and holding through stress. Because separate accounts can carry more favorable liquidity terms, investors can rebalance, add capital, or apply portfolio-wide overlay hedges during dislocations, when commingled funds may gate redemptions.
• The benefits are largest in stressed markets, and not all platforms are equal. The incremental contribution tends to be greatest during periods of stress. Only platforms that actively negotiate guidelines and run independent risk monitoring capture the full benefit, so the structure alone is not sufficient.

The Authors

This paper is part of the long lineage of quantitative research that Versor’s founders began earlier in their careers and continue to build on at the firm today.

Deepak Gurnani, Founder and Chief Investment Officer

Deepak Gurnani is the Founder and Chief Investment Officer of Versor Investments. Deepak has three decades of experience in applying quantitative methods to uncover alpha across global equity markets. Over the past decade, he has focused on pioneering the use of AI and alternative data in equity investing.

Versor’s founders co-authored this research with Christopher Vogt, colleague at the firm where this work was originally conducted.

Disclaimer: Past performance is not necessarily indicative of future results. Not an offer to sell or a solicitation of any type with respect to any securities or financial products.

Methodology: The paper draws on more than a decade of institutional experience investing in over one hundred separately managed accounts advised by hedge fund managers, supported by illustrative case studies across strategies and market episodes. It sets out a framework that distinguishes three benefits, asset protection, transparency, and risk management, and details the account-level and portfolio-level tools each enables.

To assess whether the structure carries a return cost or benefit, the analysis measures the incremental return of separate accounts relative to commingled funds using monthly cross-sectional regressions that control for thirteen strategy classifications. The return data come from four live multi-manager hedge fund portfolios over a sample that runs from May 2006 to December 2009, a window that spans the 2008 market stress. The design deliberately holds manager-selection effects constant so the comparison isolates the account structure.