Technology, Efficiency and the Portrait of the Long/Short Equity Hedge Fund Manager with an Operational Edge

A hedge fund manager's marketing pitch to potential allocators normally focuses on investment strategy, performance, risk management, principals' pedigree, etc. Few managers broach operational issues in any detail, aside from naming the fund's administrator, prime broker and legal counsel in passing.

Operational due diligence, nevertheless, forms a key aspect of an allocator's analysis of a fund, often characterised as looking under the hood or kicking the tires prior to making an investment. This process usually has two main goals. The first is to ensure general standards of management stability and regularity appropriate to running a viable hedge fund business. The second element to operational scrutiny typically entails trying to observe operational checks and balances that exist to mitigate potential for fraud.

In addition to these, it also behooves allocators to pay close and careful attention to other specific operational issues that bear upon a fund's efficiency.

For example, consider two start-up long/short equity funds with similar short track records trading in the same space and managed by individuals with commensurate relative credentials. Fund A employs sophisticated trading technology to achieve best execution of its trades. Fund B's transaction costs, execution delays and other sources of slippage compromise operational efficiency. All other things being equal, one can fairly assume that Fund A will outperform B over time and should be preferred to its less efficient peer.

Increasingly, hedge fund managers committed to their craft seek to deploy the latest state-of the-art trading technology to improve efficiency and ultimately boost returns. And managers who pay scant heed to issues of transaction efficiency will be left behind.

A story in the June 2004 issue of Institutional Investor outlines industry trends towards more efficient execution, pointing out that "the majority of institutional trades today are already executed in so-called low-touch fashion, either by a fully automated system or by a human trader employing similar technology."

The Tabb Group, a financial advisory firm, echoes these conclusions about the burgeoning use of trading technology: "Buy-side traders now have access to powerful technologies to better understand, manage and execute trades faster, more efficiently, less expensively, and more effectively than at any point in the past…The trader must examine the value that he or she brings to the table on every order…can the trader execute the order better than the market?" The 2004 Tabb report, titled "Institutional Equity Trading in America," notes that adoption rates for algorithmic trading systems far exceeded the authors' expectations.

Algorithmic trading systems model a trader's execution strategy and use technology to implement defined trades in an automated fashion to enhance productivity, improve control over intermediaries and diminish costs. These trading systems are significant in the quest for best execution and form part of a phenomenon that has been loosely termed the "electronification" of markets. The catalyst for this transformation towards low-touch trading is fragmentation of liquidity and lower commission prices according to Gavin Little-Gill, senior analyst in investment management research at TowerGroup. TowerGroup predicts total algorithmic trading volume to double by 2006.

Systems yielding more technologically savvy trading occupy a major part of the spectrum of best execution tools that reduce the variety of explicit and implicit costs associated with trading. These costs come under the general rubric of transaction costs and range from brokerage fees to opportunity costs stemming from poor execution. A strong operational infrastructure oriented towards best execution cannot be underestimated. Moreover, soft dollar arrangements that compromise execution efficiency will be less tolerable as the industry evolves.

In sum, to demonstrate a competitive edge, hedge funds will increasingly be called upon to show competence in managing trade executions. To this end, Transaction Cost Analysis (TCA), whereby managers examine individual trades to redress slippage, is a facet of trading activity to which few hedge funds can remain indifferent. The TCA scorecard uses appropriate benchmarks to assess and improve transaction efficiency.

TCA best execution covers a range of events that stretch from pre-trade actions to post-trade activities, all of which relate to efficiency.

As it becomes harder to distinguish between a plethora of funds seeking capital, one can readily envisage transaction efficiency becoming a shibboleth for allocators. A hedge fund that can point to the sophistication of its trading technology and rigorous controls over execution has qualities that distinguish it from its peers.

Peter Rajsingh, PhD, is Senior Vice President of Global Partners Group, a diversified financial services firm with offices in New York and Fort Lauderdale, Florida.