Operational Efficiency - An Integral Part of a Hedge Fund Model

Over the last few years, advising the hedge fund start-up on operations has become an industry unto itself. Indeed, one of the major themes that makes starting a hedge fund attractive is that there exist very few rules dictating how it should be done. And yet, while there is no shortage of people prepared to advise start-up managers, these advisers, in many cases, have not experienced it first hand themselves - they are typically experts in giving advice, rather than experts in starting and operating funds. Speaking as both a former start-up fund manager and, now, a service provider (although not a professional adviser), I believe it is worth sharing a few words on the subject of operational efficiency.

There is only one office

Most start-up fund managers have honed their investment skills within medium and/or large-sized organisations where they have not had to deal, day-to-day, with much beyond the origination and, perhaps, the execution of their investment decisions. After all, stock-picking is a full-time job in and of itself. These managers know the business of trade confirmations, settlement, cash management and reconciliation as the "middle office" and "back office" - within an institution, they are the domain of entire teams of people often physically located away from the fund managers' "front office," and, as such, are typically seen as lacking relevance to the manager's raison d'être.

Start-up hedge fund managers maintain this distinction at their peril. At the end of the day, there is really only one office. In a world where performance is all that matters, returns achieved by the cleverest of investment decisions can be easily eroded by inefficient operations: mismanagement of the fund's cost base and/or sloppy monitoring of actual security and currency exposures.

To succeed, a start-up manager must clearly understand the underlying business model of the fund itself and, while he may delegate the execution of parts of that business model, he must understand how to maximise its efficiency overall. In order to see, at short notice, a realistic and accurate picture of the fund at any given time, the manager needs to be able to keep and access robust records of all transactions, costs and cash movements. It goes without saying that without the use of good technology, this is doomed to be a highly inefficient exercise.

However, just capturing the data is not enough. An integral part of running an efficient fund is understanding what the fund's service providers do and don't provide, as well as what and how they charge for those provisions. Different prime brokers, for example, track and report transactions and account balances in different ways, with conventions that are often cryptic to the outsider. Foreign currency balances corresponding to short positions, for example, may be "swept" as positions are opened and closed, but those related to long positions may not be. As a result, the "natural" currency hedge upon which many equity managers rely may not happen as naturally as they hope. Equity managers who employ CFDs in the UK may look at their exposure in notional terms, as though they are trading the underlying stock, but realised P&L on CFDs will create exposure to GBP that the manager may not be expecting. Unless it is carefully monitored, the manager may make ongoing investment decisions based on false pretences. This is not the prime broker's fault - from the prime broker's point of view, an outstanding balance in a given foreign currency may represent an investment decision by the manager - it is incumbent upon the manager to understand his own exposures and to ensure that they are the ones he intends.

With only 24 hours in a day, a manager cannot feasibly do all of the time-sensitive work that traditionally comprises the "middle office" and "back office" by himself, as well as make good investment decisions. However, it is of the utmost importance that he treats the fund as a business and makes the effort to clearly understand how that business works.

An inefficient machine may work, but not for long

Once a manager understands the inner workings of his fund, it is crucial that he put into place efficient operational workflow. An experienced COO will be able to contribute significantly here, but the fund manager must take care of the efficiency of the process from idea generation all the way through to NAV reporting because it all affects profits. A manager may understand how the cash flows of his fund work and may be able to monitor them accurately, but if trades are being recorded and re-recorded several times before they reach his view, or if cash and positions are being manually reconciled over several hours every day, his business is not being managed efficiently and his returns will be affected.

Technology plays a large role in maximising the efficiency of fund management workflow, but only if it is utilised in the spirit of this cause. Allowances are still often made for traders who are reluctant to move away from processes that are already second nature, such as writing and time-stamping paper tickets, then handing them off to other employees for database entry. Yet systems are constantly being developed to make it easier for traders to enter their orders and executions directly, minimising the potential for human error and saving administrative cost. Turning a blind eye to this progress is welcoming the competition in through the kitchen door.

It may be that improving the efficiency of fund workflow requires making it the direct economic interest of the relevant parties. For a start-up manager, however, the task is more straight-forward: plan your operational workflow thoroughly, and in advance. Be the Japanese car entering a market full of Cadillacs.

Operational efficiency is a crucial part of the investment process

A manager who understands how his fund works and who has mapped out efficient workflow on the operational side will have more hours in the day to focus on making good investment decisions. However the freedom provided by the hedge fund model - the ability to effectively make it up as you go along, if you so wish - can work against a manager in numerous ways. Many start-up managers quote an investment process for marketing purposes, and then do not stick to it in practice because, in the context of a small team, the formality does not seem necessary. Formality for the sake of it is indeed unnecessary, but structure and discipline are a hedge fund manager's friend.

By planning the investment process with attention to both efficiency and accountability, a manager can extend the operational competitive advantage straight up the value chain. Streamlined communication between team members means less room for error and more hours freed up for focusing on the investment decisions themselves. Centralised record-keeping an analysis tools go a long way in this capacity, whilst enabling the manager to see clearly what (and who) is making money and what is not. Portfolio monitoring technology enables the fund manager to stick to the risk limitation rules he has developed, overruling the inevitable interference of human emotion, thus enabling him to consistently benefit from his own wisdom. It is not enough to be clever in generating investment ideas - one must be clever in executing and monitoring them as well - even those decisions that turn out not to be so clever after all.

As competition in the hedge fund industry hits new highs, managers coming to market must be convinced that they have a real competitive advantage. The ability to pick stocks, corporate access and the rest are all well and good, but they are unlikely to translate into sustainable superior returns without being addressed in the context of a broader business model, where the goal is to maximise returns on capital employed. A start-up manager is unlikely to figure out the perfect operational business plan without having taken one out for a test drive, but planning is crucial nonetheless. Reviewed at regular intervals, straight through from front to back, efficient operations may just be the secret to your success.

Clare Flynn joined Beauchamp Financial Technology in 2004 as President and Head of Product Strategy. From 2001 through 2003, Clare was CIO of Avocet Capital Management Ltd, a London-based alternative investment manager, and manager of the Avocet European Technology Fund. Prior to founding Avocet, Clare managed over US$1bn of pension funds for Deutsche Asset Management.