Changing Hedge Fund Landscape Shapes Demand For Technology

Last year’s major shakeout in the hedge fund industry – with roughly 20% of all funds closing up shop – has radically altered its technology and risk management landscape. Those funds that did survive and the new ones just entering the market are scrambling to equip their operations with the best platforms to appease both their investors and the regulators tightening the screws on them.

But after the recent market bloodbath, and the attendant disastrous returns and huge redemptions, building operations in-house or even supporting existing technology is sometimes no longer financially feasible. Outsourcing, once taboo in hedge fund circles, has become a viable option for funds looking to scale down their in-house operations, while at the same time improving risk management and transparency – the new buzz words in the hedge fund industry.

But the question of whether or not to outsource certain middle- and back-office functions is a big one and there is no blanket answer. Matt Simon, an analyst at an independent research firm Tabb Group, explains that a fund’s size, strategy and philosophy all contribute to whether or not a firm decides to utilise third-party vendors.

“One thing that hedge funds have learnt over the years is that building technology can be time-consuming and is not their core business. They are there to manage money, not to build technology,” he says. “But for some of these high-frequency/stat-arb-type players, the building of technology is their core bread and butter. So for those guys, the building of technology is something that they are going to continue to do.”

 Hedgies Split on Strategy

In fact, Simon, who has been studying the industry in preparation for a report due out in September, says that the hedge fund universe is increasingly breaking into two camps – the “Warren Buffet-style, buy-and-hold” camp, where managers study balance sheets and read sell-side reports, and the “trading” camp, where sophisticated proprietary traders try to capture small profits from large volumes of trading.

“The traders don’t really care what the underlying names are; they are more interested in being able to capture spreads and be able to profit from short-term blips in the market trading patterns,” Simon says.

Addison Tsai, managing director at Old Greenwich, a Connecticut-based hedge fund shop SDS Capital Group, is seeing tremendous growth in this area first-hand.

“A lot of trading strategies are converging to higher frequencies,” says Tsai.

And while the number of money management firms utilising so-called high frequency trading strategies is miniscule compared to the overall universe of asset managers, according to Simon, those traders are responsible for 73% of the equities trading volume on US exchanges and he expects them to consume an even bigger piece of the pie in the future.

In Shift Investors Hold the Cards

Once upon a time, an investor counted himself lucky to be able to gain access to a top-tier hedge fund. Managers such as SAC Capital Advisors’ Steve Cohen and Renaissance Technologies’ Jim Simmons could write the rules, imposing hefty minimum investment requirements, long lock-up periods and high performance fees, with smaller and less pedigreed managers following suit. Investors smiled and handed over their money, satisfied that they were getting the best possible returns on their investments.

Then in 2008, the sky fell. Lehman Brothers collapsed, Bear Stearns went the way of the dodo, liquidity and credit dried up, arch-fraudsters Bernard Madoff and Marc Dreier revealed that supposedly sophisticated hedge funds and funds of hedge funds were some of their biggest patsies, and hedge fund managers lost the biggest bargaining chip they had over their investors – solid returns.

“This fall was a key pivot point in the industry, where for a long time investors didn’t have a lot of power – hedge funds did things their way,” says Chris Momsen, senior vice and general manager of accounts at Advent, a financial software firm that specialises in portfolio management and accounting platforms for asset managers. “I think hedge funds had inappropriately structured their fees in regards to their investment strategy.” He explains that managers who were investing in illiquid securities that became even more illiquid were facing off against investors who wanted to redeem.

“Managers had to give them their money within 30 days or put up gates which caused problems,” he says. “So what I think you are going to see going forward is a better alignment between the time horizon of investors and the management style of the hedge fund.”

And how will this be achieved? Transparency.

“Some of that will be solved by look-through reporting, so the fund investors will see their underlying investments in the fund,” he says.

Transparency rules the roost in 2009. According to Tabb’s Simon, “transparency of positions, transparency of balances, transparency of pricing – anything to do with transparency,” is foremost on both investors’ and managers’ minds.

One firm that has always insisted on full transparency is New York-based hedge fund incubator, SkyBridge Capital. Co-founder and managing partner, Anthony Scaramucci, explains that all of the funds that his firm seeds must be completely transparent.

“We want to have an interface with a fund manager’s prime broker. It’s like a Reagan ‘trust but verify’ relationship,” he says. “What we do is have a feed from one of the software providers where everything gets uploaded into that system, and we have a global macro portfolio report that gets generated by that software.”

The datafeed not only provides SkyBridge with piece of mind that everything is on the up and up and the trades are being cleared and reconciled correctly, but it also serves as a risk management tool. The system SkyBridge utilises, GlobeOp Risk Services’ GoRisk, can be used for back-testing and stress-testing strategies, and also to independently confirm to investors the agreed investment style, risk profiles and limits that are being adhered to.

“It has proven to be a good way to sell these managers because when we go out to market them to institutions and high net worth individuals, us being able to say that we have transparency and that we have a great, solid risk management team working alongside the manager adds credibility to the manager,” he says.

Transparency Is Key, But Accuracy Is King

While transparency is important, accuracy is critical. If managers do not have proper data, all the analysis and transparency in the world will not help them make good investment decisions.

“The Advent view of the world is that everything is based on accurate accounting information,” Momsen says. “If people have data in spreadsheets, and the information in someone’s hand is not accurate, then the firm can make erroneous decisions, and that can allow them to be under-margined or over-margined; thus resulting in trading errors.”

Rachel Minard, president of San Francisco-based hedge fund Cogo Wolf Asset Management, agrees that the most important thing for her is to get accurate data so that her fund managers can make informed decisions.

“New technologies and the costs associated [with them] are not the biggest challenge, but rather procuring the relevant information to inform the investment team’s top-down views,” says Minard, whose firm employs a combination of both in-house and outsourced technology and software. “Almost all hedge fund data is historical. Constructing the appropriate optimisation model and programming the relevant stress tests to properly inform the portfolio manager’s macroeconomic views takes time and must be customised. It is not the complexity of the technological screens that will impact an investor portfolio, but it is the hedge fund manager’s proper interpretation of the information that far surmounts the aesthetics. All said, consistency and content outweigh all else.”

The Prime Focus

In the past year, the wisdom of the proverb warning not to keep one’s eggs in just one basket proved true once again. When Lehman’s basket had the table knocked out from under it, the hedge funds that used its prime brokerage services were left with egg on their face. Therefore, hedge funds are now using more than one prime broker. This, of course, comes with its own set of operational issues.

“Most systems out there were either built by broker-dealers or bought by broker-dealers. As a result, there was a lack of willingness to work with other broker-dealers,” says Bo Vastine, director of sales at Advanced Financial Applications, a technology company that provides a platform to help traders manage their workflow in a multi-prime environment. “When you began to see not just the large hedge funds, but the medium and small hedge funds moving toward a multi-prime scenario, the system that they may have been using for their single prime could no longer facilitate the workflow for their second prime. That meant a lot of manual processing, even cutting and pasting.”

Vastine says that what hedge funds are looking for is a system to tie these multiple primes together, with some important considerations to take into account, such as ease of use, ease of integration and connectivity.

“A system like ours that is agnostic allows them to generate those end-of-day files to multiple prime brokers and custodians,” he says.

Advanced Financial Applications currently works with 23 different prime brokers, and its open architecture allows it to be fully customised to the users’ needs.

Picking Your Providers

While there are a multitude of factors for hedge funds to consider when selecting service providers, one long-time industry expert says that hedge funds are not, in fact, actively selecting their service providers, which can be a costly mistake.

“The due diligence that hedge funds do when picking their service providers is horrible,” says Jeffrey Rathgeber, co-founder of hedge fund consultancy Pelorus Advisors. “If you go to those meetings where hedge funds are picking a fund administrator or a prime broker, they [fund managers] let the prime broker run the show.”

He also says that hedge fund firms often let pre-existing relationships influence which providers they use, even if that provider is not the best one for the given task. He points to a case where one of his former hedge fund clients traded bonds through Goldman Sachs and traded equities through Lehman Brothers.

“The managing partners had their minds set on it because those were their existing relationships,” adding that at the time, “Goldman was the king of equities and Lehman was the king of fixed-income. They had it backwards.”

Rathgeber says that no matter what the software or type of technology a fund is thinking of using, the managers should make a list of exactly what they want or need from a system, and then give that list to the service provider well in advance of the presentation. That way, the service provider will have time to put together a presentation to show the manager exactly how the system or software can perform those stated tasks.

“If you look at a hedge fund, the amount of operational effort that is spent recreating the world that they wanted all along but never really communicated effectively is staggering,” he says.

The Road Ahead Could Be Rosy

While some hedge fund investors may use the tough economic environment as an excuse to sit on the sidelines, some see a reason for optimism. In fact, according to one investor and manager, there may never be a better time to make money.

“In an environment like this there has never been greater opportunity,” says Scaramucci, who will be rolling out the third SkyBridge fund of hedge funds later this summer. “First, there is a tremendous amount of talent still looking for homes in the musical chairs of Wall Street and hedge funds. Second, there is a shortage of capital. People are fearful to put money out. And third, you add to that distressed prices and that sets up pretty well for good investment opportunities.”

But to profit from those opportunities, hedge fund managers need to adapt to the changing needs and requirements of investors and regulators, as well as those of a changing marketplace.

This article first appeared in FINalternatives Hedge Fund Technology & Trading 2009.