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
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
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
Operational efficiency is a crucial part of the investment
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