HEDGE FUND TECHNOLOGY

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Navigatingdangerous waters

Technology spend by hedge funds is on therise as they attempt to stay at the cutting

edge and stave off the ‘high risk’ moniker.Virginie O’Shea reports

may be a bubble about to burst. Someeconomists have released forecasts thatindicate hedge fund meltdowns couldslow the US economy. Turmoil in creditmarkets could therefore push upborrowing costs for businesses andconsumers and cause a ripple effectacross the market.

The woes of Long Term CapitalManagement (LTCM) drew attention tothe operational risk posed by hedgefunds and were partially responsible forthe labelling of these funds as ‘high risk’.As Nick Tyler, chief operating officer ofAdelphi Capital, notes: “The publicitysurrounding LTCM has shaped theperception of what constitutes a hedgefund manager but this idea of runningoperations off the back of a ‘fag packet’is not correct in the climate of strict duediligence procedures that exist today.”

Tyler believes there are a number ofreasons why the high risk moniker isincorrect. The business model of hedgefunds is simple and scalable, he says. Forexample, you don’t need to reworkcontrols and systems if you scale upfrom GBP2 billion to GBP20 billion.The availability of technology for start-ups and existing businesses is a benefit,as well as the fact that the commerciallysuccessful environment attracts a highlevel of staff in the front office. Thirdparty service providers also now have 10years of experience in providing servicesto hedge funds and this means that theyare better able to meet their needs, Tyleradds.

Conversely, as well as being labelled ashigh risk, hedge funds are also beingtouted as the solution to the market’sproblems. Due to their low correlation tomajor stock and bond markets, hedgefunds are considered by some to beindependent markets of their own. As aresult, many major investors perceivehedge funds as an insulated investmentvehicle that protects assets when moretraditional markets experience adownturn.

A recent example of the success ofthis strategy of betting againsttraditional markets is the returns thathedge funds betting on falls in bondslinked to US sub-prime mortgagesexperienced early in July. Hedge fundsemploying this strategy were estimatedto have achieved returns of around 40%and a USD2 billion fund run by Paulson

The hedge fund community iscoming under attack on a numberof fronts. For one, regulatory and

public scrutiny is on the rise. Rarely aday goes by without some mediaattention focused on the risks posed bythe hedge fund community to the widerfinancial market. There has even beenspeculation that the hedge fund boom

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& Co was the single best performingfund, rising 39.9% after fees in June.

Moreover, testament to the faith in theperformance of hedge funds is the factthat the largest US pension fund, theUSD245 billion California PublicEmployees’ Retirement System(Calpers), has approved plans whichcould see it double investment in hedgefunds as it seeks to reduce market risk.The fund has indicated that it willincrease allocations to corporategovernance and hedge funds from USD5billion to more than USD10 billion.Calpers established its hedge fundprogramme in 2002, when it investedUSD50 million in five hedge funds.

Regardless of whether the direpredictions come to fruition in the longterm or the future is rosy, all of thismeans that hedge funds are faced withthe short term problem: how to assureinvestors that their money is safe. Thisproblem is compounded by the fact thatlarger hedge funds are also becomingmore institutionalised and the boundarybetween traditional asset managementand hedge fund management has beensignificantly blurred. The extent towhich transparency should be imposedon hedge funds is up for debate and thiscould have a potentially negative impacton the ability of these funds to retaintheir competitive edge.

As Fabian Vandenreydt, acting head ofthe Securities Industry Division andLaurent Desnouck, market manager, FXand Derivatives, at Swift, explain,investors must recognise that the highreturn potential has a price. Putting toomuch pressure on hedge funds toincrease transparency will inhibit theirrisk taking and therefore their potentialfor extraordinary returns. Hedge fundsare, after all, investment vehicles that aregood for competition and helping todrive growth, Vandenreydt says.

Srikant Sharma, senior director ofFinancial Services at Interwoven, adds:“The scrutiny of the regulators has beena strong motivating factor for hedgefunds, as well as for the market as awhole. No one wants to have regulationimposed upon them, and so the threat ofthis alone has, to some extent, spurredthe industry on to look at ways ofminimising their operational riskthrough technology.”

David Smithers, head of IT for Hedge

Funds in Fund Services, UBS, feels thatthe influence of public pressure on hedgefunds is not the prime motivating factorfor the renewed focus on risk. “The morelikely cause is the investment manager’sdesire to tightly control risks andexposures, given that the pursuit ofalpha can lead to potentially difficultwaters without the right information athand,” he explains.

Despite the somewhat negative press,hedge funds continue to proliferate.According to recent estimates, hedgefund managers have launched 40% morefunds in the US in the first half of thisyear than in the same period in 2006.The biggest US launch in the first halfof 2007 was Carlyle Group's CarlyleBluewave, a multi-strategy fund thatbegan trading with an estimated USD2billion.

However, it is becoming increasinglydifficult to set up a hedge fund due to thebarriers imposed by higher legal andcompliance costs. Furthermore, due tothe focus on risk, it seems that investorsmay even be spending more timeanalysing hedge funds’ risk controls thantheir investment strategies.

Smithers explains: “Hedge funds areno longer regarded as too ‘exotic’ orultra high risk and the explosion ofgrowth of assets proves this fact.However, the large institutional investor,who can invest anywhere from tens tohundreds of millions in a single fund (ifnot billions in the case of some hugeglobal pension funds) has dramaticallyincreased the level of due diligence that

is being performed on potentialinvestment targets prior to anyinvestment being made.”

He believes that the medium sized andlarger hedge funds with well establishedinternal controls frameworks are copingadmirably with these requirements, butthat some of the smaller players maystruggle in this regard. “It should also benoted that due diligence hasstrengthened the case for complete

independence between the hedge fundand the administrators. Selfadministration is currently very tough tosell to investors,” he notes.

Bhagesh Malde, head of JPMorganHedge Fund Services in EMEA and AsiaPacific, agrees that the demand forincreased information and transparencyfrom investors is driving the increase intechnology spend. This requirement formore information translates to morefrequent valuations, for example themove from monthly to weekly and dailyvaluations, and the use of moreindependent pricing sources. “Hedgefund managers, partly driven by theirinvestors and regulators, do requiremore timely risk managementinformation. A number are increasinglyrelying on third party services for riskanalysis. Service providers, likeJPMorgan Hedge Fund Services, aredesigning their systems to outputinformation in a variety of formats fordifferent risk management services andtools,” Malde says.

Steve Miller, senior product manager,SmartStream Technologies, believes thata proportion of the technologyinvestment by hedge fund managers hasmoved from the front office to the middleand back office functions. This isparticularly apparent in obvious areassuch as derivatives, he says: “Majorexposures in derivatives, if notunderstood sufficiently, can lead todisaster, and one of the biggest and leastunderstood areas of risk in this respectis the loss of data quality post-trade that

still affects large parts of the derivativespectrum.”

However, one of the other impacts ofthe blurring of boundaries between thetraditional funds and hedge funds is thata number of hedge funds are nowattempting to cut their financing tieswith prime brokers. This process isachieved by raising their own permanentcapital, building in-house reporting andadministration capabilities and running ���

Conversely, as well as being labelled as high risk, hedgefunds are also being touted as the solution to themarket’s problems

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their own trading platforms. Thisdecision also inevitably requires asignificant investment in technologyplatforms and systems.

Don Finucane, vice president ofmarketing and product management forInteractive Data Real-Time Services,sees a definite increase in spending in thefront office in particular. “I can't speakfor the industry as a whole, but can saythat we have seen an increase inspending by hedge funds, particularly onthe real time services side over the pastyear, and mostly in the area of the frontoffice where our low latency data feed isused in electronic trading applications.We believe this increase in business isdirectly related to the increase indemand for low latency data as the

electronic trading markets have becomemore competitive and latency sensitive,”he says.

Jon Anderson, head of risk andoperations at BlueMountain Capital,explains: “Technology spend by hedgefunds has been getting higher everyyear. There are two reasons for that.Technology has become ever moreimportant as the volumes and types oftrades have been increasing. The realgrowth in the hedge funds is coming notfrom the small ‘mom and pop shops’,rather the larger hedge funds areachieving economies of scale by creatingmore efficient processes. This is thesame across Europe and the US.” Thereis no geographical division in spend butthere is a division in terms of the focusof the fund, says Anderson. “Where youare going to be seeing the mostinvestment, which is reflecting our ownbiases, is in the credit and interest ratemanagers, as it is the most expandingarea,” he adds.

This increasing technology spend washighlighted by a recent Datamonitorreport, which estimates that globalhedge fund IT spend could reachUSD3.3 billion by 2009. UBS’s Smithers

comments: “This spending is acrossseveral areas and varies from fund tofund depending on size, strategy andasset classes being traded. For somefunds, better internal back officeprocessing systems is the focus, whereasfor others, risk management is theprimary concern. Enhanced derivativesprocessing is also on many chieftechnology officers’ radars.”

Tim Murphy, managing director, Bankof New York Mellon, does not think theamount spent on technology by hedgefund managers has significantlyincreased over the last year. “I think it’sa broad category to characterise. Theway hedge funds spend money on theirinfrastructure varies from one house toanother. So I think their spending has

been probably about the same as it waslast year. I don’t think there is anythingparticularly extraordinary going on interms of new spend,” he says.

Murphy does acknowledge that theremay be different houses changing theirfocus one year to the next from front toback, but that this depends on whichhedge fund you’re talking about. Thefunds that have invested are generallydoing it out of a desire to controleverything in the trade lifecycle frombeginning to end, as opposed to facingregulatory scrutiny. He adds: “It’s allvery individualised so it’s hard to makegeneral comments, but at the end of theday, if regulatory scrutiny orinstitutional capital comes in, they’ll doone of two things: they’ll either invest intheir back offices and try to do itthemselves or they’ll go and leveragetheir back office providers and look formore service. Those are the two waysthey’re going to react, and of coursethere’s going to be some combination inthe middle.”

Swift’s Vandenreydt agrees thatspending varies according to the type ofhedge fund that is being discussed butcontends that overall spend has

increased, largely in the front andmiddle office areas. Large independenthedge funds have sophisticated and wellorganised operations and are able tohandle the entire lifecycle of their trade,relying on the prime broker mainly forfinancing purposes, he explains. Amongthis group, investments are rising andstrong efforts are being made to providetrue front to back office automation. Atthe opposite end of the spectrum, smalland medium hedge funds tend not toconsider operations as being in thecompetitive space and will also rely ontheir prime brokers for all downstreamprocesses.

“A substantial and increasing numberof hedge funds have become part oflarge financial consortiums and rely on

shared infrastructures to handle theirpost-trade services. Technologyinvestments are made at the group leveland shared throughout the businesslines. The front office, however, remainsa core competence and specificinvestments will be made to handle thespecific requirements from the hedgefunds arm(s) of these financesupermarkets,” Vandenreydt continues.

BlueMountain Capital’s Andersonbelieves that there is a move towardsbuilding more mature systems and that,by definition, is taking what might havebeen systems from the front office andbuilding out back office processing andrisk management platforms. “If you takea mature market, 20% of the spendingon systems is on the sexiest up-frontpart and 80% of it is the back for the‘heavy lifting’ that requires riskcalculations or transaction processing.As hedge funds are maturing andbecoming more business-like entities, asopposed to trader expertise focusedshops, they become more like multi-purpose hedge funds and processingbecomes more important. The focus ondevelopment in technology is movingtoward middle and back offices. That is a

Regardless of whether the dire predictions come to fruition in the long term or the futureis rosy, all of this means that hedge funds are faced with the short term problem: how toassure investors that their money is safe

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natural process. You could have said thesame thing about interest rate swapswhen that happened 20 years ago. Theinitial spend was on working how totrade this stuff and the real money wasspent on building the integrated STP,”he explains.

However, given the diversity of thefunds community, how can one platformhope to successfully meet the needs of

all? Anderson explains his experience ofoutsourcing at BlueMountain Capital:“The short answer to whether oneplatform can meet all hedge fundmanagers’ needs is no. But the firstquestion is then: how close can you get?And what do you focus on first? There Ithink our experience is not the norm, aswe are a derivatives heavy shop and wehave focused a lot on investing in ourprocessing of derivatives. We have atendency to rely on more establishedsystems for the processing of our moretraditional securities products. In ourcase there is a twofold reason for this:the real volumes lie in our derivativesproducts but also the systems aroundderivatives have never been as welldeveloped. The systems around equityand bond trading have been around for along time and there is therefore noreason to reinvent the wheel.”

There is a natural tendency as hedgefunds become bigger in size to bringcore competencies in-house, saysAnderson. If you are smaller you mightrely on your prime broker or youradministrator to help you withoperational support and riskmanagement, for example. As you get toa certain size, those risks become morescalable inside the business. “As we gotbigger, we brought in collateralmanagement, confirmations, a lot oftrading and STP. We established directlinks with our prime brokers too. Butthat is not to say that administratorsdon’t provide an attractive way to takeadvantage of their scale for lines outsideof your core competence,” he adds.

According to Vandenreydt, Swift

doesn’t believe one single outsourcedplatform will be able to cope with all ofa hedge funds very diverse requirements:“We’ve seen attempts at providing such aplatform, but the level of customisationis very limited and hedge funds thereforetypically have to complement these withother systems to cope with their specificrequirements. But one has to think aboutwhat activities would be better

undertaken collaboratively rather thanin competition. What really createscompetitive advantage?”

Swift therefore asserts that front officetools, including the ability to modelcomplex algorithms, as well as riskmanagement systems, will remainspecific because they do createcompetitive advantage. On the otherhand, some middle and back officefunctions could become more generic.The closer the trade gets to settlement,the more generic the platform could be,says Desnouck. If such a genericplatform were feasible, it would drivedown costs thanks to economies of scale

and scope. In addition, users of such aplatform would be more agile in meetingnew requirements. This ‘collaborativespace’ is where Swift focuses its efforts.“We aim to deliver solutions that deliververy tangible benefit our entirecommunity, without levelling theplaying field,” he adds.

Murphy is quick to assert that thisprocess of collaboration andstandardisation in the processing spacewill happen over a period of years ratherthan months. “You’ll find someparticular service niches that will have awider potential subscription frompeople, but there are no magic bullets.

The development of platforms, thedevelopment of standards, is arelentless, small step march towardsthat,” he explains.

SmartStream’s Miller adds: “The keylies in agile combination of suitablyengineered generic components.Productised solution offerings withquick time to market based on commonprocess layers, rather than engineered incode from scratch, stand the greatestchance of success.”

One of the primary areas to tackle interms of both collaboration andstandardisation, says Vandenreydt, is theindustrialisation of service levelagreements (SLAs). This can be donethrough the adoption of marketpractices and a common minimum SLA.JPMorgan’s Malde, on the other hand,feels that formalised SLAs are notneeded in the triangular relationshipbetween the hedge fund manager, theprime broker and the hedge fundadministrator. “All three parties shouldbe professional enough to work togetherto achieve their objectives. An SLA is notrequired if each party has clearresponsibilities which are well definedby the contracts that are in place withthe fund: the administration agreement,investment management agreement andthe prime broker agreement,” he says.

Rather than the imposition of an SLA,

Malde believes that communication isthe key to strengthening the relationshipbetween the three parties. “A commonmessaging format should be agreed andstandards should be put in placeregarding responsibilities anddeliverables. Furthermore, technologycan ensure that the passing of databetween all parties is both efficient andsecure. The more integrated the threeparties are from a technologyperspective, the more time human capitalcan spend on value added tasks,” heconcludes. Evidently, even in thecompetitive field of hedge fundadministration, it is good to talk.■

It is becoming increasingly difficult to set up a hedgefund due to the barriers imposed by higher legal andcompliance costs

One of the other impacts of the blurring of boundariesbetween the traditional funds and hedge funds is that anumber of hedge funds are now attempting to cut their

financing ties with prime brokers

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