A Flexible Approach to Risk Management

Imagine's formula is winning fans in the hedge fund industry

STUART FIELDHOUSE
Originally published in the April 2008 issue

Last year was a wake-up call, if one was needed, that more hedge funds and their investors needed to be paying closer attention to their risk management capabilities. We are seeing a cultural shift in this industry towards a more formalised approach to investment management, with hedge fund clients increasingly insisting on more transparent, regular reporting, which can be matched to quantifiable risk profiles.

It is a climate that will reward those technology providers with robust and easily applicable platforms that can help fund managers manage risk effectively, and throw in the sort of sophisticated reporting tools which investors are increasingly coming to expect. If the CIOs of some of the larger, well-established funds of hedge funds are anything to go by, even relatively new hedge fund operations are now being asked to make sure they have institutional-grade risk management systems in place from the start.

Imagine Software was launched in 1993, and has therefore had the opportunity to go around the block a few times, and see its systems being used by clients throughout a wide range of market scenarios. Although it is not something that some technology buyers dwell on, it is this history, stretching back over 15 years, that stands Imagine’s product in good stead when it is being deployed. We’re not talking about theoretical protocols here: this is technology that has been through the wringer and come out the other side.

“Risk management requirements are tightening up,” says Lance Smith, one of the founders of Imagine, and still at the helm of the company. “In the post-SocGen and credit meltdown environment, risk management is in the ascendancy. It is going to impact on what traders can and cannot do, on the way they model their risk presentations. The degree of challenge depends on your strategy, of course.”

The Imagine Trading System (ITS)

Imagine’s core product is best described as an advanced, real-time portfolio and risk management solution. It was originally written as a sell-side enterprise-application for large financial institutions. Now, however, you don’t need to be a Credit Suisse to use it. Thanks to the march of technology, it can be accessed as either an in-house enterprise installation, or as an ASP-based system via Imagine’s web portal, www.derivatives.com. The ASP solution is chosen by those firms that want to access market and value-added data and processing services along with the software. It also gets rid of the costly IT support requirements that might be needed if the ITS was installed on-site. The ASP route is, in short, the best solution for the small and medium-sized hedge fund operation.

Imagine’s platform is a flexible one, capable of handling a wide range of asset classes, including FX, swaps, and exotics. It can support the popular hedge fund trading strategies, including stat arb, volatility/dispersion, and convertible arbitrage. As with many other successful financial IT products, its creators have focused on keeping it intuitive, with easy-to-use filters that can provide a snapshot of any set of positions the portfolio manager might want to look at. They can be filtered via a range of criteria, including industry, security type, time period-specific position changes, or trade-specific positions.

On top of this, P&L is provided in real time in both mark-to market and mark-to model terms for OTC instruments. The range of sub-components featured include realised, unrealised, interest income, fees, and commissions for multiple periods. Historical data is highly configurable, and all data is made available at the individual position level all the way to multiple user-defined ‘roll up’ totals. Want to view thisby trader, account, or sector? No problem.

It is this level of interactivity that seems to be winning Imagine its fans in the hedge fund community. ITS deploys over 800 pre-defined data and calculation display objects (portfolio columns) which users can mix and match at will to create individual views, be it risk, P&L, or position overviews. The derivatives.com platform can also help the portfolio manager travel beyond ‘every day’ securities, by allowing him to create specialised securities. This can be achieved by bundling a group of options and trading them as a unit. Straddles, butterflies, and other combinations can thus be simulated.

Users can also access hundreds of pre-defined, industry-standard analytic calculations and data objects, but the technology also lets them build their own ‘custom columns’ using Imagine’s proprietary macro language. This involves either the construction of variations on the established portfolio column component, or the assembly of entirely new creations. It is this level of customistation that is proving to be attractive to many of Imagine’s hedge fund clients, particularly as some strategies move into more esoteric areas.

Smith is at pains to point out that using ITS doesn’t mean that data can’t be customisable in-house to a high level of specification – additional layers can be built on top of the ITS should a larger firm want to do so. Some ASP-delivered systems sacrifice that level of customisation in the process. Imagine’s doesn’t.

“You can create your prime broker’s calculations within our system,” he says. “You can stress-test the margins, create your own stress tests, and keep track of leverage. We can build the interface with a client’s prime broker that this requires.”

And while, like its competitors, Imagine can deliver end of day risk reporting, it can also provide this on a real-time, intra-day basis, “live and interactive,” as Smith says. “You can see the impact on your positions immediately.”

Pedigree

Canny purchasers of financial technology should be concerned with the firm backing the system they are planning to have their business depend on. A great piece of tech can fall down if it is not adequately supported, and if its creators are not continually involved in improving it.

Software, and more importantly, software used to provide a detailed picture of positions in the increasingly complex securities markets, needs to be dynamic. Imagine itself was founded by a handful of technical and financial experts who emerged from some of the biggest names on Wall Street in the early 1990s, and have stuck with the firm since, avoiding the temptation which some risk management specialists have fallen to, that of selling out to a larger provider which might then deviate from the original vision of the core product’s creators.

Imagine is not a small shop, mind you; it has hundreds of staff employed on four continents, and offices in New York, London, Sydney, and Hong Kong. The launch of its ASP product in 2000 meant that its capabilities were opened up to a much wider market, including hedge funds. It now boasts thousands of users, what it calls a “significant prime broker relationship” with Credit Suisse, and is widely considered to be one of the more established providers of on-demand derivative trading analytics.

Like other successful software companies, Imagine is alive to the fact that it is quality of service, and the degree of support users of its technology receive, that can really help to differentiate it. Consequently, it has a professional services team that provides training, and can advise on bespoke projects using the ITS technology. This might involve new models, some of which Imagine builds on its own time, or new configurations of existing data. “We can give our clients the default settings, and we can advise on how they can improve on the use of our system,” says Smith.

The clients

Imagine’s client list speaks for itself. It supports a massive range of financial institutions, from large to small, all with differing requirements. There are various reasons given as to why they have turned to using the ITS technology, but usually it is because of a perceived inadequacy, either in the models they constructed and used internally, or the analytical support being delivered by a third party service provider. In the hedge fund space, the use of more sophisticated or exotic instruments has prompted more than one firm to turn to Imagine. It can also be cost-effective, as hedge funds seek to keep their head counts down while managing ever larger and more sophisticated portfolios.


According to one manager, the system “allows us to get a better handle on our portfolio risk in a centralised way across all our traders. If something happens to the volatility term structure of the index, we know that our position is in real time, and in conjunction with our pricing tools and intuition we know how to take advantage of that change.” When the firm’s positions become unbalanced in any way, the problem can be tackled in a timely fashion. And everyone can see if something is happening to one of the stocks in the portfolio, not just the trader assigned to it.

Smith feels this is the ideal solution for hedge funds. “To maintain a system like this internally would require plenty of resources,” he says. “If you’re a start-up, you want to get off the ground cheaply. Because we just charge by the month, we don’t represent a big up front cost. It would take six months alone to get your spreadsheets together otherwise.”

In-house development of a risk management system from scratch is costly, plus the manager is taking on the additional risk of having to maintain and securely back up their own database. After a while, the overheads for the DIY solution start to stack up and eat into profit margins. And if that isn’t bad enough, a couple of big glitches can start to compromise the credibility of the fund manager in the eyes of his investors.

“Our decision to go with Imagine was based on a number of factors, although there was one trump card, specifically the breadth and depth of instrument coverage and flexibility,” says Mohammad Ahmad, the COO and CRO at Global Macro Investments in Switzerland.

“We are a global macro fund and therefore need that level of functionality. Secondly, we found that the configurable and practical approach to risk management and budgeting was a key determinant on how the product was integrated into our portfolio construction and rebalancing process. Last, but not least, as a result of the work that Imagine engineers did with real time interfaces with our PB, we have been granted full capabilities in trading, execution, and position keeping.”

Overall, Ahmad points to two key services which he thinks makes Imagine very successful: their very flexible approach to deal aggregation leading to any specific permutation of reporting views, and their assiduous support team.

One of the additional benefits of an ASP solution is of course the disaster recovery bonus. While a lot of hedge funds are still relying on their prime brokers to varying degrees for back-up, Imagine is now setting up its own DR site for its clients. Such additional back-up can only help when it comes to the sort of detailed operational due diligence investors are used to conducting today.

Conclusion

Although it remains difficult to assess Imagine’s market share, according to Smith, his primary competitor is RiskMetrics on the vendor side, while in the portfolio management equation it is Linedata (Beauchamp) that Imagine bumps up against. But Smith feels his real competitors, and this is borne out by client reports, are in-house systems, either those supplied by prime brokers, or those developed internally. It is when these start to creak, or a major client turns up and expresses their unhappiness with the riskreporting function, that many managers are turning to Imagine for a tried-and-tested ASP solution.


Biology

DR LANCE SMITH, CEO

Dr Lance Smith is tasked with setting Imagine’s strategic direction, and is responsible for guiding the ongoing development of its analytics. He also closely involves himself in the firm’s sales efforts. He has a combination of business and academic credentials that have stood him in good stead in this role, and can look back on over 20 years of experience in trading and risk management, mathematical modelling, and system development. Prior to founding Imagine in 1993, he was head of the equity derivatives trading desk at Sakura Global Capital. He started his career in 1986 at Salomon Brothers. He has a PhD in mathematics, and is a professor of mathematics at Columbia University.