Hedge Fund Evolution in a Demanding Environment

The need for a robust and world-class framework

Originally published in the April 2008 issue

A year ago, few would have predicted that the investment landscape would change quite so dramatically for hedge funds as it has over the past twelve months. However, the tendency towards universal pessimism is overdone. Certainly, hedge funds, so often on the cusp of innovation, have had a rough ride recently – and an early respite does not seem likely. But it is clear to many in the sector that, in this challenging investment climate, hedge funds are also experiencing the growing pains normal in a maturing industry.

Characteristically, hedge funds are waking up to the need to address shortcomings in their internal systems and processes, with the impetus coming from an increasing client need to understand where investment returns are being earned and the level of risk assumed in the process.

In addition, the growing popularity of funds of hedge funds has exacerbated the problem for many managers, where accurate reporting of performance and risk may only happen on a monthly basis. In the current market conditions, where bad news can mushroom out of nowhere and investors remain nervous about their exposure to many asset classes, even a 24 hour valuation cycle may seem too long.

An ever-changing industry

Outside of this, a number of other major factors are driving change in the industry: the dis-intermediation of prime brokerages services; increasing attention of regulators to the robustness of procedures; a focus on cost and service optimisation, especially in a year when many funds may have to live off management fees; and general growing pains as hedge funds move towards best practice operating models.

So, what techniques are available to these relatively immature organisations? The key operational issues often focus around many disparate activities, with little or no sharing or re-use of data. These problems tend to settle around the front-office/back-office interface or between the fund managers and their external service providers such as fund administrators, prime brokers and custodians. Increasingly hedge funds of all sizes are realising this and taking steps to mitigate the impact. Indeed, there are a number of tools and techniques, within business, technical and risk architectures, that can give hedge fund managers the edge.

In business architecture, logic abstraction techniques, developed within larger organisations, use tools that model processes and drive the workflow. A pre-cursor to much of this work is a basic understanding of the processes, how they differ between managers and how common activities can be leveraged. Often, opportunities for streamlining processes and establishing synergies are masked by attempts to highlight an individual manager’s unique approach. Managers should also examine data quality, management and manipulation. While sophisticated pricing and risk management models are essential tools, so too are reliable, timely and accurate sources of market and instrument data. All too often, these key ingredients reside in spreadsheets scattered around the organisation, supported by convoluted updating and validation techniques. Spreadsheets will never go – but ways of controlling the data and the integrity of the calculations are essential for maintaining competitive advantage.

Time to up their game

And so to business process re-engineering; all too often the trade process breaks down due to questions over late trade entry, fund allocation and associated valuation points. The process around performance measurement and attribution may often involve several iterations and backward adjustments particularly where funds of hedge funds are concerned. The error rate associated with data and process can be correspondingly high, adding to cost and, in extreme cases, financial penalties.

The second area where hedge funds have to up their game is within the technical architecture which supports their businesses. A re-think in the methodologies and tools needed to manage change is already being driven by the principal factors of growing business complexity and the diversity of third-party relationships, which support the business. Traditionally, hedge funds have never been short of bright and motivated staff. Nevertheless, reliance on a few good men has created hybrid roles and challenged the functional divisions, normally found in larger organisations. This has never been more apparent than in technology, and yet, as hedge fund businesses mature, those responsible for the technology are facing the double challenge of keeping the show on the road in a climate of heightened cost-awareness, while having to support the re-design of business processes and attendant software application enhancements.

The technical challenges affect service orientation and software development techniques. In response to the increasing need to share data between applications and functions, hedge funds are placing greater emphasis upon messaging services. This encourages deployment of specific datastores for necessary information and improves control and quality of data. So how do they reconcile the disparate needs of keeping small teams, delivering solutions quickly, while maintaining the necessary quality and control, commensurate with much larger IT organisations? One solution, actively pursued by some hedge funds, is agile software development techniques. Usually only suitable for a subset of all software development projects, agile does lend itself to many that arise in hedge fund organisations. Generally requiring the small, multi-disciplinary approach with which hedge funds are most comfortable, the adoption of agile development techniques requires discipline, cooperative working and cultural change, which can prove problematic in the beginning.

Stress testing is now key

Finally, hedge funds should consider their risk architecture. Of particular concern are liquidity risk, accuracy and speed in confirmations, and stress testing of market risk.

Measures of liquidity risk based on projected cash-flow matching, asset and liability matching, and scenario analysis, are key to a fund’s long-term viability. Liquidity risk is especially critical in funds of hedge funds, or funds investing in property, distressed securities, or less liquid markets, but it should not be neglected even for funds investing in securities on major exchanges. A worst case calendar for potential redemptions and margin calls should not be analysed in isolation, but combined with scenarios for market and credit risk. Separating liquidity, market, and credit risk into silos has proved dangerous.

Hedge fund operational risk is most apparent in the confirmation of OTC derivatives, where exposure is heightened by processing backlogs or systems that fail to adequately capture contractual data. The importance of correctly processing cancelled and modified trade orders has been underlined by European banks losses, but the lesson shouldn’t be lost on hedge funds. The independence of the back office is crucial for reducing hedge fund risk.

It is clear now that hedge funds’ approach to market risk must evolve. Recent market movements cannot be dismissed by an over simplified VAR analysis indicating this happens only once every 500 years.

Of course, pure market exposure is a blunt tool and some sophisticated methods need to be applied. ETL (estimated tail loss) is beginning to supplement VAR. But any method that assumes returns follow a normal distribution for losses is still crude. The main lesson is that stress testing of a portfolio is absolutely necessary and the results must be fed back into the liquidity risk control process.

In conclusion, the evolution of hedge funds is continuing through the current market turmoil. Pin-point focus on well-defined investment strategies will remain the key attraction and defining characteristic of hedge fund management. Nevertheless, such strategies need to be embedded in a robust and world-class framework in which investors, service providers, regulators and shareholders can have confidence. This requires continued investment in process, technology and infrastructure, as well as the innovation for which hedge funds are famous.