Hedge Fund Technology

Operations and industry trends for 2019

Steve Young, Marketing Director, EMEA & APAC, SS&C Advent

The same, better or worse? The global hedge fund industry endured a tricky 2018. Aggregate performance reversed into negative territory for the year, more hedge funds shut than opened, and fees, costs and margins remained under pressure. But what will 2019 hold?

Roger Woolman, Business Development Director, Asset Management & Alternatives, and Will Broadway, Sales Manager, Alternatives at SS&C Advent, talk about the key issues that we’re discussing with industry participants, and give their views on the major technology and operations trends most likely to affect the hedge fund sector in the coming year. 

Will new tech or old tech come to the fore?

Technology has become a critical enabler for hedge fund managers and the service providers that support them. Managers increasingly rely on sophisticated front-office solutions to help achieve market-beating risk-adjusted returns. Meanwhile, automated and integrated middle- and back-office infrastructures deliver the operating and compliance efficiencies hedge funds need to curb costs and maintain their profitability in an era of tightening fees.

With everyone looking for the slightest competitive edge, new technology innovations inevitably generate fevered interest. But despite the buzz around distributed ledger technology (DLT), artificial intelligence, cryptocurrencies, smart contracts and similar developments, most are yet to have much real-world impact—and probably won’t in the near to medium term.

“Look back to the developments that were talked about five or 10 years ago and many still aren’t widely adopted,” notes Broadway. “Even the shift to completely paperless processes hasn’t been fully achieved. Cloud, mobile, big data and systems consolidation have all been heavily discussed and promoted for some years, but adoption remains patchy. So it can take time for an innovation to graduate to a trend and then a real-world necessity.”

Big data has become the most widely used of these “older” innovations, with the majority of the leading hedge fund players now consuming huge and varied datasets. “By contrast, while firms still care about cloud and mobile initiatives, many have yet to fully engage with them,” says Broadway.

Despite the buzz around distributed ledger technology (DLT), artificial intelligence, cryptocurrencies, smart contracts and similar developments, most are yet to have much real-world impact—and probably won’t in the near to medium term.

Cloud on the rise

That is changing though. Cloud adoption in particular is growing and will remain an important trend through the coming year.

“Five years ago, people were sceptical of hosted solutions,” notes Woolman. “Firms used to be concerned about control and data security. But as cloud solutions have matured, those worries have faded. We’re getting to the point where cloud acceptance and adoption is becoming the norm, especially among new and more agile hedge funds. And the large funds with big existing infrastructures are seeing that cloud offerings could provide an easier, quicker, cheaper and more secure alternative to an on-site installation.” 

Mobile offerings and delivery of trading and performance-related information to investors are another work in progress. “Few hedge fund managers publish information via mobile platforms,” says Woolman. “And while the fund administrators are starting to offer a self-servicing model for managers and investors, most aren’t there yet.”

The slow progress is in part due to challenges around the timeliness of data, notes Woolman. “You can’t just publish PDFs to a portal and call it mobile delivery. People at least need to be able to interact with the data and, better still, manage their accounts.”

DLT leads the way

The question of priorities also comes into play … a factor that will have a big impact on how far and how quickly the newer breed of technologies will develop and be adopted. 

“From our conversations with market participants, hearing about the ambitions and problems they have, I think distributed ledger technology has the most likely chance of succeeding,” reckons Broadway. 

The fund industry is built on sharing information. Making sure all the data is correct when different trading partners, custodians, prime brokers and fund administrators have their own version of the truth is difficult though. 

“Distributed ledger technology in its broadest sense could therefore shake up the industry — although given some powerful players potentially stand to lose out from its widespread adoption, they will most likely be the ones to drive DLT forward in order to control how it is used,” says Broadway. 

Activity to date has focused on areas such as trade confirmations and settlements, since DLT offers clear advantages in simplifying and speeding up processes. Where Woolman sees further potential is for distributed ledgers to replace share registers for investor-level recordkeeping and servicing. 

“That could change the way funds are administered beyond 2019,” he says. “The point at which somebody issues tokens rather than shares in a fund is an exciting prospect, but I think it’s some way off. Overcoming platform interoperability issues and the regulatory barriers will be hard. Smart contracts may also be necessary where you have, for instance, investor cooling-off periods.”

AI potential in its early stages

Artificial intelligence could be even more transformative, according to a recent TABB Group survey1. Respondents cited AI as the most disruptive technology to their businesses. Two-thirds of capital markets firms are at the planning/research stage of implementing AI at a minimum, with AI/machine learning approaches used primarily in investment decision-making processes. 

However, use cases, and the potential for widespread adoption, are at an early stage. Data quality was flagged by the TABB survey respondents as the biggest challenge to further adoption and is a particular concern for the buy side.

“Artificial intelligence, natural language processing and neural networks in front-office solutions offer considerable potential to take systematic strategies forward,” says Broadway. “These come with risk, but I am sure all three technologies are currently being applied in some form or another by hedge funds.” 

Where Broadway expects to see more near-term application is in the use of robotic process automation for simple processes, or data handling and manipulation. “The number of trades firms do, and the amount of data and processes they handle mean more and more will need to be automated.” 

While efforts around new technologies such as DLT, AI and RPA will make progress this year then, the industry focus for 2019 is likely to be on more fundamental business transformation projects, such as cloud platform implementations and systems consolidations, to improve existing infrastructures. 

Another priority for the coming year, as it is every year, will be cybersecurity. Every point of data exchange is a potential security weakness. And as firms rely ever more heavily on technology, the susceptibilities grow. 

“That is another reason we see many firms switching to cloud offerings, as they offer more robust and up-to-date protection than firms can maintain in-house,” says Broadway.

Operations play critical role in hedge fund health

The technology developments seeping through the industry will also have a big impact on firms’ operations, as the two become increasingly intertwined.

Woolman and Broadway see four major operations trends gathering pace through the coming year and beyond: further systems consolidation; the incidence and role of proprietary technology; an increase in shadow accounting; and an intensifying focus on doing more with less.

1) IT consolidation

After the explosion in best-of-breed vendor technology that has taken place over the last 10 years or more, industry participants are now embarking on a programme of systems consolidation. 

“Firms are seeing the drawbacks of training staff to use all these different tools, and having to deal with disparate vendors and a multitude of system integrations,” notes Broadway. “That takes time and adds cost.” 

The proliferation of accompanying databases also means firms have to manage and reconcile multiple versions of the truth. On top of this there is often an overlap of system functionality.

“Firms begrudge the cost of paying multiple vendors, particularly when there is systems redundancy,” says Woolman. “We’re not in the gravy years anymore. There is a lot more competition for investors’ money, and it is harder to make a profit. So I think the consolidation trend will continue in 2019 as firms double down on systems and costs.”

2) Role of proprietary technology

Proprietary technology raises similar cost and capability considerations. In-house built systems may provide tailor-made functionality that can deliver a competitive edge, but they come with significant development and maintenance overheads. And adding new business, funds or asset types as a firm seeks to grow or pivot can be complex and inefficient.

“Vendor technologies tend to have broader capabilities, so they can accommodate different asset classes or structures, and give the desired scalability,” notes Woolman. “Vendors also have the R&D budget to keep up with the latest trends.”

Vendors are consolidating as well, as they seek to offer a wider variety of tools across more of the value chain, he adds. “Through a combination of M&A and systems development, vendors are getting to a position where they can bundle that best-of-breed functionality and comprehensive asset class coverage with the front-to-back integration piece — as well as offering the hosting and support for those systems where required.”

Woolman and Broadway believe the shift away from proprietary systems is clear and ongoing. Yet proprietary technologies still have their place. 

“We see hedge funds now taking more of an intelligent return on investment-focused view of where to spend money,” argues Broadway. “More and more, firms recognise it makes little sense to build middle- and back-office capabilities that are industry standard, like a portfolio accounting system, reconciliation solution or matching engine. Instead, they get the most bang for their buck by spending money on developing new front-office algorithms or systematic strategies. So where proprietary technology persists, it will be ingrained within the front office, especially where firms are trading esoteric and illiquid assets.”

Stricter operational due diligence processes are playing a part in this division of labour too. 

“The environment has changed,” notes Woolman. “Not just in terms of cost control, but in firms’ regulatory reporting and compliance requirements, and in the move into different types of funds such as UCITS to attract investors. An investor might be happy for a proprietary algorithm to send their money all over the world, but increasingly they want to know where their assets are at all times, and that they are accounted for correctly. And investors want a recognised systems provider to do that.”

3) Emphasis on shadow accounting

Investors’ growing operational expectations are also feeding into the third trend identified by Broadway and Woolman: the growing demand for shadow accounting. 

As we noted in a previous article in The Hedge Fund Journal, a robust shadowing capability provides hedge funds with multiple competitive benefits. As well as satisfying allocators’ operational due diligence demands, a shadow accounting infrastructure enables hedge funds to monitor, control and reduce market and operational risks; create and deliver reports faster to meet clients’ service expectations; provide consolidated real-time data to enhance decision-making and improve performance; and provide valuable operational flexibility and autonomy from their third-party administrators.

“Any hedge fund managing, or wanting to manage, institutional money will need to shadow,” says Broadway. “Competition for assets is intense. And if you want to attract those clients you have to operate in a certain way.”

4) Doing more with less

With competition for assets continuing to grow, hedge funds will be forced to re-evaluate and enhance how they service clients. Demand for sophisticated technology capabilities and integrated infrastructures will grow in tandem. 

The big challenge for firms will be to continue delivering on client’s evolving service expectations while keeping a tight rein on costs—especially in today’s fee-squeezed environment. Which will mean doing more with less.

“Funds are chasing marginal gains in each and every process as they strive to scale back their total cost of operations,” says Broadway. “All efficiencies count, because the fees are not flowing like they used to.”

As we head through 2019, therefore, the focus on core competencies, and for firms to seek ways to augment their operations, will become even more pronounced.

“Hedge fund managers should be spending their time generating return,” Broadway adds. “And wherever possible they should leave the rest to partner providers with the expertise to handle it.”

One trend Woolman expects to see is more co-sourcing arrangements. “For a long time, hedge funds have been able to outsource aspects of their middle- and back-office operations to a fund administrator. Co-sourcing—where a software vendor provides additional support services alongside the systems the fund has licensed—offers some of the efficiency benefits of outsourcing, while allowing the hedge fund to retain independent control over their systems and data.”

Focus on alternatives and alpha

From our conversations with clients and the wider industry, it is clear that fees and costs—and the emphasis on technology and operating efficiencies to combat those pressures—will remain a critical focus for the coming year. As will the need to drive top-line growth.

In the battle to attract allocations, the industry’s two-pronged shift towards illiquid alternative assets in search of higher returns and liquid alternatives to drive inflows seems set to continue. 

“The increase in activity in illiquid asset classes, notably private equity and real assets—as well as the adoption of different wrappers or vehicles for those—will be an ongoing feature as managers target the big institutional asset owners,” says Woolman. “Meanwhile, roll-outs of liquid alternative offerings, as hedge funds seek to leverage their expertise to tap into a more mass-market audience keen to diversify and boost investment returns, are a no-brainer for firms wanting to expand their investor base.” 

Investor demand for enhanced risk-adjusted returns at this late stage in the cycle could also herald a shift back towards active management. But where that money goes will be interesting to watch.

“Investors no longer necessarily allocate based on brand name and historic reputation,” reckons Broadway. “Investor sophistication and the availability of performance data mean there is more scrutiny now than seven or eight years ago. Investors only want to pay for proven alpha and diversification. So money will flow to those managers that can demonstrate performance and offer unique capabilities that are difficult to replicate in-house or via low cost passive alternatives.” 

And this emphasis on only paying for real diversification and proven alpha is reflected in the more flexible fee structures that are starting to emerge, adds Woolman. For example, with the “1 or 30” model, investors pay a 1% management fee if the fund is below its benchmark, but a 30% performance fee if it rises above.

Conclusion

Fee pressures, alternative fund structures, diversification into more illiquid asset classes and heightened investor scrutiny over performance may not be new for 2019, but they will continue to gain ground in the coming years. 

“Hedge funds will need high quality and responsive support in this changing environment,” says Woolman. “We may not be able to predict with certainty how the industry will fare over the next 12 months, but what we can promise is that SS&C Advent will be there to work with and help our clients, whatever challenges and opportunities they face.”

Footnote

1. Big Data, AI and Machine Learning Adoption: Where Are We Now? By Tim Cave, TABB Group, 18 December 2018.