Reinventing Hedge Funds

The effect of the September 2008 crash on the industry

Originally published in the September 2009 issue

The September 2008 market crash has shaken up the hedge fund industry. Investors have withdrawn almost $300 billion from hedge funds over the last three quarters as they look for the industry to justify management fees in the face of significant risk, losses, and the dreaded “gates”. It is only a relentless focus on core competencies to marshal resources toward differentiating strategies that will generate alphaand allow effective risk management and ultimately provide competitive advantage.

Risk management – as the first step toward regaining investor trust – across all facets of a hedge fund’s business has become crucially important as new hedge funds navigate a barely recognisable and heavily regulated post-crash marketplace. Investors demand that managers move beyond VaR in evaluating portfolio risk, and demand increased visibility into operational and technological risks. Concurrently, investors struggle to understand the implications of the surprising correlation of many hedge funds with the movement of the broader market.

This new risk landscape demands innovation of hedge fund managers in the areas that drive returns: portfolio formulation, strategy development and trade sourcing. In response, managers demand technology and business model innovation of their vendors and suppliers to retain a high degree of control while allowing focus on alpha generation. Movement toward sponsored access on the buy side, and to outsourced trade execution infrastructure on the sell side, are both driven by a demand for new approaches and new business models. In fairness, some other related trends are not new. The move to multiple prime brokers, unbundling of research and execution from clearing services, and the increased use of low-touch trading services all preceded current market volatilities. However, the pace is quickening. NASDAQ manages its Market Replay service in the Amazon computer cloud and Marketcetera and the NYSE are going to market with a managed, hosted trading application. Inflexible proprietary systems targeted at the buy side will become a thing of the past as scalability, performance and price pressure drive new approaches. Flexible, manageable solutions that do not swallow up internal resources with maintenance, integration and implementation headaches will provide the only way to survive.

By the numbers
“In this new marketplace, surviving hedge funds will still have to make investment decisions, place trades, manage risk, and report to investors,” says Matt Simon, research analyst at TABB Group. “These firms continue to react to the market’s unfavourable circumstances by adjusting strategies and trimming operations. While hedge funds’ investment in technology has been curbed because of reduced revenues, the front office has not suffered as much as other areas of the firm. In fact, software and services that support the investment process should even see growth in the near future.”

According to the TABB Group, even with conservative forecasts for hedge fund closures and IT spending cuts, there was a 40% drop in hedge funds’ total IT spending from approximately $1.45 billion to just $882 million in the 12 months following Bear Stearns. However, 2009-10 predictions tell another story, as TABB expects hedge funds to once again increase their technology budgets and overall IT spending should increase to accommodate their needs.

So, where will they spend?
Investing in risk management seems fitting in an environment where many have succumbed to a volatile and unpredictable marketplace. Having the capabilities to predict and simulate the impact of potential damage to a firm’s portfolio has become positively vital in this economy.

Innovate or die
Even in the face of shrinking budgets, adaptation is the key to survival. Hedge funds still must understand how systems are built to be able to react nimbly to new market conditions or regulations. The ability to make modifications to trading strategies quickly and easily becomes a key differentiator. Technology provided through novel business models can start to provide this level of flexibility with a minimum of management cost. Open source software as well as services delivered through an easily provisioned, pay-as-you-go cloud service model provides functionality with very low start-up costand effort (and therefore risk).

Formerly the domain of technology enthusiasts, open source software is now seeing extensive adoption on the trading desk, including at hedge funds of all sizes. Access to the source code means infinite flexibility without being beholden to proprietary vendor release schedules. This “control risk” remains the top reason cited for undertaking custom development projects on the trading desk. Organisations that have no internal software development, and even some of the largest financial institutions, can take advantage of the existing functionality in an open-source platform, and innovate where needed.

With an open source platform, evaluation cycles can be quick and unhampered by salesmen. Implementation projects can proceed along the customer’s schedule and can involve any preferred vendor. With fewer dead ends, and a quicker time to determine the value of a new trading application, distractions and ultimately opportunity costs can be minimised.

Enter the cloud
In the race to bring new ideas to reality, the ability quickly to scale and optimise increases in importance for trading applications. With sales cycles and procurement overhead for new hardware and network connectivity often extending to months, many organisations are left looking for a better alternative.

Cloud-provided services provide near-instant access to vast quantities of compute power. Through self-provisioning applications, a new application can be deployed and running in minutes. Increasingly vendors of general purpose cloud services provide applications on the same pay-as-you-go model as the compute power itself.

Specialised cloud offerings that cater specifically to trading applications are now becoming available. With a step in that direction, NYSE is an example of a traditional exchange that understands technology is a key part of the liquidity puzzle. By offering a managed service automated trading platform on the SFTI network they were able to marry a high-performance infrastructure and the agility of open source technology to meet the demands of the increasing numbers of traders accessing liquidity through the exchange. This type of easily-provisioned, fast and robust infrastructure allows unprecedented speed in rolling out new applications, while allowing the trader or portfolio manager the luxury of focusing only on the strategic elements of the build out: portfolio formulation, pricing and risk management logic.

As the capital markets edge their way out of the recession hedge funds will continue to slim down and bulk up at pace with market events. The technologies and business models that allow innovation and risk management without distracting from alpha generation will be the ones that stand out.

Graham Miller is the founder and CEO of Marketcetera, a provider of open source platforms for strategy-driven trading. He previously served as the director of electronic trading strategies at a hedge fund in New York. Before that he worked at Jane Street Capital making markets in equity options on the floor of the American Stock Exchange.