Seven Laws of Hedge Fund Physics

The emerging environment in 2014

Originally published in the January/February 2014 issue

When we talk about the new fund reality, we don’t mean just the current state of the industry. Traditional fund models used to abide by certain, unspoken rules – rules that, combined with pedigree and market share, could be a reliable roadmap in hunting alpha. But going forward, as the industry clings to continuing regulatory and market shifts, emerging managers will need to be vigilant in the struggle to stay competitive, drive capital, and keep overhead costs below fee margin levels. How will new managers move forward in an unexplored territory of changing fee structures and innovative technology choices?

Here are seven new laws of the emerging fund universe that will govern how funds take advantage of an environment in flux, yet ripe with opportunities for growth.

1. Outsized optimism does not drive outsized allocations
On average, smaller funds deliver better returns. But industry trends still point to larger funds winning more new allocations. Since 2008, new allocations have continued to flow to the largest managers, capped off in Q3 2013 when $18.7 billion of the $23 billion of net new capital, or 81%, went to hedge funds managing $1 billion or more. Continuing this trend, investors still heavily allocate to the largest funds – despite the fact that over the past five years, small funds have outperformed their larger peers by around 2.5%. This is making it tougher for emerging managers to raise money, translating to a difficult market when it comes to raising capital.

The bottom line: investors are still paying more fees to the largest, most established hedge funds in return for greater transparency, despite lower returns compared to their smaller peers.

2. There’s a new sheriff in town
Gone are the days when institutional investors would allocate to hedge funds based solely on managers’ performance. Where family offices, high-net-worth individuals, and funds of funds were the key sources of early-stage or seed capital for hedge funds, today pension funds, sovereign wealth funds, and insurers are commanding the attention of fund managers because of their out-sized bets on alternatives. Combined, these new institutional investors are more conservative and more demanding than ever before, requiring and expecting vastly greater portfolio and operational transparency. Because of this cultural shift in the fund-investor relationship, they (institutional investors) have become the new regulators.

Emerging managers can only address institutional investors’ new role as regulators with the right institutional-quality infrastructure.

3. Fee will be free from ops
In the next year operational credibility will continue to be a game-changer. Ultimately, this is the ability to instill confidence with investors through the processes, controls and infrastructure in place to manage trading and risk, reporting, BCP, corporate governance and disaster recovery.

More and more service providers are coming to the table with solutions that speak to new situation-specific demands of automation, transparency and institutional-quality services, while simultaneously lowering infrastructure costs – creating greater operational alpha.

Funds don’t have to rely on an outdated partner, vendor, or third-party technology to run intra-day activities, report over time, or scope runway.

4. Risk will be king
Performance used to be the yardstick by which all fund managers were measured. Fast forward to today, where performance is still critical, but risk management will reign supreme as a primary indicator of success for investors, and compliance for regulators. A new launch or existing fund looking to separate itself from the noise of other funds will need to clearly communicate at any time how the fund is taking advantage of, and/or limiting, the myriad of portfolio and market risks in stable and volatile markets.

Unfortunately, a vast majority of buy-side risk systems cannot produce real-time risk analytics. This complicates how fund managers actively manage their portfolios, or the ability to unify real-time risk statistics, performance and P&L – for instant insight, optimisation, and mitigation.

As a result institutional investors have crowned ‘risk’ king, demanding small hedge funds rely on real-time analytics to identify, understand and mitigate risks in the portfolio.

5. Best-Ex, just a piece of the puzzle
The fates of prime brokerages and hedge funds have been tied for many years. Through primes, fund managers can access a suite of specialised services including trade execution, international market access, cap intro, business consulting, futures clearing, cash trading, derivatives, and synthetic financing. But the modern fund community is transforming into a complex ecosystem – one where execution doesn’t define a new investor’s acquisition or trust alone.

In order to achieve more transparency while weaning themselves from single-prime models, it will be more critical than ever to have the right technology that supports full portfolio activity, including risk.

6. The present is more important than the package
The cloud is about what’s in it, not that it simply exists – cloud computing goes far beyond eliminating IT and reducing costs. And managers are becoming more mindful when selecting technology – seeking out solutions that complement their fund businesses.

Continuing the cloud conversation, the wider industry will debate private versus public clouds, further contemplating what is in the cloud versus where it comes from. Private clouds are typically built for specific and specialised use cases, with tailored security to ease concerns around sensitive data. Choosing a public cloud provided by de-verticalised entities like Amazon might not offer the level of sophistication, security, and reliability the hedge fund community needs.

7. MAP-ping out your future
The recent popularity of managed account platforms (MAPs), which capitalises on the push towards increased checks and controls from investors, offers small and emerging managers an opportunity to compete for capital alongside more established funds. While fund managers might consider a MAP similar to running a regulated mutual fund due to the limits set in the mandates, MAPs are a potential new revenue stream in a market that continues to be tight on new allocations to the smaller managers.

Managers looking to take advantage of MAPs need to address some key operational aspects of the business, including a robust order and execution management system (OEMS) that includes sub-millisecond monitoring of pre-trade compliance, and risk, to ensure trading activity does not breach investment mandates, before a trade occurs.

MAPs will continue to be a resource for managers but have the potential to de-risk institutional investors’ allocations to emerging managers through tighter controls on the risk/reward ratio, operational security and transparency.

Branden Jones is global head of marketing for Liquid Holdings. Prior to joining Liquid, Jones managed Vestek – a portfolio and risk analytics business line at Thomson Reuters. He started his career in trading and risk management in 1997 and holds a Bachelor of Arts in Communications and Economics from New York University.