Technology and Trading For Start-Ups

Called to account

Originally published in the November 2007 issue

Trading strategies and the technology required to support them naturally form an important focus for start-up hedge funds. However, the need to set up a robust accounting system, underpinned by reliable technology, generally receives far less attention from hedge fund managers. Tony Swei, CEO, Tradar, takes a look at some of the criteria involved in creating a solid accounting platform and considers where some hedge fund managers go wrong.

For the start-up hedge fund, cost plays a very important role. Firms have tight budgets and are under pressure to show good returns, particularly in the early months of their existence. Expenses such as IT spending must be met from investors’ contributions and a fund which is perceived to be overspending might fail to attract subsequent investment. Consequently, hedge fund managers often try and ‘make do’ with low cost technology solutions. A typical case in point is the use of spreadsheets to manage the hedge fund’s portfolio of positions and its post-trade processes.

Finding the right tools

While useful, a spreadsheet is not the ideal tool to manage the considerable quantities of data that a hedge fund must use on a day-to-day basis, not only high volumes of trading information but also information relating to investor contributions or data from service providers such as prime brokers. It is, in essence, a two dimensional tool being used to solve a multi-dimensional problem. If a fund is small and only makes a handful of trades per day, managing on spreadsheets is a sensible, low cost option. However, when the volume of trades starts to grow and the complexity of transactions increases, problems begin to arise.

Despite the shortcomings of spreadsheets, a good number of hedge funds manage complex transactions using them. This usually results in the fund’s back and middle office staff having to work with a myriad of different spreadsheets. It can also make certain procedures, for example, calculating NAV, particularly tricky and laborious, so funds may find themselves having to spend considerable amounts of time consulting spreadsheets in order to answer the fund administrator’s or investors’ questions. Using spreadsheets also creates great potential for error. This is well illustrated by the case of a firm that chose to calculate its NAV on spreadsheets, only to discover that when NAV was worked out a second time, using an automated accounting system, the original calculations were inaccurate by some $3million, or 5% of the fund’s value.

Finally, if the fund eventually invests in some kind of centralised accounting system, there may be problems when it transfers the data previously held on spreadsheets. In this case, a variety of scalability and data integrity issues are likely to arise, for example, historical data relating to trades may not have been preserved, making it impossible to migrate this type of useful information to the new system.

Scaling up

As an alternative to the spreadsheet, a fund might choose to invest in an ‘off-the-shelf’ application from a third party vendor or to build its own accounting system. Clearly, developing a system from scratch allows a firm to create exactly what it wants, in its own time frame. However, a number of common errors are made during the course of this type of development work, meaning that projects often deliver worse than hoped for results. For a start, hedge funds frequently build accounting systems that lack scalability and extensibility. Take, for instance, the case of the fund trading single currency securities that took the decision to spend over $100k developing its own portfolio management and accounting system. The system was developed to handle one currency, however, when the firm later wanted to trade other currencies the infrastructure could not be adapted to accommodate the extra currencies. The old technology had to be abandoned and the fund was later obliged to invest in an ‘off-the-shelf’ system instead.

In addition, while some hedge fund managers are very IT savvy, as (for the most part) ex-traders, they often have limited knowledge of back office processes. As a result, they create trading support tools rather than operational support systems. Investment managers often underestimate the complexity of the post-trade aspect, nor do they fully appreciate the sheer difficulty of building a system that can accommodate a wide variety of different currencies, asset classes, trading strategies and so forth. They are frequently also unaware of the challenges involved in building the interfaces necessary for communication with service providers such as prime brokers. Finally, hedge fund managers sometimes overlook the fact that accounting is its own discipline and one in which they are not necessarily expert.

Build or buy?

So, given that building a system from scratch can be a challenging exercise, is buying off-the-shelf technology a better bet? Interestingly, a number of ‘second and third generation’ hedge fund managers who have either run their own fund in the past or have been part of another hedge fund, are now preferring to take the off-the-shelf route, rather than going down the development road. And there are some good reasons for doing so. For a start, a number of accounting software packages has been developed specifically for the hedge fund industry – why reinvent the wheel? Installing a proven system – one which has been tried and tested by other hedge funds – can also send a positive message to investors and improve investor confidence. In addition, the hedge fund is not reliant on an individual developer, who may chose to leave at any time. In practice, however, the question of whether to develop in-house or to invest in third party vendor software often hinges on the question of support and maintenance. Does the firm want to look after IT systems internally or does it prefer to use a vendor for support and maintenance? Clearly, the latter option may mean fewer resources are needed internally, however, that is not to say that the relationship with the vendor will be free of headaches. In the end, the fund must weigh up the tribulations of maintaining an internal IT department against the possible difficulties of managing the vendor relationship.

Whether a firm decides to build or buy an accounting system, careful planning is essential. Clearly, when building, a firm must develop a system that can handle not only its current trading needs but those likely to arise in the future: building a system that cannot be extended means that the system will soon be rendered obsolete. Equally, careful forethought must go into the decision to buy. All too often, software purchases are the result of last minute decisions. Firms fail to carry out adequate requirements processes or to define their operational processes properly, simply assuming that the new technology will offer the necessary capabilities to support those processes. Take, for example, the hedge fund manager who bought an automated accounting system without having hired either middle or back office staff. While the manager was anxious to install the system and go live, so as to ensure that investors did not go elsewhere, he ran the risk that the internal post-trade processes eventually adopted were not ones that could be supported by the system he had already invested in.

Finally, it is worth bearing in mind that once a system has been installed, it can be difficult to replace later on with other technology.

Look before you leap

In conclusion, firms should look to put in place solid accounting technology as quickly as budgets allow. Introducing a degree of automation can reduce the likelihood of errors occurring and also cut down the amount of time spent managing trades. All the same, firms shouldn’t be overly hasty. Ill judged technology purchases or badly thought through development plans can create even worse problems. Careful planning is a must, with the old adage ‘look before you leap’ proving truer than ever.