Throughout the hedge fund industry portfolio management has always been at the core of most hedge fund managers’ investment strategies. In the post-2008 environment the capabilities of a manager’s portfolio management solution has been a key differentiator in their ability to generate alpha for their investors. This will intensify in the future – a number of factors are coming together in the industry to increase the importance of portfolio management to both hedge fund managers and their investors.
Trends in the industry
These days the hedge funds industry faces a more competitive landscape. Regulators have focused squarely on the industry in recent years, launching multiple regulatory initiatives in Europe and the US. The complexity of FATCA, Form PF, and AIFMD has led to many fund managers expanding their operational and portfolio management capabilities. The continued roll-out of FATCA and EMIR derivative reporting, and the forthcoming arrival of MiFID 2 in Europe, means this is a trend that will continue in the foreseeable future.
The events of 2008, where many investors found themselves gated or side-pocketed in hedge funds, have increased the demand for structures that offer more liquidity and which can provide superior portfolio reporting to their investors.
Investors have frequently been disappointed with returns from alternative investment funds over the last decade. These funds have sometimes performed worse than more established indices, once the fees were taken into account. Some large investors (notably recently CalPERS) have decided that the industry is too costly to generate an adequate return, or that the investment strategies are too complex, liquidating their positions and returning to more passively managed strategies. This means that managers will need to work harder to attract quality institutional investors. Indeed, how they manage their portfolios will be a key part of their product offering. At the heart of this is the quality of the portfolio management function. The hedge fund managers that will survive and prosper in the future will have put their portfolio management solution at the centre of their core competencies (alongside research, asset allocation and risk management).
Investor and regulatory demands have meant that hedge funds beefed up their portfolio management and operational architecture over the last few years. Operations, in particular, are no longer considered just a costcentre. It can be a keen source of competitive advantage, when it is properly integrated into the portfolio management process. Many companies have invested heavily in improving their portfolio management technology. This makes good business sense; a top-class portfolio management solution is essential to provide “institutional credibility” to large investors. Good systems promote investor confidence in both the quality and reliability of the solutions.
While operational efficiency remains an ongoing challenge for many hedge funds, managers are increasingly integrated across the full front-to-back office. A high level of straight-through integration is made easier by using a dynamic portfolio solution to provide detailed analysis of the portfolio’s positions, and give managers the edge they need to trade in a volatile environment. Some hedge fund managers have decided to outsource their portfolio management function to a third party, while the majority is still reluctant to entrust a core part of their functionality to an external provider. In recent times frothy markets have meant managers are keen to stress test their portfolios on a regular basis. An increase in volatility as the world economy changes will only reinforce this trend.
The quality of the portfolio management software is a key factor in helping fund managers improve efficiency and comply with regulatory risk management requirements, while also receiving quality data into the portfolio construction and trade process. In particular, AIFMD, puts the responsibility for fund compliance with the investment manager. Most European funds will now have a depositary watching the assets and fund valuation process in detail, as well as the movements of cash and verifying the assets. The managers need holistic portfolio management tools to manage this process and assist in generating this risk data.
Managers also need better information regarding their portfolio’s return attribution, including more detailed valuation information across their funds. This data is required much more regularly nowadays, as hedge fund portfolios become more liquid in response to investors’ demands.
Evolving solutions to portfolio management
All these changes in the industry mean hedge fund managers are under pressure to provide a world-class portfolio management function, fully integrated into all aspects of the fund management process. Hedge fund managers are heavily reliant on their technology infrastructure to achieve high levels of efficiency. For hedge fund managers to remain competitive and relevant in the current environment, they need a cutting-edge solution to manage their portfolios.
What should these portfolio management solutions look like? For a start they should be integrated across the front, middle and back end of the organization. Solutions should be intuitive and easy to use, fully scalable and integrated into the portfolio construction and risk management process. Key functionality such as advanced performance fees, expenses calculations and detailed corporate action processing are a central part of any portfolio management solution.
Detailed reporting is required for the organization, external investors and a myriad of different regulators. In particular, regulatory bodies in Europe and the US are becoming less tolerant of inadequate reporting and record-keeping and have implemented heavy fines across both the wider investment management and banking industry.
Hedge fund managers need to be able to stress-test their portfolios, running detailed simulations and “what if?” solutions to better understand the financial markets they are facing. This is particularly important as markets become more volatile, where currencies and investment markets move quickly, as they adjust to new interest rate environments and changing economic growth.
The challenge for vendors is to bring forward a solution that is easily customizable, while seamlessly integrating with their existing software – particularly around portfolio construction, risk and fund operations. Managers need detailed investment granularity on the one hand, but also a holistic view of the fund’s portfolio investments on the other. The quality of the portfolio management solution plays a central role in the portfolio construction process.
Hedge fund managers face a more competitive environment, driven by investor and regulatory demands. The quality of a fund manager’s technological infrastructure is key to achieving a sustainable competitive advantage. Portfolio management sits at the core of this operating model.
The good news is that long-term demographic trends, including population growth and a growing middle class market, all point to a positive future for hedge fund managers that can successfully manage their portfolios. The key will be for hedge fund managers to adopt portfolio management solutions that give them a competitive edge in the market and help them maintain it over the long term.
Laurent Favre is CEO and founded AlternativeSoft after four years at UBS Wealth Management Zurich, where he was head of tactical asset allocation.