The Investor

Originally published in the May 2011 issue

The global economic downturn of the past few years has changed the characteristics of the hedge fund and asset management industries for good. A report late last year by Celent, a Boston-based financial research and consulting firm, identified how the hedge fund industry moved to adopt a new operational approach despite the contraction in assets that followed the financial crisis. This has helped prepare hedge funds for the upturn in net inflows, charted by Hedge Fund Research and others, in the last two quarters. The report went on to cite regulation as being crucial for asset management and the evolution of multi-boutiques. Indeed, the European Union’s Alternative Investment Fund Managers (AIFM) directive means that asset managers will be under greater scrutiny and will need to enhance their risk management capabilities. Having said this, and despite initial skepticism, the industry appears to be warming to the directive as it becomes clearer.

With the collapse of Lehman Brothers and the ensuing fallout across the banking industry, many former bankers looked to reboot their careers with hedge funds. Initially investors consolidated assets with the largest asset managers as their size was deemed to offer greater security and stability. This made it difficult for many start-up and boutique funds to attract investor allocations. However, the price for caution turned out to be lower returns.

Smaller funds outperform
Indeed in some instances the larger firms were failing to match the returns on market indices. In contrast, smaller hedge funds were delivering higher returns as a result of their focus on a broader range of investment instruments. This diversity, together with the development of increasingly sophisticated IT systems, allowed these portfolio managers to react to peaks and troughs in the market with nimble trading strategies. Higher returns began to tip the balance in favour of performance rather than stability and investors started to make more allocations to these more agile players.

In the US, the hedge fund sector has grown rapidly against a backdrop of informal regulation. Managers avoided close scrutiny from the authorities by restricting access to accredited investors and promoting a culture of self-regulation. Some changes will occur as a result of the Dodd-Frank Reform Act that begins to take effect in July 2011. One visible change is that US and international fund managers will need to register with the Securities and Exchange Commission, although uncertainty remains around how the Act will impact different types of hedge funds.

Regardless of how the regulatory oversight of hedge funds evolves, the Celent report cited a recent paper by Rothstein Kass which reveals that three-quarters of hedge fund managers expect closer scrutiny from regulators as the industry attempts to deliver the transparency demanded by high-end investors. Hedge funds are also likely to be impacted by the knock on effects of regulation across other areas of the financial services industry.

Motivation to change
In addition to regulatory intervention, hedge funds are also motivated to change the way they operate. There is an industry consensus that a more professional approach is required which includes greater transparency, and is seeing many hedge funds act as though they are already obliged to report to financial regulators. Beyond this, investors are still nervous about investing during atime of great economic uncertainty. Therefore the application of tools and technologies allowing hedge funds to report transparently and regularly to clients and brokers are crucial to their efforts to bring more allocations to the sector.

Taken more broadly, hedge funds need to nurture investor confidence and work hard to meet the increasing demand for accurate, detailed and timely reporting. These requirements are putting pressure on operations departments, which have an increasing need for suitable software and technology to communicate quickly and cost effectively with investors.

Complex assessments
The growth of multiple prime broker relationships, spurred by the Lehman Brothers collapse, as hedge funds look to reduce counterparty exposure, only adds to the complexity of assessing cash positions in real time. This increased complexity is another driver in the need for hedge funds to install comprehensive portfolio management systems. These considerations, however, are not solely the domain of large hedge funds as new start-up ventures need to ensure from the outset that they have the flexibility to grow and develop across different asset classes.

Many hedge fund employees hail from global banking institutions where they enjoyed the support of internal risk management teams, but as they enter the hedge fund industry this in-house capability simply isn’t available. The services once provided in-house are, however, still on hand if hedge funds leverage the quantitative risk management skills inherent in the research and development teams of the major portfolio and risk management vendors.

While the experience and flair of these fund managers is absolutely imperative to the success of a new venture, having the right IT platform in place is also a very important consideration. There needs to be an understanding of the importance of a robust and reliable technology platform in order to cover market risks, credit risks and market fluctuations. Crucially, new hedge funds need to start out on a platform that allows them to trade in a wide range of asset classes, both now and in the future. This will provide them with the flexibility to adapt and out-manoeuvre larger and more cumbersome asset management firms which investors are seeking to diversify from in search of better returns.

Managing risk exposure
High quality technology solutions are now a key element of a hedge fund’s pitch to investors, allowing it to demonstrate the ability to manage exposures and positions throughout the day in a transparent manner. The right software can also help organisations manage counterparty risk by aggregating information from prime brokers and counterparties so that exposure can be better assessed. In the past it may have appeared extravagant for a new hedge fund to implement a full front-to-back office portfolio management system. Now, however, there is an appreciation of how technology can decrease workload and operational risk in both the middle and back office.

Until comparatively recently, hedge funds have been regarded as a niche market offering only a relatively low volume of sales to the major financial technology vendors. In fact, it was common practice for hedge funds to develop their own solutions for portfolio modelling, trading, and accounting. The landscape has changed over the past decade with hedge fund managers increasingly aware of counterparty risk and the need for transparency as they continue to market themselves to potential investors.

This change is being driven by more risk aware investors and the prospect that the era of relatively loose regulation is all but over. Those hedge funds that are to survive and prosper in this new operating landscape must appreciate how the needs of investors have evolved. But this also presents an opportunity to embrace change and invest in technology that will help hedge funds better service clients, remain competitive and comply with evolving regulatory measures.

James Pinnington is head of the hedge funds business at Misys Sophis and is responsible for sales of the company’s solutions to the alternative investment industry. Prior to this James was head of hedge fund sales at Beauchamp, a unit of Linedata.