The Most Overlooked Part of the Business

Overcoming the technology challenge

Barry McQuain, CTO and Chief Risk Officer, Lionhart Investments
Originally published in the November 2006 issue

Hedge funds are attracted to the complex. Dynamic hedge fund managers are financially sophisticated investors who make it their business to look for the most intricate, the most unusual, the most overlooked, or the most misunderstood opportunities. And yet, when it comes to the most overlooked part of their own business, they often fall short. In fact, an oft-cited CAPCO study suggests that about 50% of all hedge funds fail because of weak internal infrastructure. Many hedge funds are suffering because the comparatively mundane issue of technology and its crucial roles in risk management and control are not given the attention they deserve.

To create a robust risk management infrastructure, hedge funds need to put technology at the heart of their business from the outset, ensuring that investors, traders, management and auditors are fully equipped with the tools they require. They also need to make a crucial choice: whether to invest in bespoke software or an off-the-shelf package.

For those hedge funds just starting out in the market, pre-packaged third party systems are very tempting. In general, they offer simplicity and speed of deployment, helping to smooth the start up process. However, whilst the purchase of an external system can serve as an expedient, there is much variability in the industry (arrangements with third parties, for example) and creative or unusual ideas are not easily incorporated in pre-packaged systems. Furthermore, the need to manage regulatory compliance means that many hedge funds will have company-specific requirements for their system. By choosing an off-the-shelf solution, hedge funds are making themselves heavily reliant on the external support and ongoing dedication of a single technology provider.

At the same time, the issue of commoditisation also comes into play; it is increasingly difficult to maintain a competitive technology advantage with off-the-shelf solutions. If one is trading the same markets, looking for the same opportunities with the same software as everyone else, one will eventually reach a point of diminishing returns.

Alternatively, hedge funds can choose to develop an in-house system. Admittedly, this approach is more involved than simply buying a pre-packaged solution from a vendor. In-house development requires considerable forethought as well as a high level of commitment in terms of ongoing development work. The benefits, however, are far-reaching.

What's more, in-house development enables hedge funds to make technology an integral part of their business model. In this way, hedge funds can achieve better risk control, ease of use for primary users, increased clarity for back and middle office users, reduced administrative requirements and increased control. Systems that are designed from the bottom up with the capability to mutate and adapt may also provide a number of useful features: real-time information flows; accessibility from any location; generating trade ideas; risk management; accurate accounting reconciliation and reporting.

Another advantage of in-house systems is the scope for adaptability. Any hedge fund system must be capable of evolving to allow the fund to develop, grow and seize new opportunities. This means building software that not only addresses your current needs, but can also be adapted for the future. For successful evolution, hedge funds need to keep the lines of communication between all interested parties in the company open.

For example, at one investment bank, members of the IT department have been placed in the centre of the trading floor so that needs and issues can be addressed immediately or communicated while the ideas are still fresh. By eliminating committees and hearing requests first hand it can be determined how much effort is involved in a fix or adjustment to the programming and whether it will be feasible or worth the effort. Requests can be modified to be made more realistic or adapted into an existing piece of the software.

Rarely black and white

In reality, however, the situation is rarely this black and white and those hedge funds who opt for in-house development will find it advantageous to purchase from a third party at some point.

One strategy, as components change, is to set-up an ongoing, monthly review of IT plans for the coming month, supported by an annual strategic IT review. The company's full time developers will then have the necessary autonomy to design, create, and build the best software possible. If the fund managers fully understand the creative process and give the team plenty of space, good, workable solutions will result. It is also advisable to re-evaluate the Build vs. Buy decision on an annual basis. Each year one or another system component may be required from external vendors. It may be necessary to replace some of the more complex models with vendor products which are more cost-effective and more easily integrated than internally developed additions. When managing a portfolio comprised of a diverse combination of products – (e.g. CDS, options, rights, warrants, foreign exchange, private equity, convertible bonds and distressed debt), in 20 different currencies, with the need to control those interests from any location at any time, it is impossible to find an off-the-shelf solution that can manage the entire complex process.

Based on Lionhart's own experience, in-house development, albeit with external solutions in support, is the best way for hedge funds to meet the demands they face today. Technology can no longer be taken for granted by hedge funds since now, more than ever, it is the underlying software system that can make or break a business. Investors have already awoken to the reality of risk in hedge funds and are demanding greater levels of transparency and controls. As the key background tool for any hedge fund, technology is increasingly a crucial element of any investor's due diligence inspection process.

There is also a growing need among investors to see how information is managed within a hedge fund. Good software can be a key tool for establishing an investor's confidence in a hedge fund, because they can see its role in risk management, oversight of traders, and flexibility in tracking opportunities and strategies. This can provide a real competitive edge and can continue to both protect and enhance trading positions.

What this means is that with or without regulation, investors, traders and management need to ensure they have the best technology for their needs – a goal best achieved by developing a fully tailored solution. In-house development provides the ability to design tools which model factors exclusive to a trader or firm, to present information in unique and more effective ways, to develop new processes to see what works and what does not work in terms of trading strategies. In this way, technology can become the hedge fund's 'twelfth man', providing endless possibilities that will enhance a hedge fund's performance.

Lionhart Investments Ltd. is a global multi-strategy arbitrage hedge fund with a strong track record in capital preservation. Established in 1993, Lionhart's management team, which has more than 60 years' collective market experience, is led by founder Terry Duffy and manages assets of more than $600m USD globally across several strategies and funds.