Bull or bear market, operations is the grease that keeps the machine running. But in a difficult market, when the front office is struggling to eke out single basis points to please investors, operations not only keeps the machine running, but it can actually help the machine to perform better, reducing costs, risk and inefficiencies.
News that hedge funds have struggled thus far in 2008 should come as no surprise to anyone with access to a television, newspaper or computer. The media is replete with coverage of the housing collapse, subprime crisis, credit crunch and other catchy taglines that have been associated with the problems that have been plaguing the global economy. Risk inclined investors have paid the price this year and with major brokerage firms collapsing left and right, it should come as no surprise that hedge funds are struggling.
But, when compared to global equities, the average hedge fund appears to be faring admirably in 2008. The -10% return of the HFRX Global Hedge Fund Index through late September compares favorably with the S&P 500 and MSCI EAFE which are down a painful -19% and -25% respectively. But the problem is that hedge funds are supposed to be absolute return investments, meaning that they should generate positive performance in a bull or bear market.
Now consider the dynamics of the hedge fund industry. This is an industry that has grown by leaps and bounds from a small, cottage industry, to household name status. Roughly US$2 trillion sits in hedge funds and although no one knows for sure, there are believed to be approximately 3,000 hedge fund firms (not funds, mind you) globally. The hedge fund industry is a maturing, competitive business, which is under more scrutiny today than ever before from the public and from politicians.
Blurring Walls Between Traditional and Hedge Fund Managers
The biggest hedge fund managers are global firms overseeing tens of billions of dollars in assets. Many of these firms have become household names in finance and they garner the same industry clout as the largest traditional asset managers. Their trading volumes and aggressive styles make them important participants in markets around the globe and in asset classes from the most basic to the most complex. Further, over the past few years, we’ve seen the lines that separate hedge fund managers from traditional asset managers blur and almost completely disappear. Many traditional asset managers have at least partly transitioned (either openly or secretly) into hedge fund management. A look at the hedge fund league table reveals names like JP Morgan, UBS and Barclays Global Investors, once known as traditional asset managers, now known equally well as alternative asset managers.In fact, in many cases you’d be hard-pressed to tell the differences when you look beneath the covers of traditional and alternative asset managers; operationally they are very similar. Although the current economic crisis will probably result in a short-term aversion to risk and exotic investments, it’s hard to see this derailing the long-term trend that is pushing traditional managers towards more hedge-like investment products.
A Highly Competitive Business
Competition for investor assets in the hedge fund industry is fierce. According to Hennessee Group, nearly 70% of hedge fund assets now come from demanding institutional investors. In difficult market conditions, every basis point counts and fund managers need to be keenly aware of where money is made and lost and where it is being spent. Although it’s often overlooked, operational inefficiency may account for hundreds of thousands of dollars in unnecessary spending on technology, data and personnel.
Likewise the risk stemming from operations may expose the firm to thousands, if not millions of dollars in potential losses due to error-prone manual processes, unknown risk exposure to entities and counterparties and failed trades.
The events of the past several weeks have demonstrated the difference between firms that have strong operations and risk management practices, and those that do not. Further, institutional investors are demanding, not only in terms of performance but also in terms of operational soundness. They are more likely to invest their money with firms that can prove that they have a strong operational infrastructure. Current market conditions and the investor and regulatory backlash is placing more importance on transparency, requiring fund managers to disclose more information about positions, risk management and operations to their investors.
Scrutiny Brings Regulation
Regulation is sure to play a more prevalent role in the hedge fund industry in the coming months and years. The recent curbs on short sales imposed globally and the requirements for transparency into fund positions are probably a precursor of what’s to come. The term “witch hunt” may be a bit strong, but clearly politicians and regulators are looking for a scapegoat for the market swings, extreme volatility and corporate failures that have become everyday activities. Even though it is a misguided, knee-jerk reaction, hedge funds find themselves squarely in the crosshairs of policy-makers. Add to this, the disruptions in the OTC derivatives market where a string of defaults (FNMA, FHLMC, Lehman Bros.) have caused short-term chaos, resulted in many long nights for operations staff and are likely to draw the attention of regulators once the current dust settles.
Emphasis on Technology
The result of all of this upheaval is today’s perfect storm; a dynamic, challenging and competitive industry in which hedge funds need to be more considerate of operations than ever before, particularly when alpha is as scarce as it is today. That means both rationalising unnecessary technology and smartly investing in technology that will improve operational efficiency. Manual processes should be eliminated wherever possible, across the entire trade lifecycle. Phoning, emailing or faxing trade confirmations, re-keying trades into multiple systems, and using spreadsheets as “work arounds” to fill in technology gaps, which are common practices in many firms, must be eliminated. Spreadsheets are fine for modeling and analysing investments, but not for managing collateral or reconciling positions; that’s a ticking time-bomb. Although they may be the easy, low cost solution, spreadsheets are a poor fit for these mission-critical functions. Versions change, macros break, developers change jobs; this is risk that the firm can do without.
Viability of Service Providers
Historically, pillars of safety for hedge fund managers, the reliability and the viability of service providers have recently come into question. Managers can no longer feel completely confident that their service providers offer absolute safety.
The recent bankruptcy of Lehman Brothers revealed a new type of risk for hedge funds, who now have to worry about the viability and the balance sheet of their prime brokers. Those managers stuck with assets frozen in Lehman’s bankruptcy proceeding have learned this lesson the hard way. Fortunately, the average hedge fund employs two to three prime brokers, either to access liquidity or asset classes or to protect their “intellectual property.” This practice made moving assets and switching prime brokers easier in the run-up to Bear Stearns’ and Lehman Brothers’ collapses. Fund administration is not above reproach either, given that two of the top prime brokers had established strong franchises in fund administration, this new “viability risk” has to be considered with the choice of an administrator as well. Highly public fund failures, which were blamed on negligence at the fund’s administrator, also show that risk exists in outsourcer and service provider relationships. Monitoring and managing this risk should be a part of every hedge fund managers’ daily operations. CIOs have long known about technology vendor risk, but now fund managers must worry about service provider viability risk as well.
Hedge funds, like their traditional asset management brethren, should always focus on operations just as they do on portfolio management and trading. The hedge fund industry is a maturing industry and it’s time that all hedge funds, not just the largest firms, start acting like it. That means looking at the entire firm and ensuring that the best, most efficient business is being run. Though little money can truly be made in the middle and back offices, money can be saved there; both in real savings and averted potential losses. In a difficult market like this one, operations really do matter.
News that hedge funds have struggled thus far in 2008 should come as no surprise to anyone with access to a television, newspaper or computer. The media is replete with coverage of the housing collapse, subprime crisis, credit crunch and other catchy taglines that have been associated with the problems that have been plaguing the global economy. Risk inclined investors have paid the price this year and with major brokerage firms collapsing left and right, it should come as no surprise that hedge funds are struggling.
But, when compared to global equities, the average hedge fund appears to be faring admirably in 2008. The -10% return of the HFRX Global Hedge Fund Index through late September compares favorably with the S&P 500 and MSCI EAFE which are down a painful -19% and -25% respectively. But the problem is that hedge funds are supposed to be absolute return investments, meaning that they should generate positive performance in a bull or bear market.
Now consider the dynamics of the hedge fund industry. This is an industry that has grown by leaps and bounds from a small, cottage industry, to household name status. Roughly US$2 trillion sits in hedge funds and although no one knows for sure, there are believed to be approximately 3,000 hedge fund firms (not funds, mind you) globally. The hedge fund industry is a maturing, competitive business, which is under more scrutiny today than ever before from the public and from politicians.
Blurring Walls Between Traditional and Hedge Fund Managers
The biggest hedge fund managers are global firms overseeing tens of billions of dollars in assets. Many of these firms have become household names in finance and they garner the same industry clout as the largest traditional asset managers. Their trading volumes and aggressive styles make them important participants in markets around the globe and in asset classes from the most basic to the most complex. Further, over the past few years, we’ve seen the lines that separate hedge fund managers from traditional asset managers blur and almost completely disappear. Many traditional asset managers have at least partly transitioned (either openly or secretly) into hedge fund management. A look at the hedge fund league table reveals names like JP Morgan, UBS and Barclays Global Investors, once known as traditional asset managers, now known equally well as alternative asset managers.In fact, in many cases you’d be hard-pressed to tell the differences when you look beneath the covers of traditional and alternative asset managers; operationally they are very similar. Although the current economic crisis will probably result in a short-term aversion to risk and exotic investments, it’s hard to see this derailing the long-term trend that is pushing traditional managers towards more hedge-like investment products.
A Highly Competitive Business
Competition for investor assets in the hedge fund industry is fierce. According to Hennessee Group, nearly 70% of hedge fund assets now come from demanding institutional investors. In difficult market conditions, every basis point counts and fund managers need to be keenly aware of where money is made and lost and where it is being spent. Although it’s often overlooked, operational inefficiency may account for hundreds of thousands of dollars in unnecessary spending on technology, data and personnel.
Likewise the risk stemming from operations may expose the firm to thousands, if not millions of dollars in potential losses due to error-prone manual processes, unknown risk exposure to entities and counterparties and failed trades.
The events of the past several weeks have demonstrated the difference between firms that have strong operations and risk management practices, and those that do not. Further, institutional investors are demanding, not only in terms of performance but also in terms of operational soundness. They are more likely to invest their money with firms that can prove that they have a strong operational infrastructure. Current market conditions and the investor and regulatory backlash is placing more importance on transparency, requiring fund managers to disclose more information about positions, risk management and operations to their investors.
Scrutiny Brings Regulation
Regulation is sure to play a more prevalent role in the hedge fund industry in the coming months and years. The recent curbs on short sales imposed globally and the requirements for transparency into fund positions are probably a precursor of what’s to come. The term “witch hunt” may be a bit strong, but clearly politicians and regulators are looking for a scapegoat for the market swings, extreme volatility and corporate failures that have become everyday activities. Even though it is a misguided, knee-jerk reaction, hedge funds find themselves squarely in the crosshairs of policy-makers. Add to this, the disruptions in the OTC derivatives market where a string of defaults (FNMA, FHLMC, Lehman Bros.) have caused short-term chaos, resulted in many long nights for operations staff and are likely to draw the attention of regulators once the current dust settles.
Emphasis on Technology
The result of all of this upheaval is today’s perfect storm; a dynamic, challenging and competitive industry in which hedge funds need to be more considerate of operations than ever before, particularly when alpha is as scarce as it is today. That means both rationalising unnecessary technology and smartly investing in technology that will improve operational efficiency. Manual processes should be eliminated wherever possible, across the entire trade lifecycle. Phoning, emailing or faxing trade confirmations, re-keying trades into multiple systems, and using spreadsheets as “work arounds” to fill in technology gaps, which are common practices in many firms, must be eliminated. Spreadsheets are fine for modeling and analysing investments, but not for managing collateral or reconciling positions; that’s a ticking time-bomb. Although they may be the easy, low cost solution, spreadsheets are a poor fit for these mission-critical functions. Versions change, macros break, developers change jobs; this is risk that the firm can do without.
Viability of Service Providers
Historically, pillars of safety for hedge fund managers, the reliability and the viability of service providers have recently come into question. Managers can no longer feel completely confident that their service providers offer absolute safety.
The recent bankruptcy of Lehman Brothers revealed a new type of risk for hedge funds, who now have to worry about the viability and the balance sheet of their prime brokers. Those managers stuck with assets frozen in Lehman’s bankruptcy proceeding have learned this lesson the hard way. Fortunately, the average hedge fund employs two to three prime brokers, either to access liquidity or asset classes or to protect their “intellectual property.” This practice made moving assets and switching prime brokers easier in the run-up to Bear Stearns’ and Lehman Brothers’ collapses. Fund administration is not above reproach either, given that two of the top prime brokers had established strong franchises in fund administration, this new “viability risk” has to be considered with the choice of an administrator as well. Highly public fund failures, which were blamed on negligence at the fund’s administrator, also show that risk exists in outsourcer and service provider relationships. Monitoring and managing this risk should be a part of every hedge fund managers’ daily operations. CIOs have long known about technology vendor risk, but now fund managers must worry about service provider viability risk as well.
Hedge funds, like their traditional asset management brethren, should always focus on operations just as they do on portfolio management and trading. The hedge fund industry is a maturing industry and it’s time that all hedge funds, not just the largest firms, start acting like it. That means looking at the entire firm and ensuring that the best, most efficient business is being run. Though little money can truly be made in the middle and back offices, money can be saved there; both in real savings and averted potential losses. In a difficult market like this one, operations really do matter.
