Going Multi-Strategy: the IT Challenges
- Single, real-time view of data throughout the organization
- Accurate and thorough trade capture, processing and accounting for credit and derivative instruments
- Valuation of unlisted instruments
- Multi-currency consolidation
- Workflow and support for multiple geographic locations
- System performance under rising trade volumes and position numbers
- Non-standard data from multiple prime brokers and fund administrators
- Balance sheet management with multiple prime brokers
- Electronic trading connection management
- Interfacing between trading/risk/performance tools and the core portfolio management/accounting system
As assets continue to flow into hedge funds, one clear trend has emerged: the big are getting bigger. The main reasons for this seem clear:- Pension funds and endowments have enormous pools of capital to invest, but it is just as much work for them to do due diligence on a small fund management company as it is to do it on a large one. As a result, in the quest to maximize their own efficiency, these investors are favoring larger hedge fund managers.
- Many hedge fund strategies have proved that they are simply not scalable to the size of traditional long-only funds; taking on too many assets can be the kiss of death for superior investment returns.
- Managers have also had to face the reality that hedge fund strategies move in and out of vogue depending on market conditions. Those who are solely dependent upon making returns out of a single investment strategy may find that when market conditions challenge that particular strategy for any length of time, their entire business is in jeopardy.
To meet these challenges and continue to attract capital whilst diversifying business risk, many hedge fund management firms have begun to transform themselves into multi-strategy institutions.
The good news is that a multi-strategy institution can exploit economies of scale, which means more money in the pockets of the firm’s owners. The bad news is that building the operational infrastructure required to succeed as a multi-strategy institution is no simple task. Technology is key to meeting this challenge, but choosing and integrating the right elements is not necessarily straight-forward. No surprise, then, that the role of Chief Technology Officer (CTO) - practically non-existent within hedge funds three years ago - has become one that many large hedge fund management companies are fighting to fill.
The biggest operational challenge facing the multi-strategy fund manager is the ability to book, process, value, account for, and monitor the risk on a wide variety of instruments in a manner which is quick, accurate and efficient. Historically, this hasn’t always been a task handled well. Lift the bonnet on a traditional institution of old and you’ll normally find a technology infrastructure that has effectively been cobbled together over the years. Typically, this infrastructure was deployed for equities and/or vanilla fixed income only, with many legacy systems unable even to handle multi-currency consolidation. As a result, rafts of operational staff are required to manually ensure that trades in credit and derivative instruments are captured with sufficient detail and positions and P&L are valued, consolidated and reconciled accurately. Data is often riddled with inaccuracies and, at best, are only available on a delayed basis, which puts the fund managers at a competitive disadvantage in today’s real-time world.
To operate and compete effectively, next-generation multi-strategy institutions will need to take advantage of the progress made in portfolio management technology to operate meaner, leaner business models.
Because it trades a far broader variety of instruments, a multi-strategy firm must employ a portfolio management system that can capture trades, cash flows, corporate actions, and so on, for as many different instruments as possible. Multi-strategy fund holdings normally range far more widely than those of the traditional long-only firm; managers will typically consider instruments ranging from equities and bonds to unlisted derivatives and debt, and they will want to be able to move into trading new instruments as they become available. Ideally, all these transactions and their associated position data should be stored in one place, with everyone in the firm, from the front to the back office, operating from the same data at the same time.
Going multi-strategy also typically means an exponential increase in trade volumes and position numbers. As some multi-strategy managers have already found, a system may be able to capture and process trades in multiple instruments, but that does not necessarily mean that it can scale to handle high trade volumes in all of those instruments at the same time. In some cases, system performance degrades to a standstill, rendering the entire infrastructure useless.
If a system is going to support and enable the move to multi-strategy, it needs to be able to process the breadth and depth of multi-strategy transactions efficiently, with as little human interference as possible, and then reflect them in position and P&L reports in real-time. Moving to multi-strategy may often lead a firm to set-up operations in multiple geographic locations. Multi-time zone trading poses an additional challenge to the operational infrastructure. Not only is it important that the technology employed is able to handle the subtle differences in instruments and workflow that exist in different countries and markets, but it must be able to take closing prices for different markets at different times and automatically communicate with counterparties according to the schedule that is relevant to each. Most of all – and too often an after-thought in the software purchasing decision – the vendors must be able to offer knowledgeable, reliable customer support in the relevant geographies.
As fund managers adopt a multi-strategy approach, the number of counterparties with whom they deal also tends to rise exponentially. As is the case with software vendors, a given counterparty, no matter how strong it is, will not necessarily be able to handle all of a multi-strategy firm’s needs. Indeed, most multi-strategy firms prefer to take on multiple prime brokers and fund administrators not only by necessity, but also in the interest of diversifying business risk and reducing cost. Yet data from the various counterparties is not standardized. Even if interfaces are available, feeds are often inconsistent, incomplete, in the wrong format, or non-existent, which can make reconciliation very difficult. Furthermore, without basic balance sheet management tools, the cost advantages of using multiple prime brokers can be wasted.
Multiple prime brokers
Funds that use multiple prime brokers often do not have the ability to monitor the cash balances running at each, as many portfolio management systems do not offer this functionality. As a result, a fund may be long cash at one prime broker and short cash at another. Because all prime brokers quote a spread between borrowing and lending rates, a fund that is benefiting from “net financing” within each prime brokerage relationship may well be “crossing the spread” by not being clever about managing its cash between the prime brokers. Not managing cash means not maximizing the interest earned and, where funds are leveraged, that inefficiency costs even more.
Using a portfolio management and/or treasury management system that can track prime broker cash balances and interest accruals accurately and by counterparty, will allow a multi-strategy fund manager to grasp and control that bigger picture, ensuring that cash is moved between prime broker accounts, maximizing net interest receivable (or minimizing net interest payable) and negotiating better rates. That translates directly into basis points of performance.
Many hedge funds, multi-strategy or not, are already moving into electronic trading, whether for Direct Market Access, algorithmic, or standard FIX trading. This may reduce transaction costs as well as the scope for human error, but it creates its own set of challenges, mostly to do with connection management. Rather than take that challenge on themselves, many funds prefer to subscribe to a connectivity management service alongside the portfolio or order management system. This allows managers to benefit from multiple trading destinations without the resultant connectivity overhead.
Exploiting economies of scale
In order to exploit economies of scale, multi-strategy institutions may move from the traditional hedge fund operational model where the portfolio manager does his or her own trading to one that involves a centralised dealing desk. Full-blown order management systems, historically only of interest to traditional long-only fund managers, are increasingly relevant to multi-strategy managers.
To maximise efficiency, they offer workflow to accommodate a division of labour between portfolio managers and traders, and between traders specialising in different instruments and markets. Alongside order management systems, or as an alternative to them, many funds use execution management tools for electronic trading. Rather than focusing on workflow, these tools tend to specialise in functionality to enhance the speed and cost efficiency of trading and therefore the internal dealing desk’s ability to add value.
Yet, without robust interfacing to the portfolio database, order management and execution management tools introduce the additional burden and intrinsic risks of re-keying of data. The fund management company has several choices: it can employ additional teams of operational staff to do this work manually and hope they do not make mistakes, it can employ system integrators to build the requisite interfacing, or, best yet, it can buy both the core portfolio system and the trading tools from the same software vendor and let the vendor worry about the interfacing.
Of course, solving multiple tasks through a single vendor is only worthwhile if the vendor’s software is truly best-of-breed in all areas. Many multi-strategy fund managers believe in using specialist risk software to do risk measurement and specialist performance attribution software to handle that aspect. Again, it is key to ensure that this software can interface efficiently with the core portfolio management system, so that human intervention is minimized.
In conclusion, whilst going multi-strategy offers the benefits of diversification and a wider variety of products to attract investor capital, operationally, it creates a sizeable and potentially costly challenge. Key to maximising the efficiency and therefore the profits of a multi-strategy institution is the utilisation of technology. Unfortunately, no one piece of software can fulfill all of the needs going multi-strategy creates. Technology vendors that have assembled best-of-breed software suites reduce the need for the fund management company to worry about software integration, but they do not completely eliminate it.
The place to start is with investing in an experienced and knowledgeable CTO. That person should select and manage the migration to a robust portfolio management system that can capture and process trades in a wide variety of instruments and currencies in real-time, so that everyone in the firm is on the same page. That system should offer robust interfacing with the outside applications and services that may be required by multi-strategy managers, from valuation, custody and administration services to order management, execution management and risk tools.- Pension funds and endowments have enormous pools of capital to invest, but it is just as much work for them to do due diligence on a small fund management company as it is to do it on a large one. As a result, in the quest to maximize their own efficiency, these investors are favoring larger hedge fund managers.
