Hedge funds have always had a special relationship with technology. Take direct market access as an example. In its earliest incarnations, DMA was particularly associated with a group of funds conducting statistical arbitrage. This group aggressively exploits even the smallest movement in prices away from market efficiency and turns them to profit thanks to the speed of the transaction, and the scale on which they are conducted.
These movements are small and transitory: almost impossible to take advantage of without sophisticated systems that remove the need for human intervention and enable the funds to make lightning strikes on predictable correlations between instruments. As a highly specialized method of trading, stat arb relies on rigorous statistical analysis, proprietary mathematical trading models, and sophisticated trading systems, as well as DMA.
Stat arb may be an extreme example, but it illustrates hedge funds’ relationship with technology. They are what brand managers refer to as early adopters: swift to take advantage of the latest gadgetry and technological development, but always on the hunt for the next new thing. Rather than relying on comprehensive and sophisticated trading platforms with broad appeal seen in asset management firms from New York to Tokyo, they use precise, specialized, proprietary systems. Consequently, the average hedge fund trading desk will have dozens of different interfaces, each working independently.
But this world of highly-functional, although narrowly-focused, systems is coming under pressure. Publicity-shy hedge funds are increasingly facing the spotlight of the regulators’ scrutiny, particularly in the US where almost 80% of the sector is currently based. Regulation inevitably leads to greater transparency and control - which means that attitudes to technology may require a substantial shift.
A growing need for compliance
The gap between mutual and hedge funds is shrinking both in terms of strategy and investors. After two or three years of market stagnation, even the most traditional funds are investigating more exotic asset classes, such as derivatives, that were previously the preserve of the high risk/high return investors. What’s more, pension funds are taking the previously inconceivable step of investing in hedge funds, or funds of hedge funds (FoFs) themselves. In fact, FoFs are gaining in popularity across the board, and many have been opened to more and more individual investors in offshore jurisdictions with lower minimum entry levels.
Indeed, institutional investors are set to triple their holdings in hedge funds from $336 billion today to more than $1,000 billion in 2010. The next four years will also see the proportion of institutions investing in hedge funds increase to nearly 25%, according to the recent survey by the Bank of New York and consultants, Casey, Quirk and Associates. But with institutional investors making this foray into the market, the public scrutiny under which hedge funds are operating has increased. Massive losses, such as those at Long Term Capital and Amaranth, have highlighted investors’ need for due diligence when selecting a hedge fund to invest in. Even Moody’s now has a new hedge fund rating system that looks at the operational quality of a fund. High returns are no longer the only objective.
With the increase in public exposure, the regulatory watchdogs soon come sniffing around. The SEC has already made its first attempt to bring unregulated hedge funds under controls similar to those faced by mutual funds. In February 2005, the SEC put forward regulations under the Investment Advisors Act that would require the registration of hedge fund advisors. However, a ruling by the US Supreme Court stated that this was an arbitrary interpretation of the rules and not enforceable. Although the SEC backed off from the fight, opting not to appeal, the House of Representatives took up the campaign, submitting a bill to Congress in September 2006 to amend the original Act to give the SEC the necessary powers to enforce its new rules.
Given that Capitol Hill is, at the time of writing, a Republican stronghold, this may have surprised some observers. But the government’s determination to turn its back on its party’s laissez-faire roots is a sign of quite how large and powerful the hedge fund industry has become.
In total, the amount of assets under management at hedge funds was $1.225 trillion at the end of the second quarter of 2006. Hedge funds represent about 10% of the total asset management industry, and according to unofficial estimates, 45% of all traded volume through exchanges. Consequently, they have the power to shift markets significantly – affecting not only their own, risk-savvy high-net worth individuals, but anyone else caught up in market movements. With the specters of Enron and WorldCom not yet laid to rest, the government is standing shoulder to shoulder with the SEC in its attempts to ‘protect the investor.’
Meanwhile, all US activity is being closely observed by regulatory bodies in Europe as well as the European Commission itself. Discussions about how and to what extent hedge funds are to be regulated on the other side of the Atlantic are already taking place, and it seems extremely unlikely that hedge funds trading in London, Paris or Frankfurt will escape the regulators’ attentions.
Not surprisingly, there has been a great deal of resistance from hedge funds themselves: the SEC’s initial consultation period showed that half of those questioned were opposed to changes – a number that corresponds almost exactly with the number of hedge fund representatives who were involved.
The hedge funds’ argument is that costs involved with registration and ongoing compliance will severely affect the performance of funds. Regulatory compliance inevitably adds costs, while any moves to protect the investor are simply unnecessary in the case of the average hedge fund client: they are sophisticated individuals or institutional investors who are aware of the risks involved.
Furthermore, hedge funds operate in a secretive world. The returns delivered by a successful strategy are much higher if no-one else is doing it. Once a successful strategy is out in the open, it will be copied and rewards will diminish. Should the reverse happen, and a strategy bombs spectacularly, the last thing the hedge fund wants is for its failings to be available to public scrutiny: hemorrhaging investors is the typical result. It is this desire for secrecy that leads to concerns about greater and more public regulation that could potentially damage their business. Any public disclosure of their practices can lead to devastating results, as several funds have discovered when poorly performing strategies were made public.
Despite these protests, increased control of hedge fund activity is viewed as almost inevitable by many in the market. The differences between hedge funds and mutual funds is no longer confined to instruments and investors. It is also narrowing fast from a regulatory point of view, with some 40% already registered to keep their institutional clients happy. Whether the threshold for the compliance requirement is too low, currently $25 million AUM, will certainly be hotly contested since simple registration costs start at $50,000 (20bps), before even considering investment in new technology or hiring a Chief Compliance Officer.
Impacts on technology
But does the breakdown of barriers between hedge and mutual funds mean that hedge funds are ready to adopt the front-office systems being used by buy-side institutions?
Certainly the buy-side has benefited greatly from having compliance systems and order management solutions in place to handle the increased demand for transparency. And, superficially at least, there is no reason why hedge funds shouldn’t do the same. Those that will be subjected to Moody’s new rating system will certainly benefit from having comprehensive, established systems to handle their operations.
However, the lean, mean, money-making machines within the hedge fund sector do not wish to direct capital at extensive and potentially cumbersome infrastructure. It seems unlikely that current OMSs will be sufficiently attractive to the majority of smaller hedge funds to justify the investment, although future light-weight, flexible and easy-to-implement execution management systems with basic OMS capabilities are likely to see much more take-up.
Nonetheless, some new systems will be required and, for obvious reasons, hedge funds are reluctant to rely solely on solutions provided by the sell-side. For an industry sector that is obsessed with secrecy, the idea of exposing all activities through a tied relationship with one broker is anathema. No wonder that, where broker solutions are used, there are usually four or five in place.
The obvious alternative is a broker-neutral solution, but these are usually provided by more costly independent technology vendors. Portfolio analysis tools, in particular, are likely to be especially attractive to hedge funds, provided they can support the demand for true multi-asset class trading, and can slice and dice portfolios according to strategy, as well as by existing options such as asset class, sector or fund. These tools can offer the essential portfolio-wide view that enables the hedge fund trading desk to react quickly to market changes. They can also offer P&L calculations based on real-time data feeds, enabling traders to make decisions instantly and exploit tiny movements in price.
Compliance systems will also be invaluable to hedge funds allowing them to monitor specific characteristics within the funds. Simple pre- and post-trade checks, such as limiting exposure to a single issuer, flagging securities that are reaching reportable limits, or restricting specific securities will help hedge funds avoid or control the information they have to make public.
Hosted vs In-house
For the smaller hedge funds, hosted services are likely to be very popular. This model for accessing services has already seen great success in the plethora of hedge fund hotels that exist to provide office space, telephones and PCs with Bloomberg terminals and trading execution software. Whether hiring a single desk or an office for 20 people, these hotels give hedge fund operators their minimum requirement at a flat rate without any of the administrative or maintenance hassle. Unfortunately, they tend to be tied to a single prime broker system, or use the numerous free interfaces provided by the sell-side with no underlying portfolio, order or execution management system to unify them.
As these hedge funds increase in size, trading volumes and risk analysis will drive their technology requirements as the use of spreadsheets to tie together trading activities becomes too cumbersome to be practical. Third party software providers that can provide sophisticated, multi-broker, multi-functional systems through an ASP model would be ideally suited to cater for this section of the market. A trouble-free, remote access system with automatic, behind-the-scenes updates is exactly what hedge fund managers want. Unfortunately, they also want the highly sophisticated, bespoke functionality available to institutional managers on the traditional buy-side.
Although it may seem a reasonably easy development step from a single institutional system that maintains multiple in-house funds to a third-party hosted system which covers multiple funds for multiple companies, the risks involved are tremendous. Looking at data security alone, the issues range from guaranteeing the protection of individual funds holdings and trading activity from others hosted on the same system, to ensuring that only correctly licensed users have access to the live market data flowing into the system. In an industry where privacy is paramount, these concerns will not be easily assuaged.
The obvious solution to these risks is for hedge funds to have their own in-house system, securing data on their own servers, but these come with maintenance and housing costs. Supporting an in-house system would also involve resources for the periodic testing and upgrading required on any bespoke system, which hedge funds will not willingly fund. With the security of in-house systems comes the effort of having to look after them. The ideal is a robust ‘out-of-the-box’ solution that requires little, if any, customization and has a standardized set-up to reduce the time and costs involved in implementation.
Whatever route hedge funds choose, change is inevitable, as regulators prepare to tame this last wild investment frontier. It’s up to hedge funds and technology vendors alike to ensure they have the right tools in place to meet these new challenges.
