Hedge funds have experienced a roller coaster ride of highs and lows in terms of performance over the last 12 months. Now some of the players in this business are starting to deploy their own trading, portfolio management systems and associated accounting systems.
Fuelled by the growth of electronic trading and multi-asset trading capabilities, the scope of systems being installed is spanning a broader remit and becoming more deeply ingrained.
While the fiasco of Long Term Capital Management in 1998 might be a not-too-distant memory, ratings agency Standard & Poor’s (S&P) warned last summer that the rapid growth in hedge funds has heightened the risks faced by financial institutions and banks that do business with unregulated investment partnerships.
Junked cars
The warning came after the downgrade of General Motors and Ford debt to ‘junk’ in May 2005, which disrupted some complex credit-derivatives trades popular with hedge funds. S&P analyst Tom Foley, says: “Although the direct effects of poor performance of any hedge fund are expected to be minimal, systemic risks are a greater concern.”
A UK Financial Services Authority (FSA) discussion paper on hedge funds produced in June 2005, stated: “There are particular challenges in risk managing multi-strategy portfolios and possible improvements that could be made with respect to stress testing.”
Speculation about big hedge fund losses on 10 May 2005 affected the broader equity market and adversely hit shares. Fast forward nine months and the equity markets in Europe are riding high. Players like Man Group, a leading global provider of alternative investment products and solutions as well as one of the world’s largest futures brokers, saw its stock price double to £23.50 in 2005.
With that sort of share price performance (and in Man’s case a capitalisation hovering over £10.2bn), one might think investment in new and more efficient trading platforms was a no brainer. But this thinking does not apply universally across the hedge fund spectrum. Size clearly matters.
Establishing precise figures for the number of operating hedge funds is not an exact science either. That said, the total number of hedge funds registered in the Cayman Islands – where over 80 per cent of the world’s 8000-plus hedge funds are registered with the Cayman Islands Monetary Authority – recently rose by around 23 per cent over those registered in the first quarter of 2004. Some suggest the number could be nudging 10,000 today.
Europe, which represents around 25 per cent of the global hedge fund universe in terms of numbers according to the Alternative Investment Management Association, is believed to have seen a 35 per cent rise during 2005 over the year before, with three quarters of Europe’s total being UK-based. Estimates put the amount managed by UK hedge fund managers at over $213bn.
Rich pickings for the IT vendors plying their services one might conclude, although gauging the market is not easy. Denise Valentine, a senior analyst within Celent’s securities and investments group in New York, notes the market for trading system for vendors is presently “far from determined or defined.”
Golden opportunity
Many third-party vendors view potential clients as a golden opportunity and are pricing accordingly. While one can get a fairly good price from a hedge fund says Ms Valentine, vendors also need a certain depth of derivatives and trading capability in their product offering as there are a lot of competing systems on the market.
Celent’s forthcoming report, Portfolio Systems 2006: Full Suite with Risk & Derivatives, is scheduled for publication this month and will no doubt shed further light on how the IT vendors are attacking the market with their solutions. Providers like Calypso, Murex, SunGard, Beauchamp Financial, and Advent will be examined.
In terms of product offering, different applications are utilised for different purposes. Ms Valentine says she is seeing mostly front to mid-office systems. After that the vendors diverge in their capabilities, with some moving further into the back office and some not.
She asserts that they are using such systems as a means of holding and recording all their trades and, critically, their pre-trade analysis.
“I think there is something of a movement occurring,” says David Aldrich, head of securities banking (Europe) at the Bank of New York based in London, talking with respect to hedge funds deploying trading systems.
 | David Aldrich, Bank of New York |
He explains: “Some of the larger hedge funds are definitely installing their own order routing software - a facet common in the long-only [asset management] environment. Effectively they are trying to ensure that their more vanilla type trading activity - equities in the main - are directed to the most common efficient and low cost providers.
“So they are connecting up, for example, to Direct Market Access (DMA) in order that they can mark vendors on the speed of execution and the price slippage.”
Mr Aldrich says that while this effort to achieve a “more effective” method of allocating business is new, it’s also rather expensive to implement.
Consequently only the larger hedge fund managers tend to undertake it, given that there is a large bespoke and tailored element to such initiatives.
Paddy Turner, head of European sales at bond trading platform provider MarketAxess (Europe), observes that: “There is an increasing appetite among hedge funds to build their own in-house systems, but it’s not new. The hedge community tends to be quite tech-savvy. And, if they are not sufficiently tech-savvy then for sure they interested in managing their costs and raising efficiency,” he adds.
As larger traditional asset managers have bigger IT budgets which enables them to build bespoke trading systems, smaller groups tend to buy packaged products off the shelf.
“Clearly the world has moved on over the last 18 months and connectivity is becoming the key to electronic trading platforms,” states the head of sales at MarketAxess in Europe.
BNY’s Mr Aldrich says that hedge fund managers are also presented with a whole array of ways to execute their business. For instance, many are “drawn to” Bloomberg Trade Book, a leading agency broker established in 1996 and used by hedge funds and institutional investors, which provides the ability to connect directly to 36 markets and access trading capabilities on 65 markets across 54 countries. It also facilitates algorithmic trading.
While the DMA systems can help with transparency as well as execution, Mr Aldrich adds that some of the larger hedge funds are “building a piece over the top” to funnel some their business to where it’s cheapest or easiest to execute”.
They will, however, also need to channel a portion through algorithmic trading systems. “So, it’s really about control efficiency and transparency.
Greater transparency
Clare Flynn Levy, president at Beauchamp Financial Technology Ltd (BFTL) in London, speaking from the IT vendor perspective acknowledges that institutional investors and regulators alike are focusing and demanding greater transparency.
“But that does not mean that it is economical for a hedge fund to become a software developer,” she contends.
“In our experience, most hedge funds would still rather outsource software development than do it in house, as they recognise that their competitive advantage lies in investing and not in the development, support and maintenance of technology.”
Ms Flynn Levy adds that larger multi-strategy fund managers, especially those that trade a lot of over-the-counter derivatives and complex debt instruments, might be “more inclined to build certain parts of their software infrastructure in-house”, but are still more likely to buy a third-party product and build around it than they are to start from scratch, for economic reasons.
For this reason, she does not think third-party developers will be disintermediated anytime soon.
“As the big hedge funds get bigger, they are likely to require an increasing amount of consultancy and bespoke development services from third-party developers and/or technology consultants,” she adds.
“The hedge fund business model is all about keeping operational costs relatively low and leveraging them over growing assets under management.
“That said, hedge funds, by definition, are all trying to do something slightly different from one another, so do require systems that are highly configurable and relatively ‘open’,” Ms Flynn Levy contends.
On the trading side, hedge fund managers are less likely to build their own FIX execution management system than they are to choose one or several from specialist vendors. Levy Flynn of Beauchamp says managers like the freedom to be able to pick the one they want in the knowledge that they will interface seamlessly with the main trading data platform.”
Alberto Fontana, managing director of Financial Tradeware, says while this overriding theme is “definitely a very interesting one, this does not reflect our personal experience or any of our clients’ requirements in the last few years.
 | Alberto Fontana, Financial Tradeware |
“Hedge funds normally do not have the expertise and resources to develop, implement and maintain a software solution or an IT infrastructure - at least the target we normally deal with - medium- to small-size funds. This is why they claim their front-middle-back office all in one solutions are very well received.”
Mr Fontana, a former trader in Milan at Banca Intesa, says: “Hedge funds want to focus on the production of alpha without having the problem of maintaining a support a system, avoiding bottlenecks or any risk of compromising their operational efficiency.”
He adds: “It is quite difficult to find a trader with knowledge in programming and a good understanding of the IT world.”
That said, he concurs with the view that off-the-shelf products, which in the past adapted from existing systems tailored for banks, “do not fit with hedge fund requirements anymore.”
Given the high level of complexity of hedge fund strategies, coupled with increasing risk monitoring and compliance requirements, he says the need for flexibility and easy to customise tools has become essential.
“Vendors have understood that…as well as the need to cover different business areas of hedge funds, and the focus is not only on covering trading /execution functionalities, but also the complete trade life cycle automation - front to back - and across multiple asset classes including derivatives and structured products. Small hedge funds want access to the same capabilities as multi-billion dollar funds,” states Kevin LoPrimo, managing director, VanthedgePoint Securities LLC. “However, the industry’s current service providers ignore this market segment because these funds do not generate sufficient fees.”
Prohibitive costs
Mr LoPrimo says that technology costs are “prohibitive” for small fund, and, with over half of all hedge funds managing less than $25m, means that a large universe of funds go underserved.
VanthedgePoint was created to supply institutional quality tools and services ‘down market’, where Mr Lo Primo says “other service providers cannot compete due to their existing cost structures.” They claim their unique aggregation-based model allows them to create economies of scale to provide such services at prices affordable to small funds.
He claims that VanthedgePoint’s licensing of Advent Geneva®, a global investment accounting and portfolio management software from Advent Software, Inc, in February assists hedge fund clients improve their operations. And, with respect to DMA, the firm is working with NeoVest.
Elsewhere, Peloton Partners LLP, based in London, signed a deal last April to deploy SunGard’s Front Arena, an integrated cross-asset, STP product for sales, trading, risk management and administration of equities, derivatives, interest rates, credit, money markets, fixed income and foreign exchange, to manage its new hedge fund start-up, an opportunistic global multi-strategy fund focusing on macro and relative value strategies.
According to Celent’s Ms Valentine, vendors like Lombard Risk and Numerix provide valuation models as well as analytics and trading. Hedge funds need such tools to analyse their trades. Some have FIX connectivity already built-in, while others provide a gateway for clients to connect to execution venues.
Equal shares
In respect of the fragmentation of the market, are all the vendors equally equipped to share in the rewards that may come their way? According to Celent’s upcoming research, two streams are seen. “These are fully customised solutions for the big guns at a high price and often the client has primary responsibility for implementation and configuration.”
Ms Valentine argues that the vendor is basically “delivering a playground in a box” with the client having to lay out all the pieces and self build. The second stream is a focus on “the rest” of the market through the deployment of an applications service provider or solutions not built out as well with a full range and depth of derivative product. Two vendors with a packaged solution with over 100 clients each are Beauchamp (full front-to-back) and Imagine Software (front-to-mid).
She says hedge funds are focusing on derivative risk analytics and trading, but only just appreciating how important the back office is. They are gravitating to word of mouth referrals, but soon will see a much broader available applications market. They are only now finding out about full front to back suites.
“Hedge funds are only now learning all that it takes to configure and implement such a robust and complex system. I believe they misjudged the amount of time, effort and cost,” she concludes.
