As institutional clients continue to mitigate their risk and search for increased alpha in all areas of their investment portfolio, their eyes have been opened to the possibilities offered by derivative products. The exponential growth in the number of hedge funds and their strong performance, at least up until last year, saw many institutions dip their toes in waters they only ever saw from afar.
For asset managers this new interest in more complex structured products was an opportunity that could not be missed. By the handful they tumbled into setting up their own hedge funds or producing products to satisfy the demand, of which liability-driven management is but the latest user of derivatives.
New alpha methods
“The reality is that most asset managers have dealt in futures, forwards and equity derivatives for some time. Now over-the-counter (OTC) products are increasingly part of generating alpha too,” says Mitesh Sheth director of liability investments at Henderson Global Investors.
Additionally, investment banks are now more likely to directly approach pension funds
with strategies incorporating derivatives, but few trustees are confident of best execution and other issues and so interpose the fund manager.
But like their partners in fund administration, asset managers are discovering that these new products bring with them their own set of unique problems. Traditional asset managers' buy-side technology simply cannot handle derivative products easily.
In essence, asset managers are being faced with a massive investment in terms of dealing expertise and systems knowledge, as well as considerable infrastructure costs.
“The volatility and arbitraging specialties, for example, at a hedge fund strategy level are complex and there are few people skilled at doing it,” warns Sunil Chadda, senior consultant at Citisoft, a business and systems consulting firm that focuses on investment management. “This is especially true of OTC products such as credit default swaps that require pricing and risk assessment.”
On the technology side alone he estimates, depending on the number of users and the sorts of products being dealt, that houses are looking at a minimum of a million pound investment. “The technology for alternative funds is the fastest moving game in town at the moment,” says Mr Chadda.
“Today it is difficult for an asset manager to find a solution with the right functionality to handle hedge funds and alternative investments suitable for a portfolio manager,” agrees Frederic Perard, head of Global Fund Services at BNP Paribas.
“Asset managers have to move from internal systems that complied with normal business to handling derivatives and it’s difficult for asset managers to reproduce on their systems the underlying structure of the derivative and so assess valuations and risk,” he adds.
To put it in perspective, derivative products have long been a cash-cow for investment banks but the ever-increasing number of products demanded by the market has seen many of them restructure their internal operations to handle them.
Since 2003 Goldman Sachs, Merrill Lynch, Citigroup, to name but a few, have brought together their debt and equity derivative desks to operate more efficiently. Once independent desks dealing with interest rates, currency and credit derivatives have been merged at institutions such ABN Amro and BNP Paribas.
Manager obligations
If the investment houses that generate these products have faced issues with the growth of the market, then asset managers find themselves in a more difficult position in successfully booking, monitoring and processing these instruments.
“There’s no doubt that some of the asset management houses are falling foul of these new demands, and bearing in mind that the hedge fund and alternative markets are hyper-sensitive to secrecy, we’ve had a lot of clients looking for new systems,” says Mr Chadda.
In theory the asset management company has an obligation to examine and measure the level of risk involved in a derivative in the context of a fund portfolio or a pension. Counter-party risk has to be assessed and while the underwriting institution may have an AAA rating, the broker might only be AA or vice versa. Then there is pricing (vital to rating risk) which is often technically difficult to calculate both in terms of the manager’s skill and knowledge and the systems’ ability to process the information.
On top of that is getting the information. “Data acquisition is expensive, there are very few players like Bloomberg and with that there’s a realisation of what you’ve got,” points out Mr Perard.
According to Citisoft there are several ways the asset managers are going to solve all these problems, however one approach seems to be dominating. “The way the industry is resolving this is by bringing the sell-side technology more into the buy side firms,” says Mr Chadda. In other words buy the technology the investment banks use to structure, price and deal in the derivatives they themselves make.
Of course, the problem is then integrating them into buy-side technology, incorporating pre-trade compliance, order routing and other aspects of risk assessment. This has stirred a trade in building modules into sell-side systems to accommodate these things. “We’re seeing vendors build up suites of applications,” says Mr Chadda.
Currently, the asset management house has technology with good accounting procedures and poor work-flow processes while it is the other way around for the investment banks.
Some are developing their systems, a requirement for deep pockets. “Infrastructure is costly especially if it’s an independent system and you need to tweak it,” says Mr Perard.
“Asset managers need a system to reflect their position and leave the accounting side and middle office to the outsource providers,” he adds.
In following the outsourcing route one development has been in the use of applications service providers (ASPs) to provide and handle all the technical systems to firms like SunGard and Linedata, and hand the asset managers back their core job.
Other firms have dug deep and simply bought in the systems and the experience. For those having entered the hedge fund business ahead of the curve, they already have both. “We developed a hedge fund business three years ago and bought and built the technology it required and we’re using that infrastructure to handle the developments in the derivative product market,” says Mitesh Sheth of Henderson Global Investors.
Some asset managers have the luxury of being able to leverage the infrastructure and know-how found elsewhere within their company in either the investment banking arm or the custodial business. Other well-off players with deep interests in developing these markets, like Barclays Global Investors (BGI), go out and buy the company that develops the systems – Calypso in this case.
But whatever strategy the asset management houses follow, some believe there will be casualties in handling the growing derivatives marketplace. Mr Chadda warns that credit default swaps could be one derivative that could cause problems. As Mr Sheth points out, the market for credit default swaps (CDS) is larger than the underlying corporate bond market. “I’ve heard of a number of instances when a traditional asset manager has decided to trade his own CDS and to put it bluntly, then got mullered in the marketplace,” reports Mr Chadda.
Some players in the asset management industry believe that these developments bring renewed pressures on the sector to consolidate.
“There’s no doubt that these trends will lead to a consolidation,” says Joe Moody at State Street Global Advisors (SSgA). “We’ve already seen trends in the insurance industry - are they investment managers or distributors? Axa has outsourced its administration to State Street while Abbey has outsourced its asset management and kept administration. The danger is that some traditional managers may get caught in between.”
Others in the industry are more optimistic. While Mr Perard is under no illusions about the difficulties in trading derivatives and advocates outsourcing, he believes it will be alright. “I think all domiciles in Europe have been modifying their practice to handle derivatives over the last two years,” he offers.
Can administrators supply for the increasing demand?
For the administration departments that have handled traditional asset management business for some time, the rising use of derivatives has caused some problems. Like the asset managers themselves, some fund administrators are discovering their systems and people cannot handle the job.
“There are system issues and administrative process issues that can cause serious difficulties for some administrators,” warns Ralph Frank, a consultant with Mercers. “Pricing products has difficulties since many are not traded in a market, then there are the margins, pricing moves, identifying exposures and posting collateral on a daily or weekly basis, all of these things can make an administrators life difficult,” he explains.
Sunil Chadda, a senior consultant with Citisoft, agrees these issues can pose real problems. For asset managers who have already outsourced their fund administration, there is an expectation that the administrators should be closely following and anticipating their growing usage of derivative products. The reality is much different.
Mr Chadda warns that even with the secrecy prevalent in this area, it is already coming to light that some administrators are falling foul of the new needs. “It’s not only a question of the right technical systems for administrators but also of getting the right people,” he says.
But what makes the issue worse is that the problems are not just limited to the small- and medium-sized administrators who have concentrated their business with traditional asset managers. Even those administration specialists who have grown with the expanding hedge fund business and have systems to handle derivatives, are finding the new marketplace tough.
“A lot of the hedge fund administrators have been asked to take on new derivatives work, but they simply can’t find the staff with the understanding of the underlying products,” says Mr Chadda. In part, this is the result of continued growth in the hedge fund business, more expertise needed in the investment banking side to develop products and new demand from administration companies and asset managers starting in the derivatives market.
He points out that salaries for people with experience in the area rivals the investment administrators need to handle this sort of business. “It’s also been made worse that offshore centres, especially those who handled hedge fund business, are recognising the staffing problem and making visas longer and easier to get and anything to help retain people, as in Bermuda,” outlines Mr Chadda.
While the technology expense remains hefty for new administrators, there are existing software systems that can handle derivatives. Advent, for example, has a fund accounting platform including Geneva that meets real-time operational and decision-support with full accounting and, according to Citisoft, is used in 60 per cent of the hedge fund administrators.
Even so, many administrators are finding the investment cost in staff and technology too much and the industry expects to sector to thin out even further.
