November 2008

BACK OFFICE: Hedge fund ops in a bear market

In this dynamic, challenging and competitive industry, hedge funds need to be more considerate of operations than ever before, writes Matthew Nelson (Omgeo LLC, pictured) ... matthew_nelson.jpg Before I ruffle any feathers, let me state that in my opinion operations always matters. Bull or bear market, operations are the grease that keeps the machine running.  But in a bear market, when the front office is struggling to eke out single basis points to please investors, operations can actually help the machine to perform better.

News that hedge funds have struggled thus far in 2008 should come as no surprise, because everyone’s struggling in this market, right?

Well, that’s not entirely right. Hedge funds are designed to make money in good times and in bad. When compared to global equities, hedge funds are doing quite well in 2008.

But the problem is that hedge funds are absolute-return investments, meaning that they should generate positive performance in a bull or bear market, in the latter using short positions and derivatives. Therefore, a more appropriate performance comparison is versus cash as a benchmark. When measured in this light, hedge funds, on average, are severely underperforming.

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 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. 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.

For mid-sized and smaller hedge funds that may outsource some or all of their operations to a prime broker, fund administrator or a combination of the two, operational efficiency is still something that must be measured.  Outsourcing doesn’t mean wiping your hands clean of all the details surrounding operations. On the contrary, fund managers need to establish strong service level agreements with their providers and then regularly monitor them to ensure that the providers are meeting their obligations. Archeus Capital is a good example of what can happen when communication between the fund manager and service provider breaks down.

In this dynamic, challenging and competitive industry, 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, are common practices that should all be eliminated. Although they may be the easy, low-cost solution, spreadsheets are a poor fit for mission-critical functions like managing collateral.  Versions change, macros break, developers change jobs; this is risk that the firm can do without.

Hedge funds, like their traditional asset management brethren, should always focus on operations just as they do on 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 bear market like this one, operations really does matter.  

• Matthew Nelson is director of market intelligence, Omgeo LLC ©2008 funds europe

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