July 2007

HEDGE FUND INTEGRATION: Like running a marathon

As traditional asset managers move into the alternatives arena, the issue of back office compatibility becomes paramount. Angelique Ruzicka finds that the process is fraught with confusion and needs due time and attention 07_07_marathonNew Star, the UK fund firm, is one of the latest long-only managers to launch alternative funds, such as hedge funds. Having the right front office people with relevant skill sets is a challenge for traditional asset managers seeking to launch funds that employ alternative strategies, such as short selling. But what, too, are the implications for back office staff and technology at hitherto long-only businesses? And even if these backroom operations are outsourced, can managers be sure that their providers – whose businesses tend also to be rigged up for traditional asset management – can themselves cope? It would appear the answer is not always ‘yes’. John Mould, chief operating officer at New Star, told Funds Europe: “We went to a long-only administrator and they said they could only process the long-only part of the fund, but would not be able to account for the shorting of the fund on a daily basis. They advised that this part could be done via a prime broker.” Many hedge funds have in the past relied on prime brokers for their administration, but this has created obstacles for funds that want to market at institutions whose operational standards are high. In New Star’s case, the company sought out a new systems provider and subsequently, in 2006, implemented Sophis Value. “It’s one of the true leaders in the hedge fund space,” says New Star’s operations director, Karen Zachary. She adds: “We recognised that it had to change because the long-only system couldn’t cope with the complexity and valuations of the hedge fund business.” With the arrival of 130/30 funds – which allow a degree of shorting and are seen by some as the future of mainstream investment management – and other alternative products, the issues faced by New Star will affect more and more managers. But does moving into more complex asset classes always mean that current systems, which are hardwired to long-only products, need to be replaced, or could legacy systems be kept and improved? To shop or not to shop
“Long-only asset managers should go to their traditional vendors first to see if any of their new programmes fit. Some vendors aren’t keeping up with alternatives, as some haven’t had the resources to cater to alternatives. Some feel they should stick to their knitting and stick to what they do best,” says Emanuel Mond, president of SunGard Front Arena. But many financial institutions are beginning to shop around, he adds. “If we were to track the interest from traditional funds businesses it looks very different to what it was five years ago.” Essentially, the options for traditional managers that have moved into the hedge fund space are threefold. They can either outsource the whole middle and back office administration operations to a third-party administrator, purchase some off-the-shelf software, or if their own IT department has the capability, there is the option to tweak existing portfolio accounting, settlement and trade-ordered management systems to cope with the new alternative products. Adapting existing systems is possible but an assessment of whether legacy systems could cope with extras added on would have to be carried out. “I think managers should continue with their current platforms but it depends on when they were built. Many long-only systems are a number of years old and are only fit for long-only funds, and managers may find it difficult to add extra stuff to it,” says Mond. But the more complex the product, the more managers will have to look at replacing existing systems. Bill Bastow, a member at Kinetic Partners, which specialises in operational risk, says: “Some strategies bring about a whole new layer of complexity. For example, credit derivatives and interest rate swaps managers will have to implement affirmation and confirmation through DTCC and Swapswire in order to confirm and affirm those products. A few managers will have to move so far away from their existing architecture that they will have to address it by purchasing new software.” Bastow says asset managers have a variety of needs. “Some have decided that they would purchase an off-the-shelf product – like Beecham, Tradar or Advent – and run that alongside their existing portfolio account and investment administration tools. But a considerable number have decided to get their own IT departments to do some programming and come up with a viable solution,” he says. What drives the decisions financial institutions make is down to the complexity of the strategy that is being used. “If a financial institution is launching a strategy that is reasonably close to their own existing strategy in terms of instrument usage it will probably look at how their existing software can cope with it. But as the strategies become more complex with the addition of derivatives I think that the legacy accounting software that is designed for long-only managers starts to fall short in some areas,” says Bastow. However, some administrators have recognised that a one-size-fits-all approach is not going to work. “From a systems perspective we use the fund accounting product InvestOne, which is a SunGard product. For more complex strategies we use VMP, also by SunGard. For pure hedge fund managers we have to match the system and processing requirements to their accounting package,” says David Aldrich, head of hedge fund administration at the The Bank of New York. Whichever route you choose, it is essential to upgrade systems regularly. “An upgrade is basically conducted every three months – it’s a marathon, not a sprint,” adds Aldrich. At present it is too early to tell which approach has worked well for long-only managers who have entered the hedge fund space. Essentially, the decision to launch hedge fund products should not only be driven from the front end of the business. More planning needs to be done and the implications from front to back need to be thought out. “The ideas are very front office driven and some of the support structures are not scaled up to be able to support alternatives consistently and coherently. But some managers go ahead and do it anyway. And this is a risky bet from the back office admin and support perspective as it can get to a point where the project team can decide that its too hard a road to go down,” says Bastow. He adds: “One particular manager looked at the trading of index level credit default swaps and because they only wanted to do a very small number of them, the amount of infrastructure and the resource required was disproportionate to the value that would be added by including them in a mandate.” Trial and error still appears to be the main method of finding out what works best for the business. Again, Bastow provides examples of how clients dealt with getting the right system on board. Decisions, decisions...
“One client decided to purchase Tradar, which is a dedicated hedge fund software database that allows trade capture and portfolio representation, NAV calculation and position cash recording. They chose this software because the software they had didn’t support their new products that well,” he says. Another client dealt in some futures on a long-only basis and they felt they should be able to use their system on a long and short basis. They decided to try and configure the accounting system and trade order management system to be able to support that, but the trade order management system didn’t lend itself too well to derivatives. Instead they had to get the professional services group from the vendor to come in and do some customised programme.” To add to the confusion, there are a whole raft of vendors to choose from and a lot of competition. The three companies purported by some commentators to have the largest market share in the UK include Tradar, Beecham and Advent. But there are more competitors looking to muscle in on the action. “There is a firm called Global Back Office Solutions that we are aware of that is new and then there are a quite a few US systems that are entering the market,” adds Bastow. Finding the right vendor will be difficult but commentators advise on seeing as many providers as possible. The key is then to get them to do a demo on the new product or portfolio that is being launched. Getting references is important too, but Bastow remains wary of seeking out recommendations from brokers. “A lot of brokers may be using Charles River, Misys, or Calypso, which are very big sell-side systems and most managers looking to launch straightforward hedge funds will not need that kind of infrastructure. If you are looking to launch a very complex strategy or cross asset trading system then some of those systems may be appropriate, but then again the ticket price on those systems are pretty significant and could impact a great deal on the decision to launch the project.” 07_07_marathonOnce a particular software vendor is chosen the provider should preferably remain on site for a sufficient amount of time to ensure that the system is implemented correctly and that the personnel are trained appropriately to get the best use out of the new system. “There are plenty of managers out there that have bought systems and are only on the tip of the iceberg in terms of their usage and understanding of the programme,” Bastow says. © fe July 2007

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