September 2007

BACK OFFICE VIEW: Spoilt for choice?

"For a start-up hedge fund, deciding what type of IT systems to invest in can involve difficult choices" - Tony Swei / Tradar

Tony Swei

While it is fair to say the hedge fund market is considerably more knowledgeable about technology than was the case, say, even five years ago, many start-up firms are still surprisingly uncertain when investing in IT systems. In particular, the decision whether to invest in order management or portfolio management systems (or indeed both) appears to cause some fledgling funds confusion.

For some readers, the difference between a portfolio management and an order management system may appear to be completely obvious. However, personal experience suggests that a significant number of start-up firms are far from clear as to the differences between the two types of system and the functions performed by each. The fact both are so often referred to as ‘trading systems’ does nothing to clear up the confusion.

System differences
In fact, there are a number of basic differences between the two types of system. First of all, an order management system is used to optimise trading and remove as much manual intervention as possible from the placing, tracking and execution of orders. Typically, an order management system provides connectivity to a broker or market, using the FIX protocol, and allows users to route orders to a pre-determined location. Once a trade has been carried out, the system updates its database and generates an execution report. Intensifying competition amongst vendors has also resulted in a wide variety of extra features – customisable trade blotters, portfolio modelling tools, access to real-time prices and real-time market data, order status monitoring and so on – becoming available to purchasers of order management systems.

In contrast, a portfolio management system provides accounting support. Its basic functions are to keep NAV and P&L, track fund and strategy performance, warehouse data, as well as to provide operations support, for example, reconciliation with service providers such as prime brokers. In essence, its purpose is to provide accurate accounting information on which informed investment decisions can be based. Unlike the order management system, it neither executes trades nor streamlines the manner in which orders are entered, routed to destinations and controlled.

So, when deciding which type of technology to invest in, what sort of considerations should a hedge fund take into account? Clearly, some funds may decide that an order management system should be a priority. However, in my experience, funds generally prefer

to invest in portfolio management technology first, as this provides a solid accounting foundation on which other activities can be based. Off-the-shelf portfolio management technology – which is both relatively inexpensive and quick to install – is available, and, if the system is designed correctly, it should be easy to extend or integrate with other IT systems, for example, risk management or order management systems. Firms should avoid the temptation to manage accounting activities on spreadsheets; while this initially might appear a cheap and easy solution, as the fund grows in size and complexity, data and books can become extremely difficult to keep in good order.

If investing in an order management system, funds should weigh up the cost of the system against possible efficiency gains, as a significant volume of trades is needed in order to justify the added cost and realise efficiencies. Clearly for a fund making a small number of trades, say, no more than 50 a week, such a system is unlikely to prove cost-effective. On the other hand, for firms employing investment strategies involving high volumes of trades, for example, statistical arbitrage, purchasing an order management system could prove a wise move. 

Accurate accounting
Finally, for those looking to install order management technology without also putting in a portfolio management system, it is worth keeping in mind that while it is quite possible to do so, the absence of the portfolio management system could undermine the efficiency gains created by the order management technology. After all, an order management system exists to carry out trades, but how does a firm make a decision to trade in the first place, unless it has an accurate picture of its financial position? And this applies equally to any risk management technology the hedge fund may have installed. It, too, will need to be fed  accurate information from an accounting system in order to be effective. 

In conclusion, if opting to invest in in-house technology, rather than simply making use of the hosted systems provided by prime brokers or the services of outsourcers, funds must be clear both about their priorities and the capabilities of the technology they are investing in. Getting the basics right – and in particular a reliable accounting system which can easily be extended and built upon – is an absolute must. With this essential foundation in place, once fund complexity and trading volumes increase, new systems can be added.

• Tony Swei is CEO of Tradar

© fe September 2007