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TECHNOLOGY AND THE HEDGE FUND MANAGER
 

By Gene Mannella, President of International Fund Services, New York, an alternative asset fund administration company and a leading firm in outsourcing solutions for alternative asset managers. This article appeared in the August 2001 issue of Hedge Fund News┐.

It has been approximately four years since my predecessors, Thomas Conhenney and John Suglia wrote an article that addressed some of the technology and infrastructure needs of hedge fund managers ("Trade Date + 1: A Day Too Late"; HFN, August 1997). Since then, a few key events (among others: Russia’s devaluation of its currency; the collapse of Long Term Capital; and the Manhattan Fund scandal) have led people in the hedge fund industry to take a harder look at how information is processed and delivered, as well as determining what the best system or systems are at their disposal for this information processing and delivery to their ultimate end users, such as investors and credit counter parties.

Single Data Point of Entry

In this age of real-time information, a state of the art technology infrastructure is critical to the hedge fund manager’s organization and success. Beginning with a trade capture system, this system should allow for a single data point of entry. This single point of entry should then populate all of the other systems that hedge fund managers rely on in their real-time environment and to manage all other aspects of the trading activity. Optimally, this front-end mechanism should also integrate with either the hedge fund manager’s proprietary risk analytics system or with a vendor’s risk system that the hedge fund manager has licensed.

The optimal trade capture system should allow for order management and routing. The increased pace of trading and increased volatility in the current markets, and the move towards T+1 settlements are driving forces that are pushing managers towards implementing real-time, automated trading interfaces in the front office. It is becoming increasingly difficult for a manager to be effective by executing trades over the phone without the aid of automated execution interfaces.

These automated execution interfaces take on two forms. They both involve the use of the evolving FIX protocol to interface with one or more brokers and/or ECN systems and exchanges. The FIX protocol is a structured language protocol that allows the interchange of indications of interest, allocations, orders, and confirmations between a trading firm and an institution. It replaces telephone calls, faxes, and e-mails to facilitate straight through processing and minimize the chance of human error.

Direct access order routing to an ECN and/or exchange is designed to give a manager direct access to the marketplace, without the need to use a broker. ECNs such as Instinet, Redibook, and Island provide both trading managers and brokers benefits such as better transparency, deep liquidity, extended trading hours, and anonymity. Order routing technology using interfaces like SOES, Selectnet, Superdot, ACT, and FIX allow a trading manager to find the best bid and best offer for a given order to be executed among competing participants in both the primary and secondary marketplaces.

A manager faces a bewildering array of choices in terms of software and functionality when deciding to move to the use of an automated execution interface. Because of the numerous protocols and interfaces needed to interface to the various ECNs and exchanges, many managers opt to use the FIX protocol to interface to a broker, who then becomes responsible for interfacing to the various ECNs and exchanges using the appropriate protocols.

Reliable Communications

Reliable communications are an important part of an automated execution and order routing interface. Depending on the level of service and reliability required, a manager can choose from cheaper, less reliable solutions like interfacing to a broker, exchange, or ECN via the Internet, or via one or more dedicated circuits.

Using the internet allows a manager to communicate securely using Secure Socket Layer or Virtual Private Network (VPN) encryption protocols, but reliability cannot be guaranteed due to the number of "hops" through third party Internet Service Providers (ISP) involved. Internet connections tend to be less predictable in terms of performance, which can vary due to loading conditions at the various ISPs involved, and less reliable due to a general lack of Service Level Agreements (SLA) in the ISP world.

Managers requiring guaranteed reliable communications generally opt for a dedicated circuit (either Frame Relay or Direct) for at least their primary communications path, and then use either a second dedicated circuit or an Internet connection as their secondary communications path. SLAs are generally available for all dedicated circuits, and provide a comfort level to the manger in terms of guaranteed uptime and performance.

Management Systems

Upon execution of an order, the technology platform would ideally portray all trading and portfolio information in real time and broken down into segmented information qualified by fund/trader/strategy/sector. Risk management applications can help managers adhere to their approach to the markets with the metrics for evaluation of risk profiles. Managers need the eligibility to immediately understand the impact of changes in prices and underlying instruments, as they impact their portfolios and contribute to the decision making process during the trading day.

After trades have been handled by the front and middle office systems, the information needs to flow to the general ledger system which constitute the official books and records. As all transactions impact the general ledger, the ledger additionally can serve as a data warehouse for assisting in generating reports to help manage the business and fulfill obligations.

Trades and obligations from derivative contracts impact the management of funds and currencies. This brings exposure to more risk and to more opportunities. In terms of best practices, a hedge fund manager will be best served with an automated treasury function that monitors and manages cash balances, as well as help in managing exposure to changes in FX rates. Additionally, maximizing collateral management can contribute positively on performance. The treasury management system can help performance by contributing to decisions concerning managing liquidity.

After this information has been entered and processed through front and middle office systems, it then needs to flow seamlessly to the general ledger system. In a perfect world this would happen in real-time, and there are systems and service providers available to the hedge fund manager that can deliver this capability. The general ledger should also have certain modules fully integrated into its system, such as a comprehensive tax system (including wash and constructive sales analyses), as well as a module for generating investor statements and performance attribution (again, by fund, strategy, sector, trader). Furthermore, the general ledger should be an "open" system, allowing the manager easy access to the data. More and more managers are using the general ledger and its fully reconciled information to feed their risk systems and other analytical functions.

Although certain hedge fund managers perform the accounting and administration functions in-house, most managers use a third party fund administrator to prepare and maintain the books and records of the funds, as well as all investor information. It is imperative for the administrator to be able to provide data, reports and investor information on demand, and in a format that the manager can easily understand and utilize.

Outsourcing

So how does the manager achieve a best practices solution? Four years ago, the hedge funds tended to do all the middle and back office processing themselves. This function required significant management time as well as substantial resources to build and maintain in-house systems to accommodate new instruments and products. The ever-growing technology expenses have not only been a significant burden on the fund’s performance but have required management time to hire and manage technology, operations and accounting personnel. Finally, the conversion to EURO and Y2K required substantial time and resources for non-revenue generating activity. The difficulty of finding the right technology people also became a burden that hedge fund managers found distracting their focus from the markets.

A logical evolution to this circumstance was the outsourcing of these roles to vendors structured for scalability and fund administration. The vendor would have economies of scale to allow them to handle things like the upcoming EURO 2 (elimination of "in currencies" and replaced with Euros) more efficiently than each fund on its own. Additionally, the creation of new products generally requires some technology investment to automatically support the activity. For a vendor this expense is spread over a number of clients as opposed to a large expense for each hedge fund. This efficiency opportunity is of benefit to the hedge fund manager who is looking to minimize the impact of higher technology expenses on the fund performance while still maintaining the flexibility of trading new products.

Such scalability may also offer cost benefits. Many outsourcing firms charge for their services as a percentage of the manager’s assets under management and, consequently, the investment manager receives the benefit derived from treating these expenses as a variable cost. Another important advantage of contracting with an outsourcing firm is "pay for play", i.e., you buy only what you need. Many outsourcing firms offer a vast array of services that can be tailored to the specific needs of a particular manager, with the cost directly related to the services selected. In addition, outsourcing firms tend to set their fees and charges based upon the complexity of the manager’s investment strategy and other critical factors, such as the complexity of the instruments within the portfolio, portfolio turnover, operational difficulties (i.e., such as the number of prime brokers and clearing agents utilized), as well as the technology and data requirements and the detail and frequency of reporting. Outsourcing consolidates the manager’s infrastructure relationships to a single vendor, allowing the manager to focus on what they do best: trading and making money (hopefully!). u

 
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