ORCHESTRATING ALPHA: THE HEDGE FUND OPERATING SYSTEM

Friday, February 6, 2015

I. Introduction

For the financial markets 2014 was another year of change as sentiments moved forward, strategies were intensely scrutinized, and regulation remained uncertain.¹

It was no different among hedge funds as their assets under management grew – only to see more funds fold at a faster rate – compressed by conservative positioning and mediocre returns, and unable to sustain the pressures of transparency and key operational tools to hunt alpha. While the old guard held on to legacy, non-real-time infrastructures, emerging hedge funds began to exercise better credibility through smarter and faster cloud-based solutions, while topping the hedge fund industry by performance.²

This is the world we live in today; a fund-eat-fund, multi-prime, fragmented and uncertain landscape—where those that survive will do so by using strategies where data must be strictly-managed, where risk is everything, and where the “hedge fund” is not only a vehicle for other institutions, but an asset class for institutional and retail investors alike. A hedge fund, any hedge fund, is no more than the sum of its parts—no different than an automobile. It is in fact the parts that determine whether its optimal speed will be 80 miles per hour and how quickly it can decelerate to take advantage of a once-unforeseen corner of opportunity. It’s the same with the system(s) that hedge funds rely on to manage the business, whether the critical components be an order, execution and risk management system (OERMS), automated end-of-day processes, cap intro, or the Portfolio Manager him/herself.

Thus, alpha is a result of these parts but not as they are individually—instead as they are orchestrated together for more informed investment decisions, better data management, and the total evolution of client relationships.

Today, a modern hedge fund operating system must support the parts of a fund at a specific locale as well as cross-office components in London, Chicago, or Jakarta— in the boardroom or on the golf course. Orchestrating alpha is about seamlessly operating cross-function in real-time with customized, mobile, and accurate workflows for:

The Portfolio Manager
The Head of Trading
Ops & Tech

A hedge fund operating system is powered by a unified database for real-time, accurate workflows, analysis and reporting across the front-office. It is hosted in a secure data center with direct connections to leading market exchanges, data providers and sell-side brokers. And it is backed by outsourced managed services to ensure accurate valuations across all holdings on a daily basis. This ensures accurate data management, eliminates multiple points of failure and latency across disparate systems, and provides resilient disaster recovery and business continuity planning.

II. For The Portfolio Manager

Taking the reins for the fund and staying within investor mandates is no small task. Constant control of the portfolio is absolutely essential for the Portfolio Manager (PM) to generate alpha while remaining compliant and taking advantage of exposures.

Even in the early stages of a fund, the PM’s core faculties must include executing and refining methodology, compliance assurance, benchmarking against peers, and portfolio communication. And later, these responsibilities will widen to include some or all of the following, to not only take advantage of attractive investment opportunities but to also attract larger, more sophisticated clients:

Viewing, identifying, and managing the diversification of risk
Stress-testing strategies to uncover hidden exposures and bets
Client reporting to steady the hedge fund / investor relationship

Accurate, real-time views, accessible anywhere allow PMs to see current positions as they update, historical numbers over time, and hidden risks and opportunities across holdings. The right system should provide all of these capabilities within seamless workflows—contributing to a smarter investment strategy by saving time and increasing value brought to client relationships.

Consider the following scenario:

The PM fields a call from a potential investor who’s well-connected and could catapult the fund into the top endowments. The potential investor drills the PM with questions about methodology, risk and compliance, infrastructure and the middle office.

The call is an assessment on whether the fund has the capacity to take on new money— it’s as much about performance and pedigree as it is about having the scalability and infrastructure to support stiffer transparency demands that come from working with more sophisticated investors. The investor is also looking for assurances that their contribution will not decrease the PM’s ability to execute the strategy, due to patch-work operations and controls that can keep the PM away from investing… and as a result can prohibit the performance that prompted the initial call.

After walking through methodology, the PM grants the potential investor access to an app that his/her current investors access for ‘personalized transparency’—the ability to drill-in and interrogate performance, daily P&L, market and liquidity risks, and NAV-light statistics. And when the PM deems necessary, the ability to see how the fund’s top holdings or exposure to a specific industry, sector, or name are affected in real-time, as the markets move and positions update.

The best part of this scenario—the PM fielded this call away from the desk and utilized an iPad to drive the discussion.

It’s a common conversation—a discussion about ongoing strategy veiled in updates for past performance. In these instances, the PM will need a real-time tool to sift through a database full of historical numbers – using profound, accurate data sets to not only explain where they stand today, but how their decisions will influence strategy and returns tomorrow.

Overall, the right operating system will encourage better relationships by quickly allowing the PM to understand where, when, and why there was performance—and provide a single, modern entry point to communicate that performance back to investors at personalized levels of transparency, at all times.

III. For the Head of Trading

While the Head of Trading may be the same individual in early growth shops, the responsibilities that come with that title are unique—if not opposite sides of the same coin from the PM. And, the infrastructure required to support heads of trading invariably must complement those priorities:

Creating orders and ensuring best execution across a network of counterparties
Remaining compliant in a multi-separate managed account (SMA) environment
Directly fostering strong relationships with executing and prime brokers, and the rest of the street
Indirectly fostering a stronger PM/investor relationship

The right operating system will combine workflows across order, execution and risk management to ensure all trading activity, from trade inception to execution and allocation principles, is compliant with the fund’s investment policy cross-investor, cross-strategy and cross-geography.

Consider the following:

18 months ago the fund launched with $50 million in assets, two prime brokers, several executing brokers and zero SMA’s. Fast forward to today, assets have doubled, the primes remain intact and the PM has relinquished all market transactions to the newly-hired Head of Trading. And the PM is about to land a coveted investor that will change the fund’s AUM landscape all together. One requirement persists—the fund cannot co-mingle this latest allocation with its other investors.

In this instance, and moving forward, the head of trading requires modern technology with agnostic workflows to allocate positions in a compliant manner, all within a single infrastructure that does not sacrifice best-execution due to time spent on manually tying-out positions across each clients’ portfolio(s).

Compliance is another key requirement in this environment—since the fund’s strategy and investment policy are well-defined, there’s only so much wiggle-room left for the Head of Trading to augment strategy. Therefore, long-term success comes from best execution, all within boundary, while avoiding the ‘noise’ that can come from brokers, instant messenger and other social outlets. This is where sub-millisecond pre-trade controls built into the agnostic front-end not only identify—and where needed, nullify out-of-bounds transactions—but foster better relationships with the PM by eliminating hidden surprises when it comes to putting client money to work.

IV. For Ops & Tech

For some funds, operations (ops) and tech functions are supported by an in-house specialist. Sometimes this person is the last one left who knows the ‘ins and outs’ of a legacy system, or the band-aid approaches to working across many systems. Sometimes this person is outsourced and far from the time zone in which the fund centrally operates. Either way, ops and tech can play a role in eroding capital or levitating alpha.

For emerging managers especially, ops and tech can be the load that weighs down the forward movement of the fund—by limiting capabilities for institutional credibility and dragging on costs in the first months of viability.

In a perfect world, ops and tech help to orchestrate alpha by eliminating inaccurate, incomplete and at times of volatility, out-of-date data that can come about from legacy systems and manual processes, all while keeping costs and headcount down. This is where choosing the right operations infrastructure, no matter the stage of a fund’s maturity, comes into play as it should:

Provide follow-the-sun business continuity and disaster recovery
Tie-out all investment/trading activity accurately
Play nice in a multi-prime world
Nurture scale as the business grows

The right operating system will incorporate automated middle-office workflows and processes that are harbored in a managed services framework – backed by the cloud and fully supported by an outsourced team of experts – to ensure accurate, real-time mobility across data sets and time zones, no matter the size of the fund or its growth rate.

An example:

Before making the decision to allocate to the fund, the potential investor investigates if the PM has given some of the important business administration functions away at an early stage so she can focus on the strengths his/her career was built on—navigating the global markets to generate out-sized returns. A must is having an accurate, complete picture of the fund’s performance, risks and NAV at all times so the fund is well equipped to work more money and launch new products, irrespective of market conditions.

The PM, already having outsourced his/her operations to a trusted third party, provides examples of the fund’s credibility. Instant access to reliable, customized dashboards and reports from a central, mobile repository backs his/her investment decisions. The dashboards detail NAV-light statistics which are calculated, stored and refreshed on a daily basis for start-of-day accuracy and to provide transparent, frequent reporting to his/her investment team.

The outsource-decision institutionalizes the firm’s pre- and post-trade life cycle processes (file collection and normalization; corporate actions; reconciliation with brokers and the fund’s admin, short interest costs and margin financing among other calculations) and assures accurate data will be used throughout the investment process. This allows the PM to turn data into customized information that, at times, improves performance due to anytime access to granular historical information which can be used to refine forward-looking investment decisions. Said investor is convinced.

In this instance, outsourcing leads to a smarter investment core that allows the PM to spend less time working through end-of-day responsibilities. The costs and tedium of file transfers with brokers and fund administrators, corporate actions processing, reconciliation and producing / studying trade-break reports can be given to a trusted partner so the investment team can allocate the majority of their time to strategy execution and client relationships, which are driven by sound and highly accessible data. The funds who utilize automated end- and start-of-day processes for smarter data management will remain a step ahead in an overwhelming and competitive marketplace— where PMs and Heads of Trading alike need to be constantly ready for around-the-clock investing and around-the-clock communication of key metrics.

V. Conclusion

The right infrastructure is a modern hedge fund operating system, evolved away from different point solutions tailored for one aspect of the investment management process to a single, mobile source of best-of-breed approaches across the front and middle office. It’s an environment where each part of the whole, each component of any fund, emerging or established, can leverage away from cost pits and instead orchestrate alpha, whether they sit as:

The PM, managing client relationships, driving strategy and pivoting to take advantage of new opportunities
The Head of Trading, informing orders and ensuring best execution
Or the ops & tech underneath the hood

-- One system, for all of the parts of a fund—Real-time. All the time. Everywhere.

For more information on how Liquid Holdings can help orchestrate alpha across your business, request a demonstration of our operating system or visit http://liquidholdings.com/solutions/liquid-platform.