In the increasingly competitive world of investment management, it is still possible to achieve a critical edge by simply presenting information to clients in an efficient and secure manner. Many money managers subconsciously see a client as being invested solely in their fund, and yet investing clients have their own difficulties keeping track of the numerous different funds and other investment types they have exposure to.

For investors, one of the big battles continues to be around procuring information about alternative fund investments in a format that meshes effectively with their own internal mechanisms. This conundrum offers the fund of funds manager an opportunity to seize a distinct competitive advantage and win investor goodwill at the same time.

Investors face the weekly struggle of collating performance information, much of which can get lost or arrives in a format which can only be transcribed with much manual effort and with the data errors which are an inherent risk with such a process.

A typical medium sized investor will be receiving data from alternative investments as emails, sometimes as PDFs. This contrasts with data on listed securities, which is cheaply and readily available in a convenient format. It is an enormous irony of the hedge funds industry that while the fund strategies themselves are highly sophisticated, the way in which their performance is reported is not.

Know your client

Today’s hedge fund investor is looking increasingly institutional in character; moving up the sophistication curve from the individual investor towards the requirements of pension funds or insurance companies, reveals a demand that information be delivered in an easily digestible format.

For the fund of funds manager, it becomes increasingly important that you identify the manner in which your investing clients would like to receive information. It becomes critical that you become aware of how your clients view that information and particularly how that data relates to the way your investors make use of their assets – for example their risk analysis protocols.

A fund of funds manager needs to understand that his fund still comprises only a small percentage of an institutional investor’s overall portfolio. Yet, all other things being equal, the investor is likely to favour the fund which will offer him better reporting, that can allow clients to readily process the information it generates.

Tailoring your data

To secure your competitive edge, you will need to consider the process you are using to report to investors, including the data points your clients want to see, and automate this process as much as possible. In today’s back office environment the technology now exists to provide high quality transaction-driven data in a format that is easily configured to the requirements of different stakeholders.

Funds of funds must recognise that for most investors, alternatives will comprise less than 50% of their portfolios, and frequently less than 25%. Therefore, managers of alternative investment fund portfolios need to be able to report into a framework that has probably been designed to harvest information from listed security investments. It will require involving service providers like fund administrators in the reporting conversation, and being consistent about how data is marshalled and presented. It will also require investment in tools which can be shared by service providers, helping to drive down the cost of delivery.

Overall operational compliance within the hedge funds industry needs to be a lot less problematic if funds are to meet the established reporting frameworks of institutional clients. As the character of the hedge fund investor base becomes increasingly institutional in nature, fund managers will need to make more use of technology – like the secure reporting opportunity offered by the Cloud – to ensure they make the most of the competitive edge efficient data delivery can become.

Investors in alternative funds are managing far more diverse portfolios than they used to. And even within the hedge funds universe, they are grappling with wildly different structures and liquidity terms. Investors are set to increase their overall allocation to alternative investments, a trend that was already becoming established prior to the financial crisis, but by doing so they are creating some immediate operational challenges when it comes to monitoring their critical cash picture.

Fund allocators embrace new conditions of risk when they invest in alternatives. From an operations perspective, one of the key obstacles is the implementation of appropriate technology within the business that will allow for the effective management of alternative portfolios alongside other investments like long only funds and ETFs, where liquidity timelines and redemption conditions are very different. It is not unusual to have a UCITS fund with daily dealing sitting in the same bucket as a conventional hedge fund with monthly liquidity or a private equity or real estate fund with even longer liquidity time frames.

We are now living in an environment where more emphasis is being placed on internal risk controls and the quality of real time reporting is an important part of the overall risk management package. Portfolio managers and risk officers within investor organisations need to make sense of and fully understand the divergent cash flow and liquidity picture. Failure to do so will only create further pain for the organisation when another disruptive market event occurs.

Today’s institutional allocator will have a number of alternative funds within their portfolio:

• Onshore hedge funds, including Limited Partnerships
• Offshore hedge funds, usually employing a unitised holdings model including series of shares or equalisation allocations
• Private equity investments, again with a Limited Partnership structure with a commitment and funded periodically on a capital call basis
• Real estate funds
• Alternative UCITS with daily or weekly dealing
• ETFs used as indexed hedges of based on alternative markets (e.g. based on commodities futures)

There is a need for a diverse range of alternative investment funds to be managed and analysed via a single platform, particularly when a portfolio manager requires accurate reporting on cash flow and liquidity terms. Managers of alternative fund portfolios now need to see all the way out the liquidity curve, to a year or more if needed. Private equity cash flows, for example, are much less frequent than conventional funds and need to be accounted for efficiently if the investor is going to ensure sufficient cash is on hand to meet PE commitments.

How can daily cash flow commitments to alternative investment funds be monitored on a forwards basis out to 12 months?

Proper cash flow management within the alternative portfolio in this challenging environment goes beyond normal accounting requirements. There is a need to budget and estimate both future commitments and withdrawals, taking into account actual and anticipated liquidity terms. Accurate risk management and forecasting can be managed on a dynamic basis from a single point, but not with an Excel spreadsheet. The sophisticated cash flow requirements of today’s industry go beyond what is economically achievable with Excel.

Today’s portfolio management solution needs to take account of a range of varying factors – liquidity terms of a hedge fund, or a particular side letter for example.  It has to be sufficiently customisable to dynamically track commitments over time, and provide an accurate picture of cash and asset positions, on a daily basis if necessary. To do this manually seems a reckless waste of man hours at a time when many investors are very conscious of both the lack of effective reporting on their portfolios and the costs they already incur in their operations.

The typical institutional fund portfolio will hold a range of assets with varying liquidity terms that will behave very differently under liquidity stress test scenarios:

Managing the balance between longer and shorter dated assets

It is important that, as the investment manager maintains his own diversification between different asset classes, he also keeps a clear picture of the pricing and liquidity terms of the portfolio of funds. This can even change several times a day. Juggling the short and long term liquidity picture simultaneously without appropriate monitoring can be like driving a car at midnight with no headlights. An Excel basic road map may help you, but you are still placing yourself at risk.

In addition, today’s portfolio manager will also need to model liquidity scenarios on an allocation-by-allocation basis, including hypotheticals. This can have an increasingly important bearing on decisions to allocate in the first place. The biggest variable, however, is the cash flow picture.  Is the manager overweight on monthly dealing funds? Can liabilities be met without altering exposures? Can they monitor and transact on both manager and client portfolio liquidity dynamically?

During the credit crunch of 2008, managers of alternative investment portfolios were forced to turn to their most liquid investments to access cash in the shortest possible time. Sometimes this meant liquidating holdings with some of the better performing fund managers. It is an experience that has created more emphasis on controlling and diversifying the underlying portfolio liquidity picture across sophisticated hybrid portfolios. Doing this effectively without resorting to manual and error-prone Excel-based processes is another matter.

At this juncture in time we stand in an industry that is becoming increasingly institutional, with over 60% of the assets being managed by hedge funds now originating from institutional clients. The client complexion of the industry has changed while the legacy technology in use within many firms harks back to an earlier and simpler era.
Technology issues are becoming a bottle neck for institutional investors, particularly with regard to managing and reviewing hedge fund portfolios. This is creating a demand for a more proactive and integrated approach to client reporting using technology that has the ability to break down the different components of the hedge fund trade. By bridging these operational processes, institutional investors can manage and review accurate data with a higher degree of confidence.

The scale of the problem facing the industry has been highlighted by Swift’s SHARP (Swift Hedge Funds Harmonisation Project) initiative. Swift identified a number of key operational issues within the hedge fund transaction process. While custodians and administrators can handle the paper trail when transaction volumes are low, the largest service providers to hedge funds now process well over 1000 transactions every month. Each order may come with up to 50 pages of documentation attached. A typical team within a hedge fund administrator might be handling 600-700 orders with a dedicated staff of a dozen or so. Apart from reconciling data with their own records, they must also ensure investors are complying with KYC and other regulations.

Because subscriptions processing is time consuming and error prone, the entire cycle from the time when the order is taken to taken until confirmation is received and accounts are reconciled can be as much as a month. Faxes of subscription agreements must be sent to transfer agents, which in turn must be confirmed by phone, with final documents being sent over by courier.

For a fund with monthly liquidity, these transactions can prove costly, particularly if the market has moved. Missing a deadline for an order could lead to a fund holding unnecessary cash, while a missed redemption deadline would leave a fund exposed to an unwanted position for another month, quarter of a year or more.

If funds restrict liquidity, or extend their lock-in periods, or raise gates, the risks of moving transactions in and out of funds grows. It is still very hard for custodians to provide funds of funds with accurate status reports, particularly when they are bombarded by faxes from administrators and transfer agents at the end of the month. For larger custodians, with dozens of service providers to deal with, the problem is only magnified.

One of the real tests of any portfolio management system occurs when things go wrong: in the world of money management, operational failures, for instance on the part of a business further down the service provider chain, can force the portfolio manager to re-evaluate retrospectively. Can he be sure that such revaluations are being consistently applied, especially if multiple individuals within the same firm are juggling dozens of spread sheets? Once mistakes creep into the historical portfolio picture, they can be difficult to track down and correct, and they can continue to have an unforeseen impact on reporting further down the line.

Beyond the problems of effective performance tracking, investors in hedge fund portfolios today want to feel they have a better grip on what is happening in underlying hedge funds. This means being able to view a more complete operational picture. Their questions cover key issues relating to fund liquidity, including whether funds have the ability to gate withdrawals, whether gates have been initiated, the expiry of each tranche lock up, and what the options are to reduce lock ups and when. Better information on the liquidity scenario can deliver important additional advantages to the portfolio manager.

It all comes down to a question of confidence: can an investor feel confident that a trade has been properly executed? Has it been confirmed by the relevant custodian and underlying transfer agent? How long does it take to receive the estimated and real NAVs? Do they always come in on time? Are communications with relevant parties secure and dynamic enough to process real-time information flows?

With a more detailed picture comes a higher degree of confidence in the underlying investment and a superior level of reporting to end investors when required. This also helps the portfolio manager to allocate further funds more efficiently.

The investor community in particular is seeking solutions that will allow it to improve the efficiency of the hedge fund trade cycle, providing for enhanced interaction with fund managers and service providers like administrators and custodians.

Talk of ‘transparency’ is more prevalent than ever: we have statements to this effect from regulators and investors (e.g. in the recent survey of managers and investors published by Ernst & Young)[1]. But can we properly define what we mean by hedge fund transparency and produce a benchmark industry standard?  Commentators have discussed the transparency of the trade, for example in equities pricing, but how can you translate this into hedge fund investments? In the post-Madoff environment, transparency now means proper verification of every stage of the trade, from the initial investment in the fund to where the assets are held.

From the perspective of the investor, for example a typical pension fund or family office, an investment in a hedge fund is treated as a security, and with that come concerns about liquidity: where is the investment held, what it is worth? How is it treated from a legal perspective?

In short, investors would like to be able to see their alternative investments alongside their other assets, be they exchange-traded securities or long only mutual funds. The problem is that hedge funds – and their private equity equivalents – are more opaque and are still seeking solutions that will allow them to deliver this degree of enhanced reporting to the investor community. It is difficult to get away from the spread sheet when it comes to managing an alternative investment portfolio: finding out what something is worth is hard enough using Excel; what about providing a confident measure of liquidity?