Article published in AIMA Journal, Autumn 2008, by Rupert Vaughan Williams, Comada.
The three ‘Ds’ currently playing a large role in the STP conundrum in today’s fund of funds businesses are:
They have a lot to do with the specific technology risks some alternative investment firms are running; addressing the challenges these ‘Ds’ pose will help funds of funds immeasurably, both in terms of cost savings achieved and in overall operational efficiencies.
Let us start with Duplication (and its surly cousin Error): Both are an ongoing bane for funds of hedge funds that find they cannot synchronise pricing and trades as a result of both duplication and error. Fund managers are faced with a need to reconcile actual positions and performance, received from managers’ transfer agents, administrators and custodians – data which can then allow them to analyse performance/risk and report accurately to their investors. It is a goal that is hard to achieve without a serious re-think of IT strategy. Confirmed details of prices from managers, administrators, and even a sub-adviser, need to be improved to avoid creating reams of unnecessary work.
This brings us to our second ‘D’: Data.
Although the industry has changed over the last ten years, in terms of the size of the assets under management and the scale of investors participating in hedge fund type investments, much in the way of pricing and data management has not. Infrastructure which might have been considered adequate in 1998 does not really meet the grade today.
This is probably true of many areas of technology (who fancies the prospects of the Sony mini disk these days?). However, given the influence that institutions are having in shaping the way hedge funds manage their operations, funds of funds will need to seriously address the systems they have in place at the moment. The point here is, that in many cases the commitment to invest in infrastructure has been sadly lacking.
Firms must now consider the way they are managing transaction-level data within their businesses. This should take into consideration a wide variety of factors beyond simply pricing data i.e. due diligence, risk assessment and monitoring, lock-ups and gates and even tail risk, as well as charges and other fund parameters. Such information should be readily available and actionable but the unstructured tools still being employed by hedge funds, coupled with the increased complexity and illiquidity of underlying portfolios, means that it is hard to track down.
Funds of funds need to balance the benefits of operating solely with third party data, compared with managing their own transaction-based data internally. The latter solution would allow more effective modelling and risk management, as well as letting the portfolio managers make an informed comparison with third party data resources. As always, integrating these different data sources still means addressing the way data is managed in-house.
Funds of funds are also waking up to the fact that proprietary data and third party data are not the same thing. As many hedge funds start to adopt a liquidity profile that more accurately reflects private equity vehicles, funds of funds have to formalise liquidity management and risk procedures. This includes an ongoing analysis of redemption options and an awareness that these can change with the markets, as we saw last summer.
Hedge funds, by their very nature, are not liquid securities and essentially operate as private placements. One may be in for a disappointment if approaching hedge fund portfolios within the IT parameters of more conventional securities.
Managers need the peculiarities of the various funds they have exposure to at their fingertips, including the investment structure, the explanatory memoranda and the costs and terms that might be associated with accessing and redeeming units. They need a snapshot of those liquidity and cost variables but how does one get it in a scalable manner?
This brings us to the third of our ‘Ds’: Documentation. For a fund of funds, portfolio managers need to be able to retrieve due diligence and other associated documentation quickly and logically, in an electronic format. The correct management and availability of documentation on an ongoing basis, sometimes across multiple offices, is critical in helping funds to stay on top of liquidity risk. Various IT applications are available to help achieve this but some are more suitable than others. A tailored approach to document management that addresses the unique requirements of funds of funds managers, seems the most suitable.
It is obvious why the ASP delivery model has become so popular with IT providers for the investment management industry. Remotely-hosted technology is easier to mesh with a highly robust infrastructure profile, easier to maintain and it can interface smoothly with disaster-recovery protocols. The ASP approach has the added benefit of not requiring the installation of masses of new hardware in an otherwise lean investment management operations environment. It is also cheaper. Funds of funds are, after all, in the business of investment management, not technology development. The cost of developing and maintaining in-house solutions can be astronomical, affordable only if you are an investment bank or custodian with a large infrastructure but not otherwise.
For an industry that has traditionally outsourced virtually all its key components from accounting and custody to fundraising, the step to outsourcing its technology should, conceptually, be straightforward. What should make this kind of decision even easier is the ability to use an ASP solution, even better if it is web-based. If there was ever a single solution developed to help integrate a fragmented industry, the use of browser based applications is the one.
An ASP solution is also readily scalable and software can be easily updated remotely by the provider, as and when the fund manager’s requirements change. Firms that are using multiple offices can ensure that the technology is readily deployable across time zones and continents.
Integration: It is achievable
The morass of conflicting data that CIOs of funds of funds can face need not be a problem. A single, integrated ASP-hosted system can ensure that the data in use in-house is the right data, it is updated, it is accurate and it is readily accessible, whether sitting in your office in London or with a client in Jakarta. Real and accurate valuations, exposure and analyses are now more important than ever in the reporting process.
Apart from levering proprietary data out of the legacy silos it has probably been collecting in over the years, established firms will also be grappling with scalability issues as they get bigger, make more hires and open new offices. For example, we are seeing many major funds of funds opening new offices and expanding their operations in Asia. This relates partly to an appetite for increased allocations to managers in the region and partly to a need to service increasing numbers of cash-rich Asian customers. For increasingly global businesses, a single, harmonised data-management system is needed, so that fund of funds managers can make informed decisions, using real data, much of it proprietary.
This is not rocket science. It does require careful thought as to how growing businesses formalise their data management processes. It does not require building systems from scratch. However, it does need a revision of systems that might have grown organically and which might be fragmented or which might not have evolved as the fund management business has grown. As a consequence, operational risk is being created unwittingly through the failure to source appropriate data. Worse still, it is leading to the making of decisions that are based on inaccurate data. It also means that funds may end up reporting inaccurately to investors – a situation that opens up a whole new can of regulatory worms.
The ASP model is also more robust from a security perspective. Internally-hosted systems, as some major quant funds will attest, can require a huge investment in personnel and infrastructure, in order to ensure security requirements are addressed. It can take months, even years in some cases, for institutional-grade IT security measures to be properly implemented on a firm-wide basis. With ASP-delivered systems, managers can be up and running in a matter of weeks, safe in the knowledge that much of the mission-critical software is being hosted remotely in highly secure locations.
ASP-delivered software can be completely outsourced to an IT partner, or can be installed within the investment management entity to varying degrees. For funds of funds, the key is getting this balance right and finding the formula which matches one’s size and operational expectations. Luckily, many ASP solutions can be upgraded gradually over time. It is important that the solution chosen is one that the whole business can make use of, is easy to use and can run on multiple applications.