IBM Business Consulting Services. Financial Markets. Fund managers: The challenge of hedge funds

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Jeremy White
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1 IBM Business Consulting Services Financial Markets Fund managers: The challenge of hedge funds

2 Introduction Hedge funds have grown rapidly and are now attracting significant institutional assets. To traditional fund managers and their service providers, they represent both an opportunity and challenge. Existing processes and systems place constraints on fund managers who can outsource hedge fund administration to a specialist, but at the risk of increasing fragmentation. The inherent risks of fragmented operations demand a clear vision of how derivatives processing capability should be incorporated into process and systems. IBM Component Business Modelling (CBM) gives managers the ability to identify and assess the target operating model options quickly. New market conditions, new products Hedge funds have grown rapidly and while the market shows signs of maturing, institutions are allocating significant assets to this class. The key driver behind this growth was the ability of hedge funds once the preserve of high net worth individuals to deliver absolute returns in falling markets. This attracted the interest of institutions. Growth is also being driven by the wider availability of fund of hedge fund products as a result of changes to national regulations and EU-wide Undertakings for Collective Investment in Transferable Securities (UCITS). Ironically, market conditions over the past two years have been less favourable to hedge funds a key indicator, the Van Global Hedge Fund Index, under-performed the S&P 500. Although the rapid growth phase appears to have ended, institutions continue to allocate assets into hedge funds. This represents both an opportunity and threat to traditional fund managers. Competition is fierce and the lines between traditional funds and hedge funds are becoming blurred. Derivative appeal The first step for many traditional fund managers entering the hedge fund arena was to launch a fund of hedge funds vehicle, a simpler solution to the operational issues of supporting a hedge fund. The next step was to launch their own hedge fund. To do this, fund managers had to ensure that their operational and system infrastructure, or that of their service providers, could support it. In the longer term, the market is heading for more fundamental changes. As predicted in the IBM Investment Management Survey, 1 the migration from balanced to specialist mandates is becoming more evident. Active products may move toward absolute return to provide adequate differentiation from tracker products. Furthermore, insurers are demanding products that match assets and liabilities for consistency of returns with lower risks.

3 These trends drive the need for traditional fund managers to make a wider use of derivative products. However, fund managers are constrained in their ability to support derivatives in their mainstream products due to limitations in their existing systems infrastructure. Many handle low volumes of derivatives through manual and spreadsheet solutions, and by forcing book-keeping entries into underlying accounting systems. Concerns about fragmentation Service providers in turn have recognised this requirement. Some have acquired companies with this specialist capability. The challenge now is to integrate the specialist capability with existing mainstream service offerings, without fragmenting back offices and adding further complications associated with consolidated financial, risk and compliance reporting. Where fund managers have launched hedge funds, they have outsourced the administration and accounting to specialist providers. Given the extent of back office outsourcing and its creep into middle office many fund managers already rely on their service providers for the capability to support derivatives products and hedge funds. This concern is not limited to hedge funds as the tactic of outsourcing administration has been adopted for other specialist fund types such as property and private equity/ venture capital. Potential fragmentation of back offices is a concern even where the traditional fund management has already been outsourced. Number of hedge funds/assets under management Average international hedge fund returns 2000 to ,000 9,000 40% US$ billion ,000 7,000 6,000 5,000 4,000 Number of hedge funds 30% 20% 10% 0% -10% -20% -30% Annual % return Year Year AUM Number of hedge funds Source: VAN Hedge Fund Advisors/TABB Group/IBM Analysis MSCI World Equity VAN International Hedge Funds Index Source: VAN Hedge Fund Advisors/IBM Analysis Figure 1 Figure 2

4 Given the inherent risk and lack of transparency in some of the products being offered, consolidated risk and management reporting will be more challenging. In response, fund managers should take steps to: Develop clarity on their target operating model for supporting hedge funds, traditional products and emerging product types. Specifically, opportunities to share common processes such as reconciliations, corporate actions and securities standing data can be exploited to achieve economies of scale Achieve comparative levels of STP for derivatives with those achieved for traditional securities in developed markets Achieve scale and move to high-quality, low-cost service models. The changes in the industry affect fund managers and service providers across the value chain. Case study: Rationalising global operations A leading global fund manager with significant operations on four continents believed that rationalising processes and systems would yield significant savings, improve efficiency and flexibility, and help the business respond to market developments. Previous attempts to eliminate back office duplication had failed. Developing an appropriate operating model The IBM Component Business Modelling (CBM) approach to the development of a target operating model provides a flexible framework that can be easily and quickly adapted to different organisations. It provides a simple way to define the business at an appropriate level, that both the business and IT can apply. CBM allows appropriate target operating model options to be rapidly identified and assessed by a joint client and IBM team. This team brings together specialist industry knowledge and CBM expertise, enabling its members to first understand and assess existing processes, costs, resources and applications using high-level business component models. The major elements of the IBM approach are to: Assess the current model capabilities against the business strategy and key business requirements Assess the components of the current operating model: Is the component a key asset? Is the component value adding or a commodity? Are the characteristics of the component different in different locations or is there potential for sharing? Develop options for target operating models and supporting applications architectures: identify potential improvements and benefits and select target operating model Develop a business case and a rapid implementation plan for it. IBM Business Consulting Services applied CBM techniques to redesign the group s operational functions, implementing an integrated, horizontal operation where it had been vertical, regional and siloed. An IT application architecture aligned with the target operating model was designed. Finally, a business case for implementing the target operating model was developed. The model identified headcount savings in excess of 20% and an estimated 10% decrease in costs on AUM. Additional benefits at group level were achieved through economies of scale in IT. In a typical exercise of this type, initial analysis takes eight to twelve weeks to complete. The subsequent implementation effort and timescale depend, of course, on both the starting point and target end point, but in our experience is likely to take 12 to 18 months, and involve significant IT and business change. Throughout this time, IBM has the ability to support clients from initial analysis to implementation of business and IT change.

5 Hedge fund facts 1. Hedge funds are not new Despite being viewed as a recent market innovation, hedge funds have been around since Hedge funds are difficult to define Hedge fund is a generic term covering a variety of trading strategies see across for a summary. 3. The UK is the leading European centre for hedge fund management The UK has an estimated 70% market share of hedge funds managed by European-based managers (source: Eurohedge). In global terms, the UK is second only to the US in the share of hedge funds managed. It is estimated that 15-20% of global hedge fund assets are under authorised UK management. 4. The majority of hedge funds are domiciled offshore This is for fiscal and regulatory reasons. The British Virgin Islands and the Cayman Islands are the most popular locations. However, management of hedge funds is often conducted in major financial centres such as London and New York. Types of hedge funds Hedge funds may invest in various instruments including equities, bonds, junk bonds, private equity, derivatives (options, futures, swaps) and commodities. They are characterised by a clear investment strategy and proposition. Examples include: Long/short equity: Usually this is an investment strategy that removes directional market risk and allows stock picking skills to show through, e.g. 50% long positions, 50% short positions. Market neutral: Merger arbitrage: Attempts to capitalise on corporate events, for example buying shares in acquirer (where often stock prices will fall) and acquiree (where often stock prices will rise). The risk is, of course, that the deal will fall through. Fixed income arbitrage: Buying low and simultaneously selling high equivalent securities, e.g. different bond issues. It is highly leveraged due to the large positions taken and small spread. 5. Hedge funds are increasingly regulated In October 2004, the SEC ruled for compulsory registration of any hedge fund with more than 15 clients. How this is reconciled with maintaining the confidentiality of propriety trading strategies remains to be seen. Directional trading: These are characterised by a macro trading strategy based on expected changes to global market conditions. An example would be buying US dollar T-bills, borrowing yen which implies specific exposure to USD/JPY exchange rate. Level of activity and risk An emerging trend in mandate style? 1% 2% 5% 90% 80% 68% 40% 35% 30% 20% 10% 20% Multistrategy: Funds that combine some or all of the strategies defined above. Fund of hedge funds: A rapidly growing segment which is often the first port of call for institutional investors ? Hyperactive Active Passive Static Year Figure 3

6 For more information, please contact: Chris Burgess, Associate Partner Tel: +44 (0) Graham Wright, Executive Tel: +44 (0) Or visit: ibm.com/bcs/uk IBM United Kingdom Limited 76 Upper Ground South Bank London SE1 9PZ The IBM home page can be found on the Internet at ibm.com IBM and the IBM logo are trademarks of International Business Machines Corporation in the United States, other countries, or both. Other company, product and service names may be trademarks or service marks of others. References in this publication to IBM products or services do not imply that IBM intends to make them available in all countries in which IBM operates. Copying or downloading the images contained in this document is expressly prohibited without the written consent of IBM. This publication is for general guidance only. 1 IBM Investment Management Survey, May Copyright IBM Corporation 2005 All Rights Reserved. FEEE

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