Oppts-Challenges in the Global Hedge Fund Industry

8/6/2019 Oppts-Challenges in the Global Hedge Fund Industry

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August 2006, Financial Insights #FIN203112

Financial Insights: Global Capital Markets: Looking Ahead

Opportunit ies and Chal lenges in theGlobal Hedge Fund Industry

G l o b a l C a p i t a l M a r k e t s

LOOKING AHEAD #FIN203112

David Cox Randy Grossman

F INANCIAL INS IGHTS OPINION

The hedge fund industry is one of the most dynamic and fastest-growing sectors of the financial services industry and has appetite forthe latest investments in financial reporting, trading, and settlement

technology. Financial Insights believes the hedge fund sector isstrategically one of the more important parts of the financial servicesindustry in terms of its potential growth and development oftechnology and perhaps one of the least transparent. Understandingthis industry in detail is critical for both technology providers andfinancial institutions looking to protect or grow their share of businessin this rapidly growing sector. Key industry growth factors include:

Hedge funds have more than doubled in size over the last fiveyears to approximately $1.2 trillion in assets under managementand are expected to double or even treble in size over the next fiveyears.

Hedge funds, more than other asset managers, rely heavily on prime brokers for technology as well as trading, fundadministration, and other analytic tools. Approximately 10% of the$10 billion prime brokerage industry is spent on technology.

Outsourcing, particularly for middle- and back-office functions, isa necessity for this industry, which is made up of about 9,000hedge funds globally. The vast majority of these funds have lessthan $1 billion under management.

Although recent court challenges to new hedge fund registration

regulations have succeeded, regulators will regroup and continueto shine a spotlight on the opaque hedge fund industry.

The trend toward portable alpha and alternative investmentscontinues to pick up steam and will drive hedge fund growth.

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#FIN203112 2006 Financial Insights, an IDC Company

T A B L E O F C O N T E N T S

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In This Report 1 Brief Description of the Solution ...............................................................................................................1

Situation Overview 1

Introduction...............................................................................................................................................1A Brief History...........................................................................................................................................2Current Environment.................................................................................................................................3Management Challenges.......................................................................................................................... 6

The Investment Environment.............................................................................................................6Compliance and Fraud Management ................................................................................................6To Outsource or Not to Outsource.....................................................................................................7

Success Factors .......................................................................................................................................7

Business Factors...............................................................................................................................7Technology Factors ...........................................................................................................................8

Future Outlook 9

Market Trends ..........................................................................................................................................9

Essential Guidance 10

Actions for Financial Institutions ...............................................................................................................10Actions for Vendors .................................................................................................................................. 11

Learn More 12

Related Research.....................................................................................................................................12


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2006 Financial Insights, an IDC Company #FIN203112

L I S T O F T A B L E S

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1 Timeline of Important Hedge Fund Industry Events .....................................................................3


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#FIN203112 2006 Financial Insights, an IDC Company

L I S T O F F I G U R E S

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1 Estimated Growth of Hedge Funds Versus Assets Under Management, 19922006.................. 52 Flow of Investment Funds ............................................................................................................6


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combination of futures and swaps and invest in pure alpha strategies ofmid and small capitalization active managers. The alpha strategiesselected depend upon the risk characteristics of the desired endportfolio.

The need for these types of strategies and instruments will bring you

inevitably into the hedge fund industry.

A B r i e f H i s t o r y

This is an industry that has consistently been a phoenix rising from theashes. Hedge funds have exploded in number, particularly since the1960s when they first came into public attention, but it has not been anindustry without its difficulties, especially during the late 1960s/early1970s and again in the late 1990s with the rush into Internet stocks andthe collapse of the highly leveraged Long-Term Capital Managementin 1998. From 2001 to 2006, the industry saw a further resurgence of

growth, but at the same time, it has come increasingly under regulatoryscrutiny. It is still not without scandal, as evidenced by the collapse ofBayou Capital Management in 2005 (see Table 1).

We can distinguish the following main phases:

Emergence of long and short trading strategies. Jones' fundoperated in relative obscurity until its spectacular results came tolight in the mid-1960s.

Growth of global macro funds. Global macro funds are focusedon currencies and markets rather than individual stocks.

Growth in algorithimic trading models. These models are stillstrong despite the collapse of Long-Term Capital Management.

Regulatory oversight. Hedge funds flourished in an atmosphereof secrecy, but under new SEC regulations, they are finally comingunder the jurisdiction of security legislation established in the1940s.


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2006 Financial Insights, an IDC Company #FIN203112 Page 3

T A B L E 1

T i m e l i n e o f I m p o r t a n t H e d g e F u n d I n d u s t r y E v e n t s

Date Event

1949 AW Jones forms the first long/short hedge fund; beginning of long/short strategies

1966 Fortune article on Jones brings hedge funds to public attention

19691970 Heavy losses among hedge funds

19731974 Bear market more heavy losses

1986 Institutional Investor Magazine profiles Julian Robertson's Tiger Fund growth of derivative trading

19901994 Growth of global macro funds (e.g., Soros)

1994 Formation of Long-Term Capital Management growth of mathematical models

1998 Russian government defaults on bonds

1998 Bailout of Long-Term Capital Management

2000 Collapse of Julian Robertson's Tiger Fund

2004 SEC requires hedge funds to register as Investment Advisors by February 2006

2005 Collapse of Bayou Capital Management

Source: Financial Insights, 2006

C u r r e n t E n v i r o n m e n t

The hedge fund and alternative investing industry has grownsignificantly in the last few years. However, the number of hedge fundinstitutions is difficult to estimate because the industry has nottraditionally been interested in transparency. It has only recently become the subject of increased regulatory scrutiny, with the SECrequiring all funds above $25 million and with more than 14 clients to

be registered by February 2006. However, that ruling will need to berevisited as it was deemed unacceptable and thrown out by the U.S.Court of Appeals in June 2006. Financial Insights fully expects theSEC to reconsider and implement new hedge fund regulations in thecoming months.

Many small funds remain unregistered, and some that had registeredunder that requirement have since deregistered since the June courtruling because of the high cost of compliance. Even still, there are


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thought to be close to 9,000 different hedge funds in existenceglobally, of which some 4,000 represent separate firms. The industry ishighly fragmented, but there is a significant concentration of assetsunder management, with the top 50 hedge funds managing 40% of theglobal market and the top 200 managing 90% of the market.

As a sector, as opposed to individual firms, hedge funds generallyproduce higher investment returns than traditional asset or investmentmanagement firms and also provide diversification opportunities,hence their growing importance to plan sponsors and other tax-freefunds. Hedge funds, therefore, represent a rapidly growing opportunityin an otherwise extremely competitive sector. Additionally, traditionalasset managers have struggled to produce returns to support pensionarrangements that are increasingly shifting from defined benefit todefined contribution plans but remain largely underfunded despitesome recent recovery. Figure 1 illustrates the explosive growth in thehedge fund market since the early 1990s particularly in the last fiveto six years.

Over the years, the hedge fund market has shifted its customer basefrom largely wealthy individuals to asset-rich institutions seekingadditional returns or protection from increased risks. While assetscontinue to pour into the industry (hedge funds expect overall assetsfrom pension funds to rise from 15% in 2006 to 19% in 2008, withannual growth forecasts of1020% and with fund assets expected todouble from $1 trillion to $2 trillion by 2008 or 2009 or even treble by2010), the quest for portable alpha has become so intense that firms inthis space are increasingly looking for opportunities around the worldthat take advantage of market inefficiencies and are expanding their

exposures accordingly. Figure 2 illustrates the typical flow of fundsbetween fund sources and uses of funds.

Today, approximately 30% of all U.S. equity transactions are executed by hedge funds, although they represent only 5% of all U.S. assetsunder management. This reflects the fact that, unlike more traditionalasset managers, they tend to invest in strategies that have much greaterturnover and subsequent trading volumes. Hedge funds increasinglydemand best price, speedy execution, and anonymity, whichessentially boils down to electronic trading services in today's market.Many hedge funds take full advantage of the electronic andalgorithmic trading systems being offered by an eager Wall Street.

This increased focus is also forcing prime brokerage houses to upgradetheir technology and increase their range of services.

In addition to being power users of advanced trading technologies onthe equity trading front, the hedge fund community is also a key targetmarket for the derivatives industry. To meet the need for portablealpha strategies among plan sponsors, many hedge funds have beencreated to embark upon sophisticated derivatives strategies designed tocapture alpha in almost every conceivable asset class, including


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foreign exchange, credit derivatives, and energy futures, etc. Thegrowth in derivatives volume has put enormous pressure on virtuallyevery part of that business to increase automation. This includesderivatives exchanges, trading systems, risk and compliance systems,and trade processing systems.

This trend toward globalization and high-velocity trading has likewiseput increasing pressure on hedge fund service providers, most notably prime brokers and other vendors. Because of the small size of mosthedge funds, they do not have the scale to internalize a lot of theiroperational requirements. Therefore, they rely heavily on the prime brokers for trading technologies and operations such as settlement,securities lending, financing, custody, and fund administration. As aresult of the rapid growth in the hedge fund sector, prime brokers arebeing forced to invest heavily in technology to support that growth aswell as to compete for business.

F I G U R E 1

E s t i m a t e d G r o w t h o f H e d g e F u n d s V e r s u s A s s e t s U n d e r

M a n a g e m e n t , 1 9 9 2 2 0 0 6

0

200

400

600

800

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1992 1994 1996 1998 2000 2002 2004 2006

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1

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3

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9

10

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(000)

Assets under management

Hedge funds

Source: ISI Group, 19922001; PIMCO, 20022003; Financial Insights, 2006


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F I G U R E 2

F l o w o f I n v e s t m e n t F u n d s

Sell Side

Public sector

(U.S. govt.)

Public sector

(U.S. govt.)

Private

sector

(Corporate)

Private

sector

(Corporate)

BanksBanks

Investment

banks

Investment

banks

Buy Side

Insurancecompanies

Insurance

companies

Hedge fundsHedge funds

Investment

managers

Investment

managers

Uses of Funds Sources of Funds

Tax-exempt

funds

Tax-exempt

funds

Retail

investors

Retail

investors

Broker-

dealers

Broker-

dealers

Mutual fundsMutual funds

Sell Side

Public sector

(U.S. govt.)

Public sector

(U.S. govt.)

Private

sector

(Corporate)

Private

sector

(Corporate)

BanksBanks

Investment

banks

Investment

banks

Buy Side

Insurancecompanies

Insurance

companies

Hedge fundsHedge funds

Investment

managers

Investment

managers

Uses of Funds Sources of Funds

Tax-exempt

funds

Tax-exempt

funds

Retail

investors

Retail

investors

Broker-

dealers

Broker-

dealers

Mutual fundsMutual funds

Source: Financial Insights, 2006

M a n a g e m e n t C h a l l e n g e s

The Investment Environment

The expected rate of return on hedge funds has recently been falling.This decline in returns partly reflects significant elimination in marketinefficiencies as hedge funds have aggressively pursued marketabnormalities to the point where they have become increasingly hardto find. This has forced the industry to redefine itself through aproliferation of different strategies and to seek market opportunities ona global basis.

Compliance and Fraud Management

Even for unregistered funds, the SEC is an important consideration,and the hedge fund is increasingly operating in a compliance-sensitiveenvironment. Scandals like Bayou Management LLC, a hedge fundthat operated in Stamford, Connecticut, and the unexpected closure ofMotherrock LP, a hedge fund created to trade natural gas futures,underline the need for regulating an industry that has long held anaversion to an excess of transparency. Additionally, the sheer size andvalue of funds moving into and out of this industry emphasizes the


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need for the highest levels of security and fraud management at thetransaction level. Although the legislation governing hedge funds hasbeen in existence since the 1940s, many firms are conscious of the factthat they are operating in a heightened regulatory environment and,forced by their own growth and SEC regulations, have moved towardregistration with the SEC.

In addition to the hedge fundspecific regulatory initiatives discussedearlier, there are also changes to soft dollar regulations that could alsoimpact how hedge funds manage their business. Those rules have morenarrowly defined the types of research that can be paid for via softdollars. For instance, the SEC's new Interpretive Guidance on Section28(e) of the Securities Exchange Act of 1934 has eliminated many portions of order management systems from safe harbor, as well ascertain portfolio analysis tools. This may have an impact on the bottomline of those firms that heavily utilize soft dollars, forcing somechanges in their fee structures.

To Outsource or Not to Outsource

As we have noted previously, hedge funds often tend to run with fairlylean staffs that naturally lend themselves to the significant use oftechnology in trading, risk management, accounting, analytics andinvestor reporting, and other aspects of fund administration. Successfulhedge fund managers will need to determine which aspects of their business can or should be internalized and which are the likelyoutsourcing candidates.

In the meantime, service providers and outsourcers continue to salivateover the potential inherent in the hedge fund industry, and many regardit as the golden goose. However, just as in any other aspect of life,whether business or personal, caveat emptor. Hedge fund managersneed to be aware of and steer clear of firms that seemingly commit toservice levels above and beyond their capabilities. This is particularlytrue of smaller, fast-growing niche vendors, which often experience adeterioration in service levels when their business expands rapidly.Thus, firms will need to continually monitor their outsourcingrelationships carefully.

S u c c e s s F a c t o r s

Business Factors

Unlike the early years of hedge fund development, where growth waslargely due to high-net-worth individuals, the search by plan sponsorsfor portable alpha is now largely driving the growth and diversificationof the hedge fund industry. At this point, the plan sponsor and hedgefund communities are feeding off one another, with hedge fundmanager searches and requests for proposals (RFPs) being initiated byplan sponsors on a weekly basis. Likewise, many hedge fund managers


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are aggressively courting the consultants that advise plans on managerselection. Specific business factors are as follows:

Marketing. Aside from actually having a sound investmentstrategy (no small feat), a major key to success, particularly forsmall players, will be the ability to attract positive attention to the

firm from among a deluge of competitors. In addition to havingfavorable investment results, that means being able to respondappropriately and in a timely fashion to all suitable RFPs and otherleads. Those managers that utilize their technology effectively intheir responses will be more likely to get a jump on thecompetition and show reporting and customer service proficiencyto their potential clients.

Fund of funds. Hedge fund of funds are, as the name implies,pools of money that are split among a number of hedge funds tocreate a fund with a specific risk profile. Downside risk, particularly from the failure of a particular fund, is thereforelimited. Because many of these hedge fund of funds are beingcreated and marketed by large asset managers and financialinstitutions, hedge funds will increasingly need to marketthemselves in that direction as well.

SEC registration. Although there is obviously a financial cost toSEC registration and subsequent compliance, many tax-exemptfunds may begin to require registration of their hedge fundmanagers. There is indeed some evidence for this phenomenon inthat the SEC has recently reported that hedge fund registrationshave actually increased since the requirement was eliminated by

the courts in June. Only a handful have deregistered.

Technology Factors

The rapid inflow of assets from tax-exempt funds puts enormouspressure on hedge fund managers to assimilate those funds quickly andefficiently. Although, as discussed earlier, hedge funds frequentlyoutsource aspects of their business, certain areas are rarely outsourced.These areas include:

Front-office trading. Hedge funds are the most aggressive usersof self-directed electronic trading systems of all U.S. investmentinstitutions. Virtually all hedge funds, more than any othercategory of U.S. institutional investors, use some form ofelectronic trading for a portion of their NYSE or Nasdaq trade business. Electronic trading in other asset classes such as equityderivatives and foreign exchange is also growing, and hedge fundsincreasingly will need to navigate the maze of multiasset-classtrading systems being offered to the market.


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Risk management. Outsourcing risk management is a much moresensitive issue for hedge funds because their risk managementprofiles differ so much from firm to firm. For many hedge funds, particularly ones that are focused on the credit markets, riskmanagement is a core activity, and one that cannot be delegated.Therefore, successful firms utilize and are dependent on advancedrisk technologies. Market risk is another area that hedge fundsfollow closely. Yet, like many other financial institutions, hedgefunds have not yet invested in operational risk mitigation in anymeaningful way. We expect that as assets grow and costly errorsoccur, that will change.

Portfolio management and strategy development. Hedge fundstrategies are typically more complex than traditional, long only-asset-management strategies. One of the many IT challenges thathedge funds face is the ability to find systems that are capable ofdealing with the complexity and global nature of many of theirtransactions. Some managers may find themselves in theunenviable position of becoming system integrators as they try toknit together disparate systems from various asset classes andgeographies. Successful managers will architect a cohesive ITstrategy to deal with those issues.

FUTURE OUTLOOK

M a r k e t T r e n d s

Clearly, the hedge fund market continues to be on fire in 2006, with

the estimated number of hedge funds currently north of 9,000 globally.That is up 12.5% from approximately 8,000 in 2005. Hedge fundassets under management have grown at a 20% CAGR since 2000,including 2004 (which was arguably a horrible year for the hedge fundindustry). With the high level of interest in alternative investments inthe tax-exempt community and the continued growth and availabilityof inexpensive electronic trading tools, Financial Insights does not seethe industry slowing over the next few years.

Barriers to entry for potential hedge fund managers are relativelysmall. Besides the funds to manage and a good investment idea, all onereally needs is a PC and a prime broker to set up shop. That is not to

say that the majority of funds or firms will succeed. Quite the contrary.Like small business people everywhere, most will struggle, and manywill end up leaving the business without making a profit. So there willcontinue also to be a fair amount of churning at the bottom end of themarketplace.

The anticipated growth in the hedge fund industry necessarily meansthat outsourcing opportunities will also continue to grow. The vastmajority of hedge funds have less than $1 billion in assets under


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management, and some estimates put the percentage of hedge fundswith $25 million or less under management at 75% of the total. So formany outsourcers, particularly prime brokers and fund administrators,the hedge fund industry will be a relatively low-margin business thatcan only be profitable at larger scales. Outsourcers will need tocontinue to invest heavily in technology to keep the top 5% of theirclients (and their top revenue producers) happy. Yet at the same time,they must continue to attract the multitude of small funds emerging onthe scene with a combination of low fees and advanced technology.

Hedge funds and their related service providers represent a vast andrapidly growing business opportunity. In addition to the outsourcingservices we have already covered, they will also need banking services just like any other institutional client, but with some importantdifferences. For instance:

In addition to prime brokerage services, hedge funds need short-term credit, sometimes foreign exchange, and almost invariablycash management services.

Margin accounts for OTC transactions will be required to supportderivative transactions.

Balance reporting and electronic funds transfer services will beneeded to manage margin accounts and support prompt tradesettlement execution as well as manage multiple accounts, many ofwhich may be multicurrency and in multiple global locations.

Ironically, unless they specialize in foreign exchange strategies(e.g., FX Concepts), many firms outsource their foreign exchangerequirements to their prime brokers, except in so far as derivativetransactions are concerned.

The nature of the hedge fund industry is such that it touches everyaspect of financial services, from prime brokerage to cashmanagement. To be a successful provider, financial institutions willhave to find a sales and relationship management mechanism that cutsacross traditional product silos to provide an integrated solutions-basedapproach to servicing this sector.

ESSENTIAL GUIDANCE

A c t i o n s f o r F i n a n c i a l I n s t i t u t i o n s

Sound investment strategies, good marketing, and superior technologywill be instrumental for successful hedge funds. Hedge fund managersshould consider the following:


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Analyze your business and figure out your core competencies.While outsourcing is frequently the right choice, as your firmgrows, it may make sense to bring some functions back in-house.Steer clear of vendors and outsourcers whose ability to scale up issuspect.

Increase usage of electronic trading for all asset classes where it isavailable. The cost to trade electronically is a fraction of the priceof telephonic trading.

Upgrade to multiasset-class trading systems that allow one to tradesimultaneous strategies in equities/FX or equities/derivatives.

Develop relationships with pension fund consultants. They will bein the best position to recommend your fund as well as to directRFPs in your direction.

Register as an Investment Advisor with the SEC. This will enhance

your opportunities among the tax-exempt funds.

A c t i o n s f o r V e n d o r s

Although opportunities abound for technology vendors andoutsourcers such as prime brokers and fund administrators, they shouldconsider the following:

The small size of most hedge funds limits revenue potential perfirm. Therefore, concentrate on business lines that can scale. Fortechnology firms, this means being able to offer your product in an

ASP model. For large financial institutions and fundadministrators, it means reducing staffing costs by leveragingexisting technologies from across the enterprise and investing innew technologies that allow your business to scale.

Opportunities exist for outsourcers and system integrators that canhelp hedge fund firms knit together technologies across thespectrum of complex strategies, asset classes, and geographies.

Although straight-through processing (STP) is largely a reality forequities, greater attention must be paid to processing bottlenecks inthe derivatives and structured products marketplace. Firms that can

efficiently settle sophisticated credit derivatives and swaps willhave an advantage.

Prime brokers and fund administrators should ensure they cansupport the compliance objectives and activities of hedge funds.Regulators will likely continue to push for stricter regulation anddemand higher levels of reporting from the funds.


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LEARN MORE

R e l a t e d R e s e a r c h

Top 10 Strategic IT Initiatives in Global Capital Markets for 2006:Automation Rules! (Financial Insights #FIN1727, February 2006)

Worldwide Capital Markets 20062011 Spending Forecast andAnalysis (Financial Insights #FIN1700, December 2005)

Effects of Soft-Dollar Regulatory Changes on Capital MarketTechnology Spending(Financial Insights #FIN1646, August 2005)

Asia/Pacific Becomes Enamored with Hedge Funds (FinancialInsights #FIN1643, August 2005)

Hedge Funds in Asia/Pacific: Squarely on Radar(FinancialInsights #FIN1623, July 2005)

Capital Markets ASPs: A Good Starting Point for Outsourcing(Financial Insights #FIN1406, January 2004)

C o p y r i g h t N o t i c e

Copyright 2006 Financial Insights, an IDC company. Reproduction

without written permission is completely forbidden. ExternalPublication of Financial Insights Information and Data: Any FinancialInsights information that is to be used in advertising, press releases, or promotional materials requires prior written approval from theappropriate Financial Insights Vice President. A draft of the proposeddocument should accompany any such request. Financial Insightsreserves the right to deny approval of external usage for any reason.

Oppts-Challenges in the Global Hedge Fund Industry

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