19 Apr 2012, Omgeo, Hedge Funds Review
Risk management is set to play an increasing role with European fund managers, according to an online survey conducted by Omgeo, the post-trade operations specialist, and Hedge Funds Review.
Respondents to the survey – representing the majority of Europe’s chief operating, financial and technology officers by assets under management – identified investor pressure, regulatory change and the need to support increased trading volume and asset growth as the main reasons for improving risk management capabilities.
Half of those surveyed said the main role of risk management was to improve asset allocation and optimise portfolios, while more than 44% said the main function was to report risk and performance data for use by the fund and externally. The greatest emphasis was put on proving risk management to investors, with more than half of respondents saying they needed to do this in order to raise assets.
The impact of regulation is increasingly at the forefront of change. In particular, the Alternative Investment Fund Managers (AIFM) Directive, Markets in Financial Instruments Directive II (Mifid II) and Solvency II in Europe (see figure 1).
These three key European Union directives are aimed at increasing overall supervision and understanding of the financial services industry, including alternative funds. More than one-third of hedge funds and fund of hedge funds (FoHFs) expect to focus on improving reporting and transparency because of these new rules, while more than half said their main concern regarding the impact of regulations was that it would increase the overall costs of doing business (see figure 2).
“Regulatory change is going to have a huge impact on the hedge fund industry, but there has also been a major change in terms of pressure coming from investors,” said Matthew Nelson, executive director of strategy at Omgeo. “There is an internal desire to change, which is more of a response to external events. Investor and regulatory pressures are a big theme for the next 12–18 months.”
While performance is front of mind for most managers, particularly after the lacklustre results of 2008, Nelson pointed out that compliance issues would increasingly put pressure on funds. “Keeping the shop running and keeping it compliant will be a huge task. Technology is going to be extremely important for hedge funds. Whatever the need is for the institution, technology for it does exist,” he said.
According to the survey, hedge funds are most concerned about increased regulation putting pressure on the bottom line, with 52.2% admitting they expect increases in the overall costs of doing business. A further 47.8% thought there would be additional complexities in post-trade processing because of regulation, while nearly 22% thought a lack of harmonisation in regional practices would contribute to costs. As a result of increased regulatory pressures, half of the funds surveyed said they were looking to change their internal processes, while one-quarter expect to invest in IT to meet the new requirements.
More than one-third expect to improve reporting and transparency over the next 12–18 months, while less than one-quarter said improving collateral and margin management processes was a priority (see figure 3). Improving trade processing was important to respondents (17.3%), followed by independent valuations and accounting (11.6%) and account-opening time frames (7.7%).
Manual to automated processes
Fund managers operating in a cost-sensitive environment should resist the temptation to cut corners, Nelson said. “Making sure that what the firm is buying allows them to grow is absolutely critical. You can’t just look at what you are doing today, you need to look at where you want to be tomorrow and make decisions based on those priorities. You need to think about what countries you want to go into and what asset classes. You need to think about whether the technology you are buying can support that expansion and can grow with your business.”
Aside from costs, almost half of fund managers surveyed expressed concern about the additional complexities of post-trade operations. From a post-trade operations perspective, the most significant improvement area cited in the survey was reducing manual processes, at 48% (see figure 4). This was followed by achieving higher same-day affirmation (17.3%) and improving counterparty connectivity (17.3%).
To support a return to increased volumes in equities and portfolio diversification, manual processes will need to be replaced by proven automated solutions that increase efficiency and reduce risk across the trade life cycle. This is especially important at a time when there is a need to prove effective risk management to investors and regulators.
How each fund approaches the need to move from manual to automated processes will be different, warned Nelson. “A firm may have a relatively small book in a certain asset class and, if it can manage those positions in Excel, then its desire to change is going to be very low. There are other places they could spend money now and get better return, not just performance, but for the firm.”
However, Nelson believes that, when scale and complexity of the fund crosses a tipping point, having one or two people dedicated to operations is no longer a solution. When this becomes “a bit of a handcuff for the fund”, Nelson said it is time to look for automated solutions.
“At some point, operations will get large enough and complex enough that the fund will want the benefits of having multiple prime brokers. That’s a huge operational challenge for the fund. That might be the trigger – not necessarily for regulatory compliance, but for the growth and expansion of the fund. When you get to that point, you can no longer rely on the prime broker to provide all of those services and the technology,” he said.
“How do they keep the costs down? That is the perennial challenge they will be faced with but, at some point, when the lean operation and the manual processing are acting as handcuffs for the fund, I don’t think you have a choice. You invest smartly and you leverage as much efficiency and automation out of your investments. That’s the model we promote at Omgeo; efficiency through the operations.”
While mitigating counterparty risk was widely viewed as a key area from a regulatory perspective, most hedge funds are making changes to their operations in this area because of internal pressures. Pre- and post-trade improvements will be all the more important as funds move into a wider asset class mix.
Nelson warned of the risks of manual processing, particularly where multiple sources – such as phone, fax and email – are used. Excel spreadsheets may be useful for funds that run relatively straightforward strategies with few trades, but more complex funds need to automate processes to reduce the operational risks inherent with manual processing. Because of the Madoff scandal, where trade confirmations were being fabricated, there is a lot more investor focus on this part of the overall due diligence. According to Nelson, investors want to know what technology is in place and that the fund has the policies and procedures to manage trades post-execution.
Return to growth
Hedge funds acknowledged a return to risk driving growth from an investment perspective. According to the survey, managers expect to see the most significant increases in trade volumes in foreign exchange (26.7%) as funds take advantage of arbitrage and high-frequency trading (see figure 5). Other areas of expected growth include equities (23.3%), fixed income (15.9%), contracts for difference (17.5%), exchange-traded derivatives (9.8%) and over-the-counter (OTC) derivatives (6.8%).
More than three-quarters of respondents to the survey said they were prepared for the move to central clearing of OTC derivatives. This result may be a bit surprising, but the reason could be a large reliance on prime brokers and fund administrators to handle the heavy lifting in this area.
“The hedge fund market has always been a large consumer of derivative instruments and this will be a big change for them. They will need to trade differently and consider the cost of those trades. Individually, they may not be worried about the post-trade environment, but the way trades are executed and new risk exposures are managed are the main concerns,” said Nelson.
The survey reflects these concerns. Most funds are worried about the increased cost to clear OTC transactions (42.9%), while one-third are looking at margining and collateral management processes across cleared and non-cleared derivatives, including more frequent calls, optimising collateral allocations and other factors. More than one-quarter expressed concerns about the availability of eligible collateral due to a loss of exposure netting, lower thresholds, stricter eligibility rules and other issues.
Of lesser concern, but not considered marginal, are the complexities around providing a consolidated view of counterparty risk across OTC derivatives, exchange-traded derivatives and securities lending markets.
To cope with these worries, funds are more or less evenly split on how they will manage collateral requirements – using internal technology (38.4%), using an outsourced solution either from a custodian or other provider (34.6%), or using third-party technology (27%).
Nelson believes the move to OTC exchange clearing has acted as a trigger for hedge funds to reassess how they use derivatives. Whatever the final outcome of the rules, he believes the markets will still demand specialised OTC products.
Looking to the future
Technology will continue to close the gap in current offerings. Only a few years ago, it was a big move for the funds to start trading across multiple asset classes and, as a result, technology had to find solutions for pre- and post-trading. “The customer continues to steer us to where they want technology providers to go,” said Nelson.
As new and unusual asset classes continue to be used and adopted by funds, the challenge will be to keep up with the changes. “We never know what the next trendy asset class will be. The technology side, in that respect, is always playing catch up. But when these asset classes come to market, we try to be quick to close the gap. That’s what comes of having a good relationship with the funds.
There were 52 respondents to the survey. The majority of responses came from single-manager hedge funds (65.4%), with FoHFs making up almost 35% of respondents. Funds with assets under management of less that $500 million made up the majority of respondents.
Funds with $500 million to $1 billion represented 15.5% of respondents, those with $3–$5 billion represented 3.8%, funds with $5–$10 billion represented 9.6%, and funds with more than $10 billion represented 13.4% of respondents.
Only those responsible for technology in funds based in Europe completed the survey, usually at the level of chief financial, operational or technology officer for the fund management company.
The online survey was conducted between February 20 and March 20, 2012 and results were compiled by Incisive Media’s in-house analytical team.