Asset Managers Tackle Hidden Demands Of Convergence

Jun 17 2015 | 1:53pm ET

By Alan McKenna
Global Head of Product Development
Equinoxe Alternative Investment Services

In the mid-2000’s, it was the multi-strategy hedge funds that first blurred the lines between investment strategies and asset classes. Ten years later, we’re seeing pension funds, family offices, insurance companies and mutual funds extending into the alternatives arena, and hedge funds, themselves, are responding by entering into more retail-oriented markets.

The suddenly broadening focus that characterizes today’s marketplace is driven by the hunt for new sources of fee income, tax efficiencies, and of course, alpha. Many hedge fund managers, for instance, have adopted new 40-Act, alternative UCITS and long-only fund strategies. Active managers are moving into ETFs; passive ETF managers are migrating into active strategies (smart beta) and market participants across the spectrum are intent on breaking new ground in markets and strategies that were heretofore thought to be spoken for.

Never has this trend been more conspicuous than in March, when Vanguard registered an alternative strategies fund and Mario Gabelli’s GAMCO Investors made its first foray into ETFs. Elsewhere, insurance company Arch Capital Group paired with Highbridge Principal Strategies to form Watford Re in 2014, a diversified reinsurance business that invests primarily in non-investment grade credit assets. Furthermore, this push for convergence only seems to be gathering more steam. A September, 2014 Deutsche Bank survey of over 200 hedge fund managers found that over 40% of those polled already offer liquid alternatives products (“liquid alts”), up from just over 25% in the prior year. Further, one in three said they would consider introducing new liquid alts products in the coming years.

While these moves and the ongoing push into new products translate into new fee streams for both hedge funds and traditional asset managers alike, the converging marketplace has weakened the pricing power traditionally enjoyed by hedge fund managers. Vanguard’s move into alternatives, for instance, would seem to signal that these previously considered “esoteric” strategies were entering their commodification phase. Vanguard’s debut Alternative Strategies Fund comes with an estimated expense ratio of 1.10%, nearly 80 bps below that of the average alternative fund based on Morningstar data.
The irony, however, is that while convergence brings pricing pressure, these moves into complementary strategies also entail more in the way of new expenses and added demands on back- and middle-office infrastructure. Catering to a broad range of strategies demands that asset managers can accommodate the differing liquidity, leverage and risk profiles inherent to the audience of each new product set.

As a consequence of alternative strategies creeping further into the retail landscape from their historic investor base of high-net-worth individuals, pensions and sovereign wealth funds, fund managers realize that they’re being watched more closely than ever before. Whilst regulators expect transparency, they have little to no appetite for decoding the underlying assets that factor into a firm’s exposures and risk profile. This has led to regulations like the Alternative Investment Fund Managers Directive (AIFMD), which seeks to streamline regulatory standards across the European alternatives universe, whilst setting reporting standards and creating new transparency requirements.

For these reasons, fund managers only expect more complexity as it relates to running their day-to-day operations. In fact, in a 2014 State Street survey, nearly 90% of hedge fund managers polled said they expect more operational complexity over the next five years, with nearly one in three anticipating a significant increase. As traditional asset managers move into new product categories, the biggest hurdles can often relate to infrastructure as legacy systems may not be able handle the accounting demands that come with new types of securities, be it derivatives, real estate or private equity, or new multi-currency, multi-basis reporting requirements (IFRS, IAS, US GAAP, Canadian GAAP) that come with a more diverse investor base.

For these reasons, fund managers fully recognize that offering a wide range of products comes at a cost, though some may be surprised just how high those costs can run once all of the back- and middle-office expenses are pieced together at the time of product launch. As asset managers, hedge funds, pension funds and even family offices seek to expand their product offering, they first need to understand where they can leverage their existing capabilities and where they need to build new functions and skillsets. Indeed, many have discovered that the growing volume and complexity of transactions can very quickly outstretch the functionality of their legacy systems or consume the available bandwidth of operational staff members.

For instance, the back office needs to be able to untangle collateral management requirements to optimize allocations and improve efficiencies around margin call management. It also needs to be able to support corporate actions and maintain links with prime brokers and custodians, while handling new, increasingly customized fee models. The middle office, meanwhile, must be able to generate model pricing for a whole range of esoteric instruments and derivatives, whilst simultaneously managing risk, providing real time P&L and cash-flow analysis, and allowing for “what if” checks to produce informed hedge recommendations. As complexity ramps up, the front office requires more sophisticated cash forecasting capabilities, integrated connectivity with custodians and prime brokers, as well as pre-trade execution tools with definable limits, whether it’s by trader or issue. As the moving pieces multiply, eventually portfolio managers will demand a trade-capture system that processes transactions in real time.

These types of back- and middle-office capabilities used to represent a competitive advantage available to only the largest and most sophisticated asset managers. Today, it’s the standard for firms that seek to build out their product set. Asset managers, particularly those investing across a broad range of security types, require an operating platform as well as scalable architecture that passes the due diligence tests of institutional investors and can meet the different demands of retail investors. Moreover, in this new era of transparency and regulatory scrutiny, the risks are too high for asset managers to not be fully confident in their compliance and reporting programs.

Convergence isn’t going away. The bar will only continue to rise, demanding diligent focus and attention from fund managers on their investment strategy and its execution.
Alan McKenna is the Global Head of Product Development at Equinoxe Alternative Investment Services, a premium alternative investment service provider. Equinoxe Solutions provides customized answers for managers when considering internal technology and outsourced services

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