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Tuesday, 24 January 2017
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Jul 2 2009 | 8:55am ET
By Gurvinder Singh and Bijesh Amin -- Historically, despite all the cited benefits (liquidity, transparency, control over assets, independent pricing etc.), the managed account model has not attracted the best managers. Why should it have? Capital was abundantly available for those with good track-records, and investors were happy to pay for the “privilege” of being charged “two-and-twenty” for access to the best funds. These managers therefore had no incentive to subject themselves to the operational overhead imposed by a managed account; as well as the daily transparency (read: scrutiny) into their positions, leverage levels and marks. Established managed account businesses such as Société Générale’s Lyxor or Deutsche Bank’s x-markets have attracted funds but they are certainly not the best performing ones in their respective strategies.
Managed Account – Has Your Time Come ?
The future for the managed account however may be quite different; the collapse in investment markets alongside increased regulatory oversight and investor due-diligence in a post-Madoff era will lead to a higher rate of adoption for access to hedge funds via managed accounts. If hedge fund managers are to attract capital from HNWs or even attract institutional flows from retirement or endowment funds, the quid pro quo may be the operational overhead of a managed account. Already in the past few weeks prominent names such as TCI and MAN Group have announced the launch of managed accounts to attract investors back into their hedge fund complexes.
Additionally, the demise of large-scale prop trading within investment banking will also have a positive uplift for managed accounts as former “star” prop traders will either consign themselves to trading client flow or strike out on their own. The latter being the most likely option for those with the better track records, and managed accounts being the vehicle through which they can attract risk capital in a scandal-hit, leverage-limited market. With this in mind, and given the increased regulatory oversight in the near future for all hedge funds, it appears that the managed account’s time may have come.
Technology - The Good Kind Of Leverage
The good news is that technology geared to easing the operational burden of running and maintaining managed accounts has now become more widely available. This will benefit both the hedge funds who operate managed accounts as well as the platform providers (i.e. custodians, fund administrators and prime brokers).
Typically managed account platforms have been built within either investment banks (piggy-backing off their prime brokerage systems) or the large, multi-strategy buy-side institutions (piggy-backing off their long-only investment management systems). These platforms have increasingly been unable to cope with the multi-asset class, multi-geography, multi-jurisdictional nature of most hedge funds. For example, the mundane but key function of supporting multiple data feeds from multiple counterparties has often presented a significant challenge for these ‘closed’, slow moving, legacy platforms.
In 2005 the European Central Bank specified the areas in which prime brokers needed to improve their business models with hedge funds, these were specifically; STP, risk management and reporting. Each of these areas are inherent to a successful managed account – or any hedge fund servicing – platform, and are weaknesses that still exist amongst the majority of platform providers today.
To build a complete managed account platform proprietarily, would take an enormous amount of fixed cost. In past years, prime brokerage required a similarly large capital expenditure on technology, and this gave early adopters such as Morgan Stanley and Goldman Sachs, a durable competitive advantage which has lasted until today. No such appetite for large-scale spending on technology currently exists amongst those institutions contemplating building out a managed account platform today. However, the good news is that hundreds of millions of dollars is no longer a pre-requisite to building out a managed account capability.
Buy The “Plumbing”, Build The “Pipes”
Contrary to the conventional wisdom of the past – the high fixed cost approach to building technology platforms is no longer the only viable option. Firstly, there are now enough credible product vendors to provide a suitable depth of selection across all of a managed account’s functional requirements. These include but are not limited to;
A word to the wise here; your business requirements may not be as ‘unique’ as you think – more often than not the 80:20 rule applies i.e. 80% of your needs will be met out-of-the-box , with the remaining 20% met through customization. Customization is often key to a successful platform, but there are options. The work can be done by either the product vendor themselves, internal IT personnel or consultants (in descending order of cost). As usual be vary of vendors that promise too much and ensure you conduct ‘beauty parades’ and ‘under-the-hood’ due diligence on their product offerings. As always caveat emptor applies even if the reference client list and market penetration of the product vendor seems initially impressive. But the point remains; vendor products are now mature enough at the enterprise level, to provide a cost-effective and viable alternative to building proprietary applications.
So that takes care of the “plumbing,” by which I mean the functional areas listed above. But what of the “pipes”? This is where the leverage of technology can make a real difference operationally to a managed account platform. And it is also where the attention has been most lacking to-date.
The hedge fund investing world of tomorrow (and today) will need a managed account platform that will support trading and settlement with multiple counterparties, across a range of products and geographies. In addition, increased regulatory and investor scrutiny – be it in terms of portfolio transparency or risk reporting – will become the norm. For example, the ability to see the sources of independent prices or marks within portfolios and the ability to support ‘n’ period reporting (monthly, weekly, daily or intra-day) are just two examples of this. And this is where a distinct layer of ‘pipes’ becomes indispensible.
These “pipes” basically comprise the technology infrastructure of the platform and involves the use of separate feed handling and messaging layers distinct from the applications or “plumbing” referred to earlier. These ‘pipes’ facilitate the movement and transformation of data to and from (and within) the platform by adopting industry standard messaging protocols, counterparty data feed adaptors and automated mapping tools for normalizing data. This will all require custom development and systems integration expertise. However, it is this infrastructure that will differentiate the truly successful platform that can achieve flexibility and scale without sacrificing stability or performance. The applications may change but the essential infrastructure around them should remain intact – effectively creating a sandbox. This ability to plug-and-play is greatly facilitated by the trend amongst all major product vendors to incorporate open APIs (Application Programmable Interfaces) into their products.
A word on databases…while not strictly “Pipes” – the same design principle should apply here – product vendors often tie their applications to specific proprietary databases (most support standard database query language, a minority still do not). In any event, a separate database or databases for the managed account platform will need to be built to consolidate data from various systems, to enable standard querying and portfolio monitoring and to support in-depth investor/regulatory reporting, outside of any one vendor’s purview. Proprietary control of the database and data model are often key in any large-scale technology platform, to ensure operational independence from vendors.
Who Will Build The Platform ?
Traditionally the Prime Broker, has filled the interfacing and risk intermediation role for the hedge fund. This was after all their raison d-être. However, the re-deployment of risk capital and the shrinkage of banks balance-sheets available to high-risk activities such as hedge fund financing, will mean - at least in the interim - that Prime Brokerage investment in technology will be constrained. With these economics combined with the regulatory pressure to keep “Chinese walls” solid rather permeable structures, it is likely other players most notably Fund Administrators and Custodians will step into the breach, leaving risk intermediation and financing for the bank-owned Prime Brokers.
Fund Administrator – Where Is Thy Competence?
Unfortunately, the dirty little secret is that many, too many, Fund Administrators have neither the skill nor the technology to support the role of ‘Interfacing Agent’ for the hedge fund industry. The higher operational burden likely to hit the hedge fund industry in the wake of increased regulation and investor due-diligence will present a formidable operational challenge for them. Other than for exchange-listed, easily marked securities, most Fund Administrators are woefully under-qualified vis-à-vis their staff and systems to efficiently produce daily NAV and risk reporting with independently-sourced or derived prices.
One positive trend for hedge fund investors is that as more OTC products become centrally-cleared and exchange-listed, their pricing should become more transparent and easily sourced. Although, illiquid products (with private equity type horizons and payout profiles) – always likely to be priced most credibly by the funds themselves. In these cases perhaps the most Fund Administrators can do is to externally verify model inputs into the black box and try to make assumptions more transparent to investors. There is also a case to be made for more interpretive risk management by managed account providers; the kind which actually analyzes the risk in a hedge fund portfolio to look for amongst other things; correlation and concentration risk, ‘style drift’, hedging efficiency etc. This can only be facilitated by technology; personnel with the requisite expertise are essential for this role. For example, as yet there is no automated solution that can distinguish whether a short position in a portfolio represents a hedge or a negative view on a stock.
There are third party services that could be used to fill the ‘Valuation Agent’ role but without a secure, robust and open infrastructure in place the costs of integration and the operational risks involved may outweigh the benefits.
Managed account providers will need to think very carefully if they are to not replicate the inefficient and operationally unsound “one man, one spreadsheet, one fund” model that many Fund Administrators have followed to-date.
Those platforms that can seamlessly integrate vendor products and third party service offerings within a robust and scalable infrastructure will be best placed to support the Interfacing Agent and Valuation Agent role required of managed account providers today and in the future. Battered hedge fund investors deserve no less.
Gurvinder Singh is CEO and Managing Director of Indus Valley Partners, a niche, technology consultancy focused on the Capital Markets industry. Bijesh Amin is a Managing Director at the firm.