IBM Business Consulting Services
The challenge of hedge funds
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
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 Derivative appeal
Hedge funds have grown rapidly and while the market The first step for many traditional fund managers entering
shows signs of maturing, institutions are allocating the hedge fund arena was to launch a ‘fund of hedge funds’
significant assets to this class. The key driver behind this vehicle, a simpler solution to the operational issues of
growth was the ability of hedge funds – once the preserve supporting a hedge fund.
of high net worth individuals – to deliver absolute returns in
falling markets. This attracted the interest of institutions. The next step was to launch their own hedge fund. To do
this, fund managers had to ensure that their operational
Growth is also being driven by the wider availability of ‘fund and system infrastructure, or that of their service providers,
of hedge fund’ products as a result of changes to national could support it.
regulations and EU-wide Undertakings for Collective
Investment in Transferable Securities (UCITS). In the longer term, the market is heading for more
fundamental changes. As predicted in the IBM Investment
Ironically, market conditions over the past two years have Management Survey,1 the migration from balanced to
been less favourable to hedge funds – a key indicator, the specialist mandates is becoming more evident. Active
Van Global Hedge Fund Index, under-performed the S&P products may move toward absolute return to provide
500. Although the rapid growth phase appears to have adequate differentiation from tracker products. Furthermore,
ended, institutions continue to allocate assets into hedge insurers are demanding products that match assets and
funds. This represents both an opportunity and threat liabilities for consistency of returns with lower risks.
to traditional fund managers. Competition is fierce and
the lines between traditional funds and hedge funds are
These trends drive the need for traditional fund Concerns about fragmentation
managers to make a wider use of derivative products. Service providers in turn have recognised this requirement.
However, fund managers are constrained in their ability Some have acquired companies with this specialist
to support derivatives in their mainstream products due capability. The challenge now is to integrate the specialist
to limitations in their existing systems infrastructure. capability with existing mainstream service offerings,
Many handle low volumes of derivatives through manual without fragmenting back offices and adding further
and spreadsheet solutions, and by forcing book-keeping complications associated with consolidated financial,
entries into underlying accounting systems. risk and compliance reporting.
Where fund managers have launched hedge funds, This concern is not limited to hedge funds as the tactic
they have outsourced the administration and accounting of outsourcing administration has been adopted for other
to specialist providers. Given the extent of back office specialist fund types such as property and private equity/
outsourcing – and its creep into middle office – many venture capital. Potential fragmentation of back offices is a
fund managers already rely on their service providers concern even where the traditional fund management has
for the capability to support derivatives products and already been outsourced.
Number of hedge funds/assets under management Average international hedge fund returns 2000 to 2004
1,000 9,000 40%
Number of hedge funds
Annual % return
400 4,000 -30%
n AUM n MSCI World Equity
n Number of hedge funds VAN International Hedge Funds Index
Source: VAN Hedge Fund Advisors/TABB Group/IBM Analysis Source: VAN Hedge Fund Advisors/IBM Analysis
Figure 1 Figure 2
Given the inherent risk and lack of transparency in Developing an appropriate operating model
some of the products being offered, consolidated risk The IBM Component Business Modelling (CBM) approach
and management reporting will be more challenging. to the development of a target operating model provides a
In response, fund managers should take steps to: flexible framework that can be easily and quickly adapted
to different organisations. It provides a simple way to define
• Develop clarity on their target operating model for the business at an appropriate level, that both the business
supporting hedge funds, traditional products and and IT can apply.
emerging product types. Specifically, opportunities
to share common processes such as reconciliations, CBM allows appropriate target operating model options
corporate actions and securities standing data can to be rapidly identified and assessed by a joint client and
be exploited to achieve economies of scale IBM team. This team brings together specialist industry
• Achieve comparative levels of STP for derivatives knowledge and CBM expertise, enabling its members to
with those achieved for traditional securities in first understand and assess existing processes, costs,
developed markets resources and applications using high-level business
• Achieve scale and move to high-quality, low-cost component models.
The major elements of the IBM approach are to:
The changes in the industry affect fund managers and
service providers across the value chain. • 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
Case study: Rationalising global operations potential for sharing?
A leading global fund manager with significant • Develop options for target operating models and
operations on four continents believed that rationalising supporting applications architectures: identify
processes and systems would yield significant savings, potential improvements and benefits and select
improve efficiency and flexibility, and help the business target operating model
respond to market developments. Previous attempts to • Develop a business case and a rapid implementation
eliminate back office duplication had failed. plan for it.
IBM Business Consulting Services applied CBM In a typical exercise of this type, initial analysis takes eight
techniques to redesign the group’s operational to twelve weeks to complete.
functions, implementing an integrated, horizontal
operation where it had been vertical, regional and The subsequent implementation effort and timescale
siloed. An IT application architecture aligned with depend, of course, on both the starting point and target end
the target operating model was designed. Finally, a point, but in our experience is likely to take 12 to 18 months,
business case for implementing the target operating and involve significant IT and business change. Throughout
model was developed. this time, IBM has the ability to support clients from initial
analysis to implementation of business and IT change.
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.
Hedge fund facts Types of hedge funds
1. Hedge funds are not new Hedge funds may invest in various instruments including
Despite being viewed as a recent market innovation, equities, bonds, junk bonds, private equity, derivatives
hedge funds have been around since 1949. (options, futures, swaps) and commodities. They are
characterised by a clear investment strategy and
2. Hedge funds are difficult to define proposition. Examples include:
‘Hedge fund’ is a generic term covering a variety of
trading strategies – see across for a summary. Long/short equity:
Usually this is an investment strategy that removes
3. The UK is the leading European centre for hedge directional market risk and allows stock picking
fund management skills to show through, e.g. 50% long positions,
The UK has an estimated 70% market share of hedge 50% short positions.
funds managed by European-based managers (source:
Eurohedge). In global terms, the UK is second only to the Market neutral:
US in the share of hedge funds managed. It is estimated • Merger arbitrage: Attempts to capitalise on
that 15-20% of global hedge fund assets are under corporate events, for example buying shares in
authorised UK management. acquirer (where often stock prices will fall) and
acquiree (where often stock prices will rise). The
4. The majority of hedge funds are domiciled offshore risk is, of course, that the deal will fall through.
This is for fiscal and regulatory reasons. The British Virgin • Fixed income arbitrage: Buying low and simultaneously
Islands and the Cayman Islands are the most popular locations. selling high equivalent securities, e.g. different
However, management of hedge funds is often conducted in bond issues. It is highly leveraged due to the large
major financial centres such as London and New York. positions taken and small spread.
5. Hedge funds are increasingly regulated Directional trading:
In October 2004, the SEC ruled for compulsory registration These are characterised by a macro trading strategy based
of any hedge fund with more than 15 clients. How this is on expected changes to global market conditions. An
reconciled with maintaining the confidentiality of propriety example would be buying US dollar T-bills, borrowing yen
trading strategies remains to be seen. which implies specific exposure to USD/JPY exchange rate.
An emerging trend in mandate style?
Funds that combine some or all of the strategies
1% 2% 5% defined above.
Level of activity and risk
90% 80% 68% 40% Fund of hedge funds:
A rapidly growing segment which is often the first
port of call for institutional investors.