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Fund managers:


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Fund managers:

  1. 1. IBM Business Consulting Services Financial Markets Fund managers: The challenge of hedge funds
  2. 2. Introduction 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 increasing fragmentation. 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 becoming blurred.
  3. 3. 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. hedge funds. Number of hedge funds/assets under management Average international hedge fund returns 2000 to 2004 1,000 9,000 40% Number of hedge funds 900 30% 8,000 Annual % return 20% 800 US$ billion 7,000 10% 700 6,000 0% 600 -10% 500 5,000 -20% 400 4,000 -30% 1999 2000 2001 2002 2003 2004 2000 2001 2002 2003 2004 Year Year 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
  4. 4. 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. service 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.
  5. 5. 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. Multistrategy: 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. 35% 30% 20% 20% 10% 2015? 1993 1998 2005 Year n ‘Hyperactive’ n Active n Passive n Static Figure 3
  6. 6. For more information, please contact: IBM United Kingdom Limited 76 Upper Ground Chris Burgess, Associate Partner South Bank Tel: +44 (0)20 7202 3381 London SE1 9PZ Graham Wright, Executive The IBM home page can be found on the Tel: +44 (0)20 7201 8541 Internet at IBM and the IBM logo are trademarks of Or visit: International Business Machines Corporation in the United States, other countries, or both. Other company, product and service names may be trademarks or service marks of others. References in this publication to IBM products or services do not imply that IBM intends to make them available in all countries in which IBM operates. Copying or downloading the images contained in this document is expressly prohibited without the written consent of IBM. This publication is for general guidance only. 1 IBM Investment Management Survey, May 2004. © Copyright IBM Corporation 2005 All Rights Reserved. FEEE11239-0