HEDGE FUND SERVICES MARKET GUIDE 2008

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2008

INVESTORSERVICES

JOURNAL

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WWW.ISJNEWS.COM

BEYOND THE SPIN

HEDGE FUND SERVICES

MARKET GUIDE


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managers. There are though a lot of hedgefunds that have taken great care to ensure thatthey are well equipped to deal with heavyinvestor scrutiny, but this has been takingmoney away from their traditional investmentsin leading edge front office technology. We lookat what is happening in the front office in ourfeature on algorithmic trading.

The issue of hedge fund replication hasalso become a hot topic in the industry and it

is difficult to gauge exactly what impact it willhave on the market in the long term. We tookthe time to talk to Professor Harry Kat, one ofthe key proponents of hedge fund replication,to find out his views on the future.

While prime brokers were long a key andoften only resource for hedge funds, they arenow joined by a proliferation of serviceproviders and must work harder to keep theircompetitive edge. Mayiz Habbal, managingdirector of the Securities and Investments

Group at analyst firm Celent, provides hisviews on the developments within thehedge fund administration market over thelast 12 months.

We have also gathered together a number ofleading providers in the hedge funds space todebate the issues in ourfuture of the market paneldiscussion and provide youwith key insights into the

landscape of the sectortoday and tomorrow.

Virginie OSheaGroup Editor

Welcome to the 2008 edition of ISJs annualHedge Fund Services Market Guide.The questfor a more transparent market has been thedefining theme of the hedge fund sector overthe last year. Rarely a day has gone bywithout some media attention focused on therisks posed by the hedge fund community tothe wider financial market and the creditmarket crisis of the latter half of the yeardrew yet more attention to the subject.

As an industry that has been largelyignored by the press, it has been a shock tomany hedge fund managers to find them-selves made scapegoats for the financialcrisis. The secrecy that surrounds the fundsand the reluctance of managers to discusstheir positions has made them seem evenmore suspicious. Will this crisis thereforeincrease the push for transparency in themarket? Our main feature examines thedevelopments in the market over the last 12months and the likely impact of the creditcrunch on the future of the hedge funds sector.

Investors have also become more demandingmasters and the process of due diligence hasbecome even more onerous for hedge fund

INTRODUCTION

Risky business

HEDGE FUND SERVICES

MARKET GUIDE

2008

Hedge funds have had ahard time of it this summer,but are things are looking up?


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Foreword Hedge Fund Association

2 INVESTORSERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008

The hedge fund industry over the past four and ahalf years has enjoyed robust performance and alargely favourable investment environment. As aresult, assets in the hedge fund industry have

swelled. Today, assets in hedge funds areapproaching USD1.5 trillion, with an estimated10,000 plus hedge funds managing those assets.Attempts at formal regulation of the industry inthe US have come and gone, but may certainlyreappear at some point in the future.However, events of this summer have resulted in

many hedge funds facing their most challengingenvironment since 1998. The sub-prime mort-gage debacle and ensuing credit crisis resulted inlosses for many hedge funds. As banks becamenervous, margin calls were made to hedge funds,resulting in forced selling, which wreaked havocfor many statistical arbitrage hedge funds.Large losses mounted for several large hedge

funds in July and August, most notably funds man-aged by Bear Stearns and Goldman Sachs. Investornervousness is now the prevailing theme, and thequestion is how long until the environmentimproves. Remember, although 1998 proved to bea black eye for the hedge fund industry, many

hedge funds were able to profit enormously in theaftermath in 1999, as spreads narrowed and equi-ty markets recovered. Will we see a similar occur-rence for hedge funds in the fourth quarter of2007 and into 2008, or will these problems havea more lasting impact? The answer to that questionwill play itself out over the next months and years,and should provide for very interesting times forhedge funds and hedge fund investors.The global reach of hedge funds, the depth of

product available and the size of the industry cer-

tainly make for an exciting and challenging indus-try. The Hedge Fund Services Market Guide coversmany of the cutting edge issues facing hedge fundmanagers, investors and service providers it is amust read for anyone interested in keeping on topof developing and changing trends in the industry.

The guide takes a close look at the recent creditcrisis, and evaluates what happened, and whatthe likely outcome is going to be. It takes a look atthe latest in hedge fund technology - who is using

it and how they are using it. How will recentevents in the industry impact on risk averse moneymanagers, particularly with regards to secretivepractices that are still somewhat prevalent in theindustry? Will we see a reduction in secretiveblack box algorithm trading strategies?Discussions about hedge fund regulation, despitebeing put on the back burner temporarily in theUS, are likely to resurface shortly. Industry propo-nents have always advocated the theory that thehedge fund industry should be self-regulated dueto the sophistication of hedge fund investors. TheSEC however, remains adamant about crackingdown on hedge funds.The range and depth of topics in this handbook,

which extend beyond what I have discussed here-in, are certain to be of interest to you. If you wantto gain insights from many of the most experi-enced practitioners in the hedge fund industry,the Hedge Fund Services Market Guide is a mustread for you, whether you are a hedge fund man-

ager, hedge fund investor, or service provider tothe industry. In an evolving and fast growingindustry where new issues, concerns and trendsconstantly arise, where can an investor turn to inorder to keep up to date? Associations like theHedge Fund Association and others are certainlyuseful in providing guidance and education, but interms of a single resource to provide answers tomany of your questions, this guide is as good astarting point as any.

David Friedland, president, Hedge Fund Associationand president of Magnum US Investments. The HedgeFund Association www.thehfa.org is an internationalnot-for-profit association of hedge fund managers, serv-ice providers and investors formed to unite the industry,and increase education and the awareness of the oppor-tunities and advantages of hedge funds

Swings and roundaboutsDavid Friedland of the Hedge FundAssociation (HFA) reflects on thepast 12 months


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After years of unprecedented liquidity andtightening spreads, US credit markets firstblinked, then buckled as falling real estate

prices and rising short term rates fed their waythrough the system to negatively impact theability of the weakest of borrowers to meettheir mortgage obligations. As default ratesbegan to rise at lending institutions specialis-ing in these sub-prime mortgages, broaderquestions emerged regarding the creditworthi-ness of much of the outstanding paper backedby these same mortgages.

This, in turn, has led to a market widereappraisal of the broader CMO market. Manyof these securities have found their way into asignificant number of hedge fund (as well asinstitutional) portfolios around the globe. What

came as a surprise was not that these securi-ties were marked down in price, but the speedand extent of the markdowns, as well as thespill over effect it had on other marketsincluding asset backed commercial paper andTreasury bills.What lessons can one take away from this

experience? Certainly, one valuable remindermade abundantly clear by the markets reac-tion is that liquidity is a variable, not a con-stant, and that it should never be taken forgranted, no matter how long it persists inample supply. Borrowers and lenders shouldbe grateful when its plentiful but prepared tocope when its not. A second reminder is of theinterconnectedness of markets around the

globe the world really is becoming smallerand smaller.But perhaps most important of all is that

change happens and that markets, especiallyadolescent ones such as the hedge fundindustry, are rapidly and continuously evolv-ing. Recognising that education is not a staticprocess but a lifelong challenge, the onus issquarely on all of us to keep apprised of thesechanges.The Hedge Fund Services Market Guide is an

excellent starting point to help novices and

professionals, investors and service providersalike stay on top of developments within thealternative space. The various sections foundwithin this annual publication cover not onlycurrent market developments (such as those

found within the sub-prime mortgage market),but also geographic, operational, andregulatory trends affecting the industryglobally. Contributions come from a variety ofexperienced professionals representing a crosssection of industry participants, ensuring thereader of a balanced, diverse perspective. Iencourage all of you to make full use of thiscomprehensive industry resource.

Craig Asche, executive director of the Chartered

Alternative Investment Analyst (CAIA) Association.CAIA is an independent, not for profit global organi-sation committed to education and professionalismin the field of alternative investments. Founded in2002, the association is the sponsoring body for theCAIA designation

Foreword Chartered Alternative Investment Analyst Association

Rollercoaster rideIt has been a hectic few months in the

market, says Craig Asche of theChartered Alternative Investment Analyst(CAIA) Association

One valuable reminder made abundantly clear by the markets reaction isthat liquidity is a variable, not a constant, and that it should never betaken for granted, no matter how long it persists in ample supply


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Contents

1 Introduction Hedge Fund Services Market Guide 2008

2 HFA Foreword Swings and roundabouts

4 CAIA Foreword Rollercoaster ride

8 Year in review A review of the last 12 months

12 Fair play Hedge fund replication

14 Electric avenue Algorithmic trading and hedge funds

18 Celent report Following the flow

20 Panel debate Industry experts discuss the issues

28 Statistics Numbers from Hedge Fund Research30 Ask the experts Practitioner perspectives

36 UBS Back to the future

38 ATC Fund Services Are hedge funds still alternative?

40 Custom House Resilient returns

42 Dillon Eustace The coming storm

44 Advent Hedge fund compliance and its silver lining

46 Fintuition Trends in hedge funds

50 Guide Sound practices for hedge fund managers

60 Profiles Details of hedge fund services providers


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YEAR IN REVIEW

There can be no doubt that hedge funds have had ahard time of it in the international press over the last

half of 2007. The US sub-prime mortgage mess andits impact on the global economy has meant that anumber of funds faced significant losses and somewere even driven out of business completely. Ofcourse, the trade press has also had a field dayreporting on the carnage, but when it actually comesdown to it, how much of an impact has the crisisactually had on the future of the hedge fund indus-try?The coverage has centred on a number of high pro-file hedge fund failures such as the USD1.5 billion

failure of Bear Stearnss two sub-prime funds, whichwere put into provisional liquidation in the CaymanIslands in August. Moreover, BlueCrest CapitalManagement, which had around USD12 billion ofassets under management at the end of June, closedone of its equity funds at the start of September dueto a period of what it termed as unacceptable per-formance.At that same point in time, Goldman Sachs NorthAmerica fund, which follows a statistical arbitragestrategy and was hit hard in the second week of

August, finished the month down 16.7%. Goldmanwas also forced into injecting USD3 billion into thefirms quantitative hedge fund, the Global EquityOpportunities Fund, which lost about 30% of itsvalue in a week.Hedge funds investing in the credit markets were the

worst hit and quantitative strategies funds were lam-basted by the media for poor performance.

Deleveraging by funds of hedge funds as they facedredemptions from investors rushing to recover theirassets may have also contributed significantly to thestock market turmoil in the summer, according toresearch by BarclayHedge and TrimTabs. Theresearch indicates that investors in funds of hedgefunds may have redeemed as much as USD 55billion in July, largely due to concerns about riskexposure within credit derivatives. The risk ofredemptions is higher for hedge funds compared toprivate equity funds, because the period during

which investors cannot access their investments isshorter at 90 days or less.However, hedge funds are renowned for bouncingback quicker than equity markets from turmoil in thewider financial marketplace. Just look at the dataprovided in Credit Suisse Indexs report on hedgefunds in financial crises (Analysing Past MarketTurmoil and Outcome for Hedge Funds), which wasreleased in October, for proof positive of this fact.The research, which looks at five separate incidentsincluding the dotcom bubble burst and the World

Trade Centre attacks, highlights how hedge fundshave proved resilient despite unfavourable marketconditions, due in a large part to the use of diversifi-cation strategies.Hedge funds, as represented by the CreditSuisse/Tremont Hedge Fund Index, have tended to


It has been a year of significanthighs and lows for the hedge fundcommunity. Virginie OShea reflects onthe past 12 months in the market

Beyond the spin


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remain less volatile and have retained some positiveperformance throughout most market crises, the

report states. Given the current sub-prime marketfallout, we believe that hedge funds are well posi-tioned to be successful once again. Hedge funds areable to take advantage of new opportunities, such asthose created in the past few months.The Lipper TASS Asset Flows Report on hedge fundsfor the second quarter of 2007 seems to tally with thisview. From the results of the report it is possible tosee that despite the sub-prime situation, most hedgefunds displayed a strong performance over the quar-ter. The aforementioned Credit Suisse/Tremont

Hedge Fund Index returned 5.19% during the secondquarter, according to Lipper. And if such reports areto be believed, the average fund only lost 1.31% as aresult of the sub-prime crisis, according to figuresreleased by Hedge Fund Research.Figures for September from Hedge Fund Researchindicate that the market has rallied yet further still.The industry generated a positive return for investorsof 0.85% net of fees for the month to 26 September,according to the firms investable hedge fund index.The index indicates that, of the eight hedge fund

strategies it details, six made a profit in September.It also seems that hedge funds will not experience along term crisis of confidence from the industry.During the last few weeks of July and the first week ofAugust at the peak of the market turmoil, Citi sur-veyed almost 50 pension managers from Europe andthe US that collectively manage over USD1 trillion inassets and the results highlight that the hedge fundindustry has little to fear in the future. Respondentsindicated that they would, on average, raise their allo-cation in alternative investments to nearly 20% by

2010 from 14% today, effectively adding anotherUSD1.2 trillion into alternatives over the next twoyears. A large proportion of this investment will be viahedge fund investments.The slowdown in the hedge fund market over the latesummer period will not put these pension funds off,says Kenneth Heinz, president of Hedge FundResearch: Investors are continuing to focus on thelonger term merits of the industry. They are notimpacted by one bad month.The convergence that is occurring between mutual

funds and hedge funds is also set to continue. DavidSmithers, head of IT for Hedge Funds in FundServices, UBS, explains: There is no question thatconvergence is underway and will continue, and weare already seeing some traditional mutual fundsinvesting in alternative asset classes. The largest

area of impact is increased asset flows from pensionfunds into hedge funds and in particular fund of

hedge funds, which are seen as less risky, highlydiversified investment vehicles.The short term impact of the crisis has been a trendtowards consolidation in the sector. For example,London-based Integrated Asset Management boughta majority stake in fellow fund of hedge funds groupAltigefi in mid-October. Chicago-based hedge fundCitadel Investments decided in July to take over thecredit portfolio of Sowood Capital, a smaller fund thatran up heavy losses in the credit markets. This M&Aactivity seems set to continue, as the casualties of the

sub-prime losses are swallowed by the larger andmore resilient hedge fund players.Bob Guilbert, managing director, Eze CastleIntegration, elaborates: As the hedge fund marketcontinues maturing, there will most likely be moreconsolidation and more publicly traded firms.Industry analyst reports and public surveys fromorganisations like CPA firm Rothstein Kass say thatconsolidation is likely within the next three years, aslarger firms target more institutional money andcompetition increases among smaller firms.

But it is not just the hedge funds that are buying eachother; big brokerages and banks have also been busysnapping up hedge funds over the last year. Thesemajor deals include: Citigroups purchase of OldLane Partners in April; Merrill Lynchs purchase ofstakes in GSO Capital Partners and Sterling StamosCapital Management in May; and Lehman Brotherspurchase of DE Shaw in March.The negative press surrounding hedge funds has alsohad a significant impact in the area of regulation.Calls for tighter regulation of hedge funds are nothing

new; the Securities and Exchange Commission (SEC)has been debating the extend to which the sectorshould be regulated for some time. However, tighterregulation of hedge funds would essentially hamperthe sectors ability to achieve significant returns.Concerns over this outcome have caused a rift toappear in the US between the SEC and the Federalcourts over the scope of the SECs ability to regulatehedge funds.The Goldberg decision last year, which struck downthe SECs authority to require hedge funds to register

as investment advisers, meant the SEC had to comeup with new proposed procedures to regulate themarket. To this end, on 10 September, the SEC adopt-ed a new rule clarifying hedge fund fraud. The regula-tion prohibits advisers to investors in hedge fundsand pooled investor vehicles from making false or

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YEAR IN REVIEW

misleading statements to investors or defraudinginvestors and prospective investors. The SEC justified

the introduction of the rules by citing the rapid growthof hedge funds in recent years combined with the ris-ing interest of retail investors and a growing numberof fraud cases in the industry. The Investment AdviserAct Rule 206(4)-8 therefore represents a substantialshift in the SECs regulatory priorities, as it is the firsttime it is seeking to extend its regulatory authority toall private funds in this manner.As the hedge fund industry matures and increasesits coverage with the mutual fund industry, it may gothrough similar cycles that affected mutual funds.

There may be a blurring as mainstream regulationbecomes looser for mutual funds and tighter forhedge funds, explains Bhagesh Malde, head ofJPMorgan Hedge Fund Services in EMEA and AsiaPacific.However, this regulatory intervention could be apotential threat to the future profitability of hedgefunds, says Fabian Vandenreydt, head of Broker-Dealer Services at Swift. Tighter regulation inhibitstheir ability to take risks and provide higher returns.We suggest that more transparency and participation

in regulatory efforts is the best way to mitigatethis factor. You have to work with the regulators,he adds.In the spirit of collaboration, the US TreasuryDepartment has announced the formation of twoadvisory groups under the direction of thePresidents Working Group on Financial Markets todevelop recommendations for best practices in theoperation of hedge funds. One advisory group willcomprise investors in hedge funds and be chaired byRussell Read, chief investment officer for the

California Public Employees Retirement System andthe other will be composed of asset managers andchaired by Eric Mindich, the chief executive of EtonPark Capital Management. The groups will maketheir suggestions available for public commentbefore they become finalised and Read has alreadyindicated that some recommendations will be readybefore the end of 2007.In a similar move and as a bid to fend off regulatoryintervention in the UK, the Hedge Fund WorkingGroup (HFWG), which represents 14 leading hedge

fund managers based mainly in the UK, has pub-lished a consultation document on best practicestandards for the hedge funds industry. The pro-posed best practices focus particularly on the areasof valuation, risk management, disclosure and fundgovernance. The working group has also recom-

mended that hedge fund managers improve theirtransparency by disclosing more information to

potential investors and the public. Following a periodof public consultation, the HFWG intends to publishits final report in January 2008.The consultation document has already been wellreceived by a number of key figures in the industry.Germanys Finance Minister Peer Steinbruck haspublicly supported the idea of a voluntary code ofconduct for the hedge fund industry and believes itwould solve many of the problems being experiencedin the hedge fund market today. The AlternativeInvestment Management Association (AIMA) has

also welcomed the consultation paper.Eze Castles Guilbert highlights the change he seescoming in the market: Hedge funds have had a rep-utation for being cloaked in secrecy and resistant todisclosing information for fear trade secrets or strate-gies would be exposed. We are seeing this changeand demands from investors is one of the primarydrivers. Regulatory compliance has also played a rolein removing the veil of secrecy and driving funds tobe more transparent in their dealings with investorsand the market.

Rory Gage, management consultant at Morse, adds:Looking forward, hedge fund managers are going tobe forced to build far more robust compliance frame-works around their businesses if they are to attractfurther inflows of new investors in the future and tomeet with regulators requirements. Our clients aretelling us that they are seeing an ever increasingnumber of due diligence questionnaires. These ques-tionnaires have also grown in length and are nowbeginning to probe almost every area of a fund man-agers operations, from their structure to who their

third party service providers are and how they priceindividual instruments.It seems that the issue of transparency is key to thefuture of the hedge fund market, but exactly howmuch transparency will be required is likely to be abone of contention for some time to come. It is alsoprobable that the characteristics that distinguish ahedge fund from other funds will break down yet fur-ther still. For instance, short selling, leverage and analpha strategy no longer define a hedge fund, youonly need to look at the 130/30 funds to realise that.

As Mark Brady, partner at Eversheds, explains, itsnow becoming a question of degree. Registeredfunds that use leverage and short selling are limitedin the strategies they can pursue. Most hedge fundsarent, he says. How long this distinction will last,only time will tell.



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HEDGE FUND REPLICATION

It is difficult to gauge the effect hedge fund repli-cation will have on hedge funds themselves. It iscertain that their existence wont be threatened,for to have replication you need the original ele-ment, and for replication to be a success, hedge

funds have to keep generating positive returns.Yet it is the cost of these returns that have beenone of the catalysts behind the creation of hedgefund replication.Professor Harry Kat of the Cass Business School,states: Anybody who is well calibrated to the real-ities of the global capital markets knows how dif-ficult it is to systematically do better than the mar-ket and will find it hard to believe that there arenot just one or two, but thousands of managersout there that have no difficulty systematicallyoutperforming the market to such an extent thattheir services are truly worth 2 plus 20.Hedge fund fees are often in the newspapersbecause they are an easy target with which tobash the corporate fat cats. Since 2000, the

hedge fund world has doubled in size. Now withover 9,000 funds and combined assets of aroundUSD1.9 trillion, the quest for alpha has turnedinto a crusade. If these hedge funds are not mak-ing the mythical alpha, perhaps people are justi-

fied in questioning the 2 plus 20 fees these man-agers charge. Do people need to be educated inorder to demystify hedge funds ability to gener-ate alpha?According to Kat, the public needs to be educateda lot: People are extremely eager to believe thereis something out there that is going to makethem a lot of money. In addition, the marketingmachine surrounding hedge funds is extremelypowerful and aggressive as there is a lot of moneyto be made by selling hedge funds. In a way there-fore, we are not just fighting a simple lack ofunderstanding, but one of the most basic humanemotions: greed.Kat has published two papers questioning the 2plus 20 (or 3 plus 30 in the case of some fund of


FairplayGiles Turnerexplores theimpact of hedgefund replicationon the market


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funds) fee structure. The first, published in 2003in the Journal of Financial and Quantitative

Analysis, highlighted the failure of funds to out-perform the market benchmark. Looking at thefee adjusted returns of 77 funds between 1990 and2000, in relation to similar risk profiles that gen-erated the market benchmark, Kat discovered thatonly five out of the 77 outperformed the bench-mark. The next article, released in 2006, analyseda considerably larger field of 1,900 funds andcame to a similar conclusion. This time, only 18%of the funds beat the benchmark and even the

most successful funds couldnt keep up their highreturns over a longer time frame.Northwater Capital Management, a Toronto-based fund of funds manager, has come to the

rescue of the hedge fund industry, providingquantitative research defending hedge fund fees.According to Northwater, the underlyingapproaches to hedge fund replication are limitedin their ability to access the performance of hedgefunds. This suggests that Kats method is justplain vanilla variance rather than a method of tap-ping alpha generated by hedge funds. Anotherproblem is that Kats method relies on historicalcovariance, which is unstable in the financial mar-

ket, as recent events have highlighted. A simpleresponse on Kats behalf would be that Theywould say that. Northwater is a fund of fund afterall.It is important to note at this point that hedgefund replication does not attempt to replicatehedge fund returns in their entirety. Short of risk-ing Hedgegate by planting microphonesthroughout Mayfair or Greenwich, this would beunfeasible. William Fung and David Hsieh, thetwo original replicators, coined the term alterna-tive beta. They aim for an average rather thanalpha, and their benefits go beyond returns. GilesDrury, senior manager with KPMG, explains: Aswell as lower fees, hedge fund replicators alsoappear to offer a number of other potential bene-

fits to their clients. According to promoters, theyare often rules-based so performance can be

easily understood and explained, appear moretransparent, make liquid investments and can beexecuted at a lower cost than a typical hedge fundstrategy. There are also potential benefits for thewider industry: if alternative beta does exist andcan be truly replicated, this will encourage hedgefund managers to concentrate on skill-based per-formance rather than deriving performance frommarket risks. It should encourage funds to chargefees for delivering real alpha, and help investors

to better understand where returns come from.Also, some replication products could offer theability to short alternative beta, enabling hedgefund investors to capture the pure alpha element

of their portfolios.Drury also points out some underlying problemswith hedge fund replication. According to Edhec,the French business school, replication productshave been launched too soon, without sufficientacademic research. Then again, the only way youcan test a theory is apply it to the real world.Whether Edhecs postulation is merely rivalrybetween business schools or a well thought outobservation, only time will tell. But one factor that

Drury hits on the head is that, regardless of whetheror not hedge fund replication is a worthwhile prod-uct regarding returns, it will definitely have an affecton the mentality of hedge fund managers.The mere threat of passive indexation and repli-cation in the hedge fund world will help focus theminds of managers and investors, and help toensure that the industry remains focussed on thedelivery of uncorrelated absolute returns. Nohedge fund manager likes to be compared to acommodity product. As the industry moves for-wards, and becomes more mainstream and moreinstitutional, financial innovation will continue topush the boundaries further and prevent the tal-ented from sitting comfortably on their laurels fortoo long, concludes Drury.


The mere threat of passive indexation and replication in thehedge fund world will help focus the minds of managers andinvestors. No hedge fund manager likes to be compared to acommodity product


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Buy side firms are using algorithms like neverbefore and the most rapacious of users, the hedgefunds, are at the vanguard of adoption as theyseek fragmented liquidity in complexmarketplaces. But concerns have been voiced thatrecent market volatility could halt the investmentfrom pension funds that has been fuelling hedgefund growth, and bring to an end the algorithmicexplosion.

However, not all hedge funds are using algo-rithms for front office trading. While researchingfor this feature, it became apparent there are manyfunds unwilling to talk to the press, for fear theirclients would surmise they had started using thiskind of technology. Clearly, algorithms are not forall those operating strategies that require onlyminimal trading on long term stocks, perhaps asfew as a handful of trades a day, are not in need ofalgorithms that scour every market for hidden liq-uidity or the best prices.

Front office trading algos are also bound to beless useful to those buy side funds trading outsidethe traditional FX and equities markets. ChipLowry, senior managing director and head ofGlobal Link EMEA at State Street, explains someof the largest growth in the foreign exchangeindustry has come from hedge funds. But onceyou leave the equity and FX space, the assetsclasses which you can trade electronically dropsdramatically, he says. I think hedge funds will

use new asset classes for their strategies; they justwont be traded electronically. For example, somehedge funds have looked at property and fine artas investments you cant really trade those elec-tronically.But there is a growing army of hedge funds that

needs the best prices and operates in the equities,FX and, to a growing extent, fixed income markets.Whether funds are using algorithms comes downto the specific investment profile of the fund ratherthan whether they are a hedge fund or institution,explains Chris Jackson, director of execution salesat Merrill Lynch. Stat arb, day trading funds andlow cost, high volume traders, like index funds, arenatural users of automated trading.

These natural users want several things from

their algorithmic fixes. First, hedge funds like theanonymity algorithms afford them, explainsRichard Balarkas, head of Advanced ExecutionServices (AES, Credit Suisses algorithmic tradingplatform) sales at Credit Suisse. Trading throughAES minimises signalling risk to the market, hesays.Second, algorithms are extremely efficient at find-

ing dark liquidity, which is not displayed onexchanges, and aggressively trading it with the

minimum market impact, says Balarkas. Third,liquidity fragmentation. The only way to operate isvia smart order routing. For example, in the US,there are dozens of venues. You need ultra fasttechnology constantly monitoring and probing inorder to know which venue to use. Changes inmarket microstructure are leading to an explosionin data volumes. In the US, it is estimated thenumber of trading related data points in equitieswill rise from roughly 250,000 per second to550,000 by the end of the year. You execute in thisenvironment without first class algo, crossing andsmart routing technology.Recent research suggests hedge funds willincrease their technology spend over the comingmonths and years. Jackson says hedge funds are


ALGORITHMIC TRADING

Hedge funds are passing on their algorithmic needs to brokers asthey search for more customised systems, Jamie Darlow reports

Electric avenue


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going to increase spending on technology expo-nentially over the next six to 12 months. They areoften starting from a low infrastructure base per-

haps relying on technology from a prime broker yet their trading requirements are at least assophisticated as institutional managers, he says.A recent poll by Ernst & Young of over 100 globalhedge funds and fund of funds managers, collec-tively managing around USD900 billion in assets,showed that three quarters of respondents identi-fied technology as the biggest spending area in thenext two years. The survey found 58% of respon-dents said expenditure on risk management tech-

nology was expected to take up the biggest pro-portion of overall spending.The larger hedge funds are also now finding they

must spend money on technology for the backoffice. As the more established funds begin tomature, they are starting to need the enhanced lev-els of process and control that have traditionallyonly been seen in the institutional space, explainsJackson. For example, a pension fund investing ina hedge fund may have strict maximum holdinglimits, a bespoke restricted list and limits on theamount of cash that can be held. Modelling thesekind of requirements across multiple accountsrequires significant technology.Increasingly, hedge funds have seen investmentfrom more traditional fund sectors, like pensionfunds. The overall trend amongst all money man-agers is towards absolute returns, commentsBalarkas. Even pension funds have to look at allo-cating some portion of their funds into diverse oralternative strategies in order to improve perform-

ance.While these funds may still be investing only a

fraction of their total assets typically less than10% of their capital this represents an increas-ingly important revenue stream for hedge funds.But the recent market turbulence seen over thesummer months has caused some to worry aboutthe continuation of this investment, and therebythe increasing investment in algorithmic tradingstrategies. Lowry suggests the unfavourable mar-

ket conditions will cause some investors to revisittheir policies. Some investors have already statedthere must be transparency in the hedge fundsinvestment process in order to invest, heexplains. Some hedge funds have made it clear,however, that transparency could potentially come

at a performance cost.Those responsibilities involve making returns oninvestments, but it is the nature of hedge fund risk

that some funds will fail. In essence, nothing haschanged since the high profile failures at BearStearns over the summer. If there has been signif-icant growth in investment in hedge funds, thatstill represents a relatively small percentage oftotal assets invested, comments Jackson. Thereis still huge growth potential in the hedge fundspace as investors seek to increase returns anddiversify risk.

KPMGs advice is for pension funds to invest in

hedge funds via fund of funds, which invest acrossa range of investment strategies, and thus reducefund specific risk. The recent spate of hedge fundfailures highlights the importance of this approachas investors have much lower exposure to singlemanager or single strategy risk, explains DanielBroad, executive consultant, Investment Advisory,Pensions, Tax and People Services at KPMG. Forexample, during August 2007 when many algorith-mic trading funds had significant draw downs,many multi-strategy fund of hedge funds experi-enced a relatively small loss in the range of 2%-3%. Therefore, we believe that recent events willnot slow down the investment in fund of hedgefunds by pension schemes in the near future.To maintain this investment in hedge funds and tocontinue to increase returns in spite of possibleregulatory scrutiny, hedge funds must continue toupgrade their algorithms. VWAP or participationalgorithms are no longer good enough for bestexecution.

Hedge funds rely on being more nimble in theirapproach than the sell side they can be moreinnovative and target specific areas more quicklythan large banks can and, while they sometimespay a price, they often gain the edge. RobertBoardman, head of Algorithmic Sales at ITG inEurope, says that while hedge funds dont neces-sarily have technologically superior algorithms,they are less rigid in their approach. They are lessresistance to change and, therefore, are usually

early adopters of the latest technology, heexplains. Hedge funds are therefore searching forthe latest and greatest and, at the moment, thismeans more flexibility. The industry issteadily moving towards the adoption ofcustomised algorithms, supplied by the banks,




ALGORITHMIC TRADING

and away from proprietary systems built in-houseby funds themselves.

The latest research note from Tabb Group sug-

gests that before the end of 2008, at least 30% ofall algorithmic flow will be sent through cus-tomised strategies, up from 18% today, as brokerslook to offer customisation to a broader set ofclients. The reports author, Tabb senior researchanalyst Adam Sussman, says that for algorithmicproviders, customisation re-engages buy sideclients on a personal level and differentiatesbrands in a market with much choice. In the end,this is a buy side issue because what traders real-

ly want is a tool that allows them to control anorder using a wide range of variables, he explains.Credit Suisse is alive to this buy side need, accord-ing to Balarkas, and the bank may even be aheadof the game. More than 60% of algorithmic usageby Credit Suisse clients involves tactics that havebeen adjusted or customised in some way to meetan individual clients needs, he explains.Customisation is sometimes regarded as a newphenomenon but we invested in rebuilding thewhole of AES in a modular fashion about threeyears back. Compound strategies are very easy toput together. For example, we can build a complexstrategy that includes the DNA from several otherstrategies, or a strategy that will flip between strate-gies based on triggers defined by the client.He continues: Markets are getting more complex.Trading is turning into a technological arms raceand its getting hard for trading desks to simplymaintain existing products, never mind build newfunctionality to exploit new opportunities. This is

why our mantra on the AES desk is innovation.Similarly, for Merrills Jackson, customisation is

key. Weve never marketed our algorithms asblack boxes, he says. The first thing thatstruck us coming to the market, was the huge voidbetween the understanding of what is going oninside the box and the desire of the street toshow them. Lifting the lid on the process isimportant to us.

ITGs Boardman concurs, some hedge funds are

building algorithms in-house, he says, but mostare buying them in or working with external partiesto develop products specifically tailored for them.Having a bespoke or highly customised algo-rithm is important to hedge funds as its one of thethings that sets them apart from each other and

also from the more traditional funds, he explains.Hedge funds are choosing broker provided algo-rithms because the technology on the marketplace

is now more client specific. Two years ago therewas little choice for funds but to build their ownsystems, as those provided by brokers were nottailored to clients needs. Hedge funds wouldrather buy in technology and leave the designprocess to others, instead concentrating on whatthey do best maximising profits, and today thereis great potential to do this. The arguments do notstand up for building algorithms in-house becausea hedge fund can be at the market with a broker

provided, custom designed algorithm withinmonths at a fraction of the cost and years beforean in-house design, says Boardman.

The Tabb report found two major trends withinelectronic trading. The first is for greater choicewithin strategies: a greater amount of market datathat drives the decision making, more choices onhow to interact with the marketplace and moreexecution venues to execute with. This frustratesthe buy side in the short term, Sussman says, buta period of rapid growth is followed by rationalisa-tion and consolidation. The end result is not moreor less strategies but different strategies that moreaccurately reflect the way the buy side trader wantsto execute, he explains.

The second trend Sussman found was thatvarious technology components such as tickerplants, FIX engines, event processors, and marketsimulators are available off the shelf. This meansthere are enough specialist products andchoices available that the buy versus build

dichotomy has been replaced with: where is yourcompetitive advantage?Algorithms are often the key differentiating factor

for hedge funds to gain that all important compet-itive advantage. The successful hedge funds arethose that can exert significant control over theinvestment process. These sophisticated fundsthat can properly manage and spread risk havedone well over the turbulent summer, while thosewith less sophisticated management strategies

have struggled. These strategies do not necessari-ly require algorithms, but for a growing number offunds, they are indispensable. Hedge fundsspend on algorithms looks set to increase at leastinto 2009, as firms struggle in what Balarkastermed the technological arms race.


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20/68

Technology that serves the global hedge fundmarket, which is approximately USD1.3 trillion inassets and is expected to reach USD2.38 trillion by2009, is moving from mere administration to fullbusiness process outsourcing. Hedge fundadministrators (HFAs) are providing a variety ofservices classified as mid to back office opera-tions. Still, other firms offer a full front to backoperational platform that includes trade captureand allocation. The HFA market is diverse, withsome firms exclusive to hedge funds and some

market neutral, serving hedge funds, mutualfunds, wealth managers, and institutional assetmanagers.

The hedge fund administrator group consists oflong term providers, as well as relatively recententrants from the global custodian market. Largeglobal custodians and HFAs have spurred onindustry consolidation, and the acquisitions andmergers will continue. Globally, there are about 70hedge fund administrators, as well as a few smallfirms in local markets. Among these hedge funds,

Citco, HSBC Alternative Fund Services, and FortisFund Services are the top three hedge fund admin-istrators, as measured by total assets underadministration.

Hedge fund administration used to be a lonelybusiness. Twenty years ago, just a handful of firmswere catering to this niche market. Large mutualfund administrators, arguably in a parallel busi-ness, had no interest in hedge fund administra-tion. The booming mutual fund business did keepadministrators quite busy, but hedge funds were

not on the radar. Times have certainly changed.The niche administrators have grown larger, andseveral global custodians and administrators havemade acquisitions into the hedge fund side of thebusiness. A variety of other firms are also enteringthe market, from startups to management con-

sultants with BPO units.The hedge fund industry relies on multiple coun-

terparties and service providers. Prime brokers areengaged for trade execution, security structuring,

financing, securities lending, and, often in the US,custody. In Europe, regulation generally requires aseparate custodian for safekeeping of the assets.HFAs have traditionally provided fund administra-tion services and are now rapidly expanding BPOfor core operations.

Technology vendors are gaining traction in thehedge fund market as well, providing point or fullfront to back solutions typically supported by port-folio management and accounting solutions tosupport core operations. Technology vendors

have targeted hedge funds with application serv-ice provider (ASP) deployments that offer lowerupfront costs and eliminate the clients ongoingsystem maintenance involvement. Building coreinfrastructure internally has kept many largehedge fund technology teams busy.

And finally, hedge funds serve both institutionaland high net worth clients, each with uniquedemands. Institutions require evidence of internalcontrols and typically request ad hoc reports. Highnet worth individuals require client relationship

tools and benefit from web-based reporting.Outside the US, where retail investment restric-tions are less onerous and income restrictions donot often exist, hedge funds are gaining (and willcontinue to gain) traction with the mass affluentinvestor, which will put further pressures on clientservicing tools and automation.

Business process outsourcers targeting hedgefunds are establishing or enhancing their plat-forms to support investment operations andmulti-asset class funds. Hedge fund administra-

tors in particular are capitalising on their industryinvolvement by adding offerings, primarily in mid-dle and back office operations.

Longtime providers are finding the space a littlesnug and are intent on keeping their market posi-tion through technology and service enhance-ments. Product positioning frequently promotesdomain knowledge and staff retention.In addition to the expanding variety of providertypes, consolidation activity is creating a new setof factors to consider in provider selection. The

hedge fund market is orienting itself to the caliberof these new organisations, increasing servicequality, range of product offerings, staff expertise,and pricing. Hedge funds have a diverse selectionof providers to choose from, and this does notmake the task any easier.


A major transition isoccurring in the hedge fundadministration market, saysMayiz Habbal

CELENT REPORT

Following

the flow


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The USD1.3 trillion hedge fund industry has chal-lenged the investment business to rethink itsstrategies. Dozens of businesses have come intoexistence or seen sales take off. While prime bro-

kers were long a key and often only resource forhedge funds, they are now joined by a proliferationof service providers.There is no shortage of service providers offering

business process outsourcing. Some focus on thetraditional fund administration services, and oth-ers add investment operations support to the mix.Still others provide what one might call pointBPO, outsourcing select processes that are a painpoint in the organisation, such as reconciliation,security master maintenance, or performance

measurement. Examples of BPO service providersserving the hedge fund market include traditionalmutual fund administrators and custodians,prime broker affiliated HFAs, management con-sultants, offshore firms, and technology providers.

Traditional fund administration services includefund accounting, general ledger, NAV, shareholderaccounting, and payments transfer. However,these services are widely expanding.

HFAs today are a mixture of automation andmanual processes. There is definitely progress

being made toward a new vision, but HFAs areequally encumbered by the challenges facing theindustry. Several issues are from the external envi-ronment such as prime brokerage silos that sendseparate client data files by asset class or that pro-vide files without complete data sets that wouldbetter facilitate HFAs workflow. There are alsoissues from the settlement processes the com-plex tracking of OTC documents and novation,where there is substitution of a new contract for anold one; or the substitution of one party in a con-

tract with another party. The hedge fund adminis-tration business is caught in the automation whirl-wind occurring throughout the financial servicesindustry: on demand access and automation arethe key ingredients in the new environment.The global hedge fund community is entering the

next phase. Over the past few years, discussionhas focused on the tremendous explosion ofassets, market impact, investment capacity, hedgefund scandals, and the surge of high profile man-ager startups opening their doors with USD2 bil-

lion to USD3 billion in assets.The next few years will turn greater attention tocross border distribution, finding the appropriatebalance in regulation and free markets, the middleground for fund disclosure that protects invest-ment decisioning, while assuring investors can

monitor their advisers, securities valuation, retailinvestor access to hedge funds, long only manag-er mandates with widening use of derivatives, andthe continued hedge fund firm infrastructure.

On this last point, access to technology pur-chased or outsourced, is the key. Hedge fundsaccustomed to operating in lean environmentswill find the long term competitive road tough totravel without automation. Given hedge fundfirms aggressive stance and openness to change,they are likely to be at the forefront of positivechange in the financial markets.Hedge fund administrators have an advantage in

service provider selection. These firms mayalready be providing fund administration services,

and there are generally pricing benefits to workingwith the same vendor. They are generallyindependent providers in the hedge fund supportframework. Aggregating fund transactions anddetails with an HFA is not as threatening to thehedge fund manager as disclosure is to a primebroker.

HFAs have significant domain knowledge in thealternatives industry and can be an asset to thefirm, which might otherwise go it alone.Furthermore, HFAs are investing in technology

enhancements that will offer improved platformand servicing features.Hedge fund firms tend to have an open mind and

are not encumbered with traditional market prac-tices. If a business case can be made where theservice is priced appropriately and genuinelyremoves pain points from operations, the pre-ferred focus is on investments. However, as thehedge fund business continues to mainstream,and, in particular, very large funds diversify theirproduct lines, there may well be something

inevitable about running operations in-house.Perhaps it is empire building or simply the needfor greater control.Outsourcing is not for everyone, but the outsourc-

ing market is quite fragmented and may serve avariety of firms. There will be small firms that ben-efit from outsourcing, as well as mid-size and largefirms that face internal chal-lenges in staffing or cost struc-tures that benefit from out-sourcing all operations or

select processes.

Mayiz Habbal is managingdirector of the Securities andInvestments Group at Celent




Hedge Fund Services PANEL DEBATE

Donard McClean is head of Fund Services Ireland at UBS Global AssetManagement, with specific responsibility for the development andmanagement of the business. He is a member of the Fund ServicesManagement Board and is responsible for hedge fund operations within FundServices globally. McClean has 18 years of investment industry experience.

THE HEDGE FUND SERVICES

PANEL DEBATE

Dermot Butler, who is chairman of Custom House Administration and CorporateServices Limited, the Dublin-based alternative investment and hedge fundadministrator, has over 35 experiences in the financial services industry. He is adirector of several international financial services and fund companies and is

deputy chairman of the Alternative Investment Management Association (AIMA).

Ras Sipko graduated from Rutgers University with a BA in AppliedMathematics. He has been involved with Koger for the past 10 years, and iscurrently working in the capacity of chief operating officer.

Robert Chin, general manager at ATC Fund Services, started ATC FundServices Curaao in March 2003. Prior to joining the ATC group, he was themanaging director of Fortis Fund Services in Curaao. Chins professionalexperiences include a seven year tenure as chief financial officer of Dutchbrokerage firm where he was a member of the European Option Exchange andthe Amsterdam Stock Exchange.

Chris Cattermole is the European sales manager of Advents Global Accountbusiness. In this role he has responsibility for European strategy, product mar-keting and sales of Advents Geneva solution to the Alternative InvestmentManagement market. Prior to joining Advent in 2005, Cattermole heldpositions in the financial services industry at Fidelity Brokerage Services,SS&C and Linedata Services.

James Lasry is a partner of Hassans International Law Firm in Gibraltar.He specialises in corporate and fund work and he advised the governmentof Gibraltar on the regulatory and tax treatment of investment funds. Lasryserves on the boards of various private investment companies and funds inGibraltar and abroad.


23/68HEDGE FUND SERVICES GUIDE 2008 INVESTORSERVICES JOURNAL 21

It has been a hard few months for the hedgefund market how will it bounce back andtackle the issue of risk?McClean: Although it has been a difficult time for

financial markets, many hedge funds, as onewould expect, have fared well in the volatile mar-kets. Recent market events have caused manyinstitutions and hedge funds to push risk assess-ment and its management further up the agenda.

Sipko: Hedge funds are known to do well in thedownturn of the market as well as in the upside ofthe market. Therefore, since the markets are cycli-cal, we feel that hedge funds will recover, particu-larly with the amount of assets that they attract for

new investments and opportunities.

Butler: From what I have read in the press, pub-lished as far afield as The Irish Times and theSydney Morning Herald, the hedge fund markethas already bounced back, having, apparentlyrecouped in September, most, if not all, of the

losses of August.What I suspect had happened is that tabloid and,inevitably, some of the broadsheet press jumpedon those funds that were directly affected by thesub-prime debacle and subsequent credit crisisand succeeded in writing their copy in such a wayso as to persuade the world, not only that allhedge funds had collapsed, but also were respon-sible for the sub-prime problem and the subse-quent credit crisis, using an unrepresentative

small sample as a basis for the allegations. Ofcourse, as we all know, truth and accuracy mustnever stand in the way of a juicy headline.

What has been demonstrated by the whole affairis that there were good grounds for the regulatorsand the industry to be concerned some timebefore this summer about pricing but it shouldalso be recognised that, if liquidity dries up in anymarket, pricing will become an art, rather than ascience. The only price that is valid is the price atwhich a deal is struck between a willing buyer and

a willing seller.We have also seen, in the last few days, the pub-

lication of the UK Hedge Fund Working Groups(HFWG) consultation paper, which makes 15 rec-ommendations for sound or best practices thathedge fund managers should follow and risk man-

agement is one area covered in that paper.Chin: Managing risk has always been an issue inthe industry. With new financial instruments con-tinuing to be developed, it will take severe market

conditions to stress test new instruments. Wehave seen this in 1994, when the mortgage backedsecurity funds collapsed, in 1998, with the globalfinancial crisis and, recently, with the sub-primemortgages. I consider these developments as partof a maturing industry.

Cattermole: While some strategies may have beenhit in the recent market turmoil, others have prof-ited too. Likewise, some funds that took losses inJuly and August have recouped them in the subse-

quent rebound, with September proving to be abanner month for hedge fund performance. Andthat is the nature of the hedge fund industry.Volatility creates investment opportunities. As forthose that survived the summers tribulations,they will take note of what happened, learn les-sons and move forward with new trading modelsand strategies.

In addition, hedge fund managers increasinglyare tackling risk by improving their risk manage-ment technology capabilities. For example, a newsurvey of more than 100 hedge fund and fund ofhedge fund managers by Ernst & Young,Navigating New Complexities, found that technol-ogy will be the biggest spending area in the nexttwo years for three quarters of respondents, andthat for 58%, funds investment in riskmanagement systems will be the largest piece of

that technology expenditure.

Lasry: In fact, it was not so bad. September was,according to CSFB/Tremont, a successful monthfor hedge funds. This does not mean that in thehedge fund universe, which is composed of manydifferent strategies, there were some that did notperform very well.There are now a lot of industry initiatives in place,

which deal with risk in the hedge fund world, suchas the UK Hedge Fund Working Group (HFWG)

that just sent out a consultation paper and theAlternative Investment Management Association(AIMA), which published several sound practiceguides. Also in the US, there is a presidential work-ing group. All these initiatives will lead eventuallyto an industry standard that will allow for better

Hedge fund managers increasingly are tackling risk by improving theirrisk management technology capabilities



risk management and more transparency.

What impact would greater regulation on thehedge fund market have?

McClean: Regulators ultimately decide on the levelof regulation they determine appropriate for theirjurisdiction. It is a balancing act for regulators tobe able to provide meaningful regulation at thesame time as maintaining the attractiveness oftheir own domicile to asset managers andinvestors alike, allowing business to flourish in awell regulated environment.

Fair Value Measurement (FAS 157) designed inresponse to investors requests for more informa-tion on how hedge fund managers are measuring

investments at fair value will continue to be a keyregulatory issue.Recently, it has been reported that a number of

major players in the hedge industry in Londonhave collaborated to propose self regulation in anattempt to avoid unwanted over regulation. Whilemanagers vigorously pursue investment opportu-nities with as few barriers to investment as possi-ble and keep their investment strategies confiden-tial, regulators seek transparency. However, tofacilitate increased distribution through a broader

investor base, managers need regulation and theincreased oversight this can bring.

Sipko: There are two kinds of opinions on this sub-ject, one for and one against, however we feel thatimposing greater regulations on the hedge fundmarket would limit the creativity of hedge fundmanagers, thus restricting the opportunities thathedge funds take advantage of.

Butler: At the risk of sounding glib, it depends on

what form the greater regulation takes andwhere the regulation comes from. Many fear thatthe SEC could impose quite draconian regula-tions on hedge funds, if for no other reason thanto get their own back for being made to look nota little foolish by Mr Goldstein. Of course, from aEuropean point of view, I think it is not the fund,but the manager that should be better regulatedin the United States, given that, in fact, they arenot regulated at all at the moment. In Europe, wehave strong and, in my opinion, very adequate

regulations governing hedge fund managers,both in the United Kingdom and Ireland and I donot see the need for any more regulation. Havingsaid that, a tweak here and a tweak there canalways be justified.What I think is recognised by some regulators, in

Europe, certainly, is that the hedge fund industry isa responsible industry and this is largely becauseof the Alternative Investment ManagementAssociations (AIMAs) prodigious efforts. This is

in the context of introducing the Sound PracticesGuidelines for Managers, Administrators andDirectors of offshore funds, their research paperson the pricing of hard to value assets, backed upby the six Due Diligence Questionnaires. All ofthese documents have been, or are in the processof being, updated since they were first introducedand I think it is fair to say that they have gone along way to set standards in the industry.

It is to be hoped and, I think, it is not too opti-mistic to hope, that the HFWGs efforts will go

even further to show that in the UK and Europe, atleast, the industry is being proactive in keeping itshouse in order and following practical self regula-tion in the context of sound or best practices.

Chin: It will depend on the form of regulation todecide what the impact would be. The recent ini-tiative by a group of London-based hedge fundmanagers appears to be a good starting point forregulation that is acceptable to all parties involved.

Cattermole: It depends on where it is implement-ed and what it entails. Reactionary and restrictivemeasures implemented unilaterally for examplein the US run the risk of forcing managers torelocate to more benign jurisdictions. That seemsunlikely to happen in any of the countries with ameaningful industry presence though.

However, some form of voluntary code of prac-tice aimed at raising the bar of internal risk con-trols and providing greater transparency toinvestors is looking more likely in the wake of Sir

Andrew Larges recent report. If widely embracedand adopted by managers, such measures couldwork to their advantage, by nipping the threat ofmore onerous imposed regulation in the bud, andby sending a positive message to the more cau-tious and risk averse institutional investors.

Lasry: It is very important to state that the hedgefund market is not unregulated at all. All the man-agers in the UK and account for about 20% of theworlds hedge fund assets are regulated under the

Financial Services Authority. In the US, managerstake advantage of safe harbours in order not to beregulated, but these safe harbours were set up inorder to protect retail investors, so the safe har-bours themselves have a lot of restrictions.Nevertheless, it is also true that hedge funds use



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offshore regulations, which do not prevent thefunds of investing in certain asset classes orstrategies. The industry sees its responsibility andthis why it started all the initiatives mentioned

above. I think these sound practices and industrystandards are more than sufficient and show howmature the industry is.

In terms of technological developments whathas had the greatest impact on the hedge fundcommunity?McClean: One of the key issues for hedge funds isthe standardisation of communication and mes-saging. A platform similar to the Swift platform formutual funds, available for all types of instru-

ments including OTCs and funds of funds, wouldimprove efficiencies and avoid bottlenecks. A stan-dard messaging platform is the ultimate solutionto straight through processing and would allowgreater frequency of net asset value (NAV) produc-tion, therefore greater liquidity for hedge fundsand fund of hedge funds, which in turn would leadto greater investor participation in the industry.Until such time as a global platform is in place,trade and information files will continue to bedeveloped, enhanced, sent, received and mapped

between investment managers, prime brokers andadministrators.

The introduction of specialist pricing vendorsfacilitates a more automated approach allowing amanual exercise to be replaced with an automated

process. Again, a more automated approach leadsto greater frequency of NAVs and greater participa-tion in the industry. Specialist pricing vendors alsocreate independence in valuation of a funds port-folio, which, as we see through due diligence ques-tionnaires, is a high priority for investors.

Sipko: As a technology firm, we feel that the great-est impact on the hedge fund industry is yet tocome, particularly with the products that wouldcreate information flow down to the investors.

Butler: Although this affects all communities andnot just hedge funds, in my opinion, it must be theamazing growth of the internet and the web andthe huge advances in communication overall,

which has resulted in automated STP, not only inthe context of trading, but also in administrationand reporting. And that refers to the technologicaladvances described at their simplest, compared to

the extraordinary developments in analyticalprocesses and trading algorithms that some man-agers have introduced. This obviously explainswhy economics seems to be a secondary qualifica-tion for hedge fund managers, after PhDs in neu-ral networking and nanoscience!

Cattermole: Electronic trading capabilities, in theshape of black boxes and direct market accessplatforms, have radically altered the trading oppor-tunities open to hedge funds, with a growing share

of their order flow routed via no touch and lowtouch channels. And going forwards, as marketglobalisation and cross asset strategies prolifer-ate, we can expect to see a growing sophisticationin multi-asset class algorithms.

Lasry: The upcoming of automatic trading, thedevelopment of sophisticated trading algorithmsand the increased interconnectivity crystallised inthe so-called quant funds who are machine onlyfunds and free of emotions. Some of the worlds

most powerful computers are owned by hedge

funds in order to trade securities within millisec-onds. These funds are exploiting mis-pricings indifferent markets or securities and are helping themarkets to become ever more efficient.

In the triangular relationship between hedgefund managers, prime brokers and administra-tors, where does the weakest link lie? How cancommunication between these parties beimproved?McClean: The relationship between the three par-ties relies on the strength and effectiveness of thecommunication between them, as well as themethod of communication. In the absence of anindustry-wide communication standard, particu-larly for hedge funds trading instruments, includ-ing OTCs such as derivatives and other illiquidinstruments, any corner of the triangle could bethe weakest link.

Establishing an industry-wide communicationstandard would require collaboration of industry


Historically, hedge funds have had more association with and relied moreheavily on their prime brokers than on an independent administrator


27/68

participants including investment managers,prime brokers and administrators. The degree towhich these methods can be standardised has adirect impact on the strength of this three-way

relationship.Sipko: We feel that communication is weak in gen-eral, and the weakest link lies in the technologythat could be used by each of the three groups tocommunicate more effectively.

Butler: It is not possible to give a standard answerto this question. The weakest link will dependupon the relative quality and ability of the manag-er, the prime broker and the administrator

involved and, in particular, the relative quality oftheir systems and how they communicate witheach other.Of course there are other considerations, such as

the complexity of the investment strategy of thefund, the volume of trading, the difficulty of valu-ing the portfolio or certain instruments in it, andthe required liquidity (daily/weekly/monthly) ofthe fund. But, all other things being equal, theweakest link will be the party that has the most dif-ficulty in delivering the information needed to

enable the other parties to do their job properly. Itis, of course, communication again and thisapplies not only to the single strategy funds withdifficult portfolios, but also to funds of fundswhere the weakest link may be the ability to obtainprices from uncooperative administrators and/orcustodians of the underlying funds.Many of these problems can be, at least, mitigat-

ed and, at most, eliminated, with improved auto-mated data delivery systems. For example, withautomated communication, which avoids and

reduces the human element.Finally, having raised the subject of the humanelement, often the weakest link in a relationshipbetween service providers is personality clashesbetween individuals in the various organisationsand it is a given that this is something that needsto be carefully managed by each company.

Chin: There is some room for improvement in therelationship between the prime broker and admin-istrator. Since the administrator is not being con-

sidered a client, the prime broker is not alwaysinterested in reconciling differences reported bythe administrator.

Cattermole: Historically, hedge funds have hadmore association with and relied more heavily on

their prime brokers than on an independentadministrator with many domestic US funds stillhandling administration in-house. However, theperceived and potential conflict of interest

between fund managers and their primes, many ofwhom run sizable prop trading desks that effec-tively compete with hedge funds, continues to bea source of tension and mistrust. How thin theChinese walls are between the banks prime bro-kerage units and the rest of their organisations isnot always easy to tell. In many cases fears ofinformation leakage may be unfounded. But nev-ertheless, perception is what matters. To this end,hedge funds are embracing the independence andanonymity that electronic trading advances are

bringing. In this environment, actions speak loud-er than words, so it is up to the primes to provetheir impartiality.

Lasry: The communications in this triangle arenormally very good and of mutual benefit.Administrators are the ones that provide an inde-pendent third party valuation for the funds assets,the prime broker helps to execute the trades andgives the fund the necessary facilities for imple-menting the respective strategy and provides addi-

tional services.

Given the growth in the size of hedge funds, willback office outsourcing become a thing of thepast? How will the role of prime brokers andadministrators change over time?McClean: In the mutual funds world, it is widelyaccepted that the investment management, mid-dle office functions and administration can alltake place in-house. This is also largely the casefor US-based hedge funds. In Europe, back office

outsourcing for hedge funds is a more commonpractice.

As the alternative funds industry grows everlarger, this could develop two ways. It could followthe pattern set by the mutual fund world by per-forming the administration in-house. Alternatively,the benefits of employing the services of an inde-pendent administrator could be further recog-nised, thus further allowing managers to focus oninvestment and adding value to the fund. If inde-pendence is deemed the priority, the latter will pre-

vail with independent service providers, primebrokers and administrators, allowing an openarchitecture arrangement.

Sipko: It is very likely that with the improvements




in technology and with automation it will takefewer resources to perform tasks of the brokersand administrators.

Butler: I believe that the larger hedge funds will getlarger and this will be because of the growth indirect institutional investment and, indeed, indi-rect institutional investment, via increasingly largefunds of hedge funds. The question is whetherthese large hedge funds will be administered bythird party administrators or whether the man-agers will keep the administration in-house. Weknow that several of the larger US managers dotheir own administration and, presumably, this isacceptable to their investors. This is because the

vast majority of US hedge funds are self-adminis-tered, which is a legacy matter from the way inwhich the US hedge fund industry has grown overthe years.I think it is also true that, with the exception of the

very large players I have just described, most pro-fessional and institutional investors prefer to investin funds that have independent administrators.

It should also be remembered that between 60%and 70% of all the hedge funds have less thanUSD100 million or, perhaps USD200 million andmany of these, including most, if not, all offshorefunds, will be administered by independentadministrators. So, for the vast majority of hedgefunds and their prime brokers and administrators,business will continue as usual. For the largerhedge funds, the prime brokers and/or the admin-istrators will have to continually upgrade their

service and technology, as new complex deriva-tives and pricing problems are introduced. It isworth remembering that in AIMAs first pricingresearch paper, it was noted that what was hard tovalue two or three years prior to the paper beingproduced, had become a commonplace andstraightforward pricing procedure by the time thepaper was published. So the whole area is one ofcontinual evolution and development.

Also, it is possible and perhaps probable thatwhen we know what the HFWG and the

PWG finally decide in terms of the best or soundpractices, it will be the administrators who willhave to confirm that the funds comply withthose practices. This will, no doubt, requirerevised and upgraded systems and moredetailed reports from the administrators.

Chin: To the contrary, back office outsourcing willbecome more important. As most of the newassets invested in hedge funds are from institu-tional investors, the need for greater transparency

and independent pricing will grow. The large fundsare likely to appoint global service providers(administrators and prime brokers), however, thevast majority of the funds have assets less thanUSD1 billion and these funds will probably appointsmaller administrators who are typically more costeffective.

Cattermole: No. Hedge funds will, for the mostpart, continue to outsource to specialist servicingproviders, particularly given that between 60%

and 70% of all hedge funds have less thanUSD100 million in assets under management andare keen to focus on their core competencies.

Meanwhile, those that do take on the back officefunction internally will be lumbered with a heftycost base that is only likely to become greater asinstruments and trading strategies become evermore complex. One way to offset that is to hive off

the functionality and sell it as a service to third par-ties, la correspondent clearing. Convincing thenotoriously suspicious hedge fund communitythat the Chinese walls at these firms are sufficient-ly robust to avert any information leakage wouldbe no easy sell though.As for the roles of prime brokers and administra-

tors, we are seeing a blurring of the lines. Someprimes, such as Morgan Stanley and GoldmanSachs, have already set up administration units,

while the administrators are always looking atways to move up the value chain with their suite ofservices, potentially into areas traditionallyoccupied by the prime brokers.

Nevertheless, the growing demand forindependent instrument pricing and fundvaluations means administrators continue tohave a central role, while prime brokers remainunchallenged (for the moment) in their core offer-ings, for example for financing and start up assis-tance. Whether the big custodian banks, such as

State Street and the Bank of New York Mellon,which have piled into the administration space inrecent years, will ultimately use their bankingmuscle to challenge that role remains to be seen.

Lasry: Outsourcing will be ever increasing, since


As the industry grows, so will the requirements for new funds,notwithstanding the media concentration on the huge funds


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the growth of the industry is exponential and man-agers should concentrate on their strategies.Prime brokers eventually will, as regulated entities,assume more responsibility for risk controlling in

the funds and administrators will be strengthenedin their role as an independent valuation party.

How are the new entrants into the hedge funddomicile race standing up to the traditionaljurisdictions?McClean: New centres such as Singapore, Maltaand Dubai all have their role to play and will findtheir niche in an expanding global alternativeinvestment industry. The more traditional jurisdic-tions of the Cayman Islands, Luxembourg and

Ireland continue to grow and develop and are like-ly to do so in the future. Asia and Europe will con-tinue to be growth opportunities for hedge fundmanagers. Many large fund of hedge fund and sin-gle managers opening local offices, especially inAsia, illustrate this. In addition, domiciles such asLuxembourg and Ireland are approving new andimproving existing fund structures, in order toallow more alternative products to be distributedacross Europe and Asia.

Sipko: We believe that most new entrants are verywell positioned to compete with traditional juris-dictions, since in order to attract hedge funds theywill have to provide an environment that the tradi-tional jurisdictions may not at the moment.

Butler: I think that Luxembourg, the ChannelIslands and Malta are doing well and I would sus-pect that, over time, they will become well estab-lished hedge fund domiciles. On the other hand, Ido not think that, at this time, the Cayman Islands

or Dublin should worry, but nor should theybecome complacent. The Bahamas, the BVI andBermuda will retain their faithful supporters forsome years to come, but I fear that, certainly in thecase of the BVI and the Bahamas, their marketmay fade away. While Bermuda may maintain itsrespectable and respected status, it is unlikely topose a huge threat to the European centres.

The point is that, as the industry grows, so willthe requirements for new funds, notwithstandingthe media concentration on the huge funds. As I

have said, the majority of funds still are relativelysmall and there will always be such smallerfunds. The one point that could change theweighting of the relative importance of domicilescould be any legislation that the EU may bring inthat requires funds sold in the EU to be domiciled

in the EU, or affiliated domiciles such as theChannel Islands. Watch this space.

Chin: If one takes a look at the most recent data

published by jurisdictions such as Jersey andGuernsey it appears that they are gainingmarket share. These jurisdictions seem to beespecially of interest to European basedmanagers. In addition, these jurisdictions areplanning to launch products (lightly regulatedstructures) to compete with the traditionalCaribbean based domiciles. In the Asia time zone,Hong Kong and Singapore are also reportinggrowth in locally domiciled funds. It is obviousthat this is happening at the expense of the

traditional jurisdictions, although these domicileswill continue to incorporate new funds due to thegrowth of the industry as a whole.

Cattermole: While European n

HEDGE FUND SERVICES MARKET GUIDE 2008

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