Alternative Investment Management Association
Key Asset Management
Fund supermarkets in the mutual fund world have revolutionised the way wealth managers can aggregate client investments on a single platform and as a result substantially reduced back office costs. The concept of Straight Through Process (STP) is now regarded as a standard service provision for the vast majority of cost conscience wealth managers.
In the hedge fund industry, the hedge funds are beneficiaries of the investments in STP by brokerage firms, exchanges and large asset management firms. These investments permit electronic connection of each of the different steps in the lifecycle of trade execution, including of course trades initiated by hedge funds.
Until recently, however, there has been little progress towards STP in the hedge fund of funds industry. There are few electronic links between funds of hedge funds on the one hand and the hedge funds in which they invest and the administrators who provide them with back office services. In fact, there appears to be a major disconnect between the level of sophistication in administrative systems employed by single manager hedge funds and those employed by the hedge fund of funds industry. Single manager hedge funds have often led the way in developing proprietary administrative systems because of the edge such systems give individual managers over their competitors.
Therefore, we have developed – with an external company – a portfolio management system and fund accounting system which will take the industry nearer to STP by solving critical management, risk, compliance and cost issues, particularly those resulting from over-reliance on error-prone spreadsheets.
Progress is occurring on other fronts as well. There are a number of companies that have identified a potential business opportunity in the collection and automated uploading of data from hedge funds – such as prices and investment terms - to the hedge fund of funds industry. Administrators are also beginning to respond to the demand for more streamlined links with their fund of hedge funds clients. A key challenge will be to convince underlying managers that it is worth their while cooperating on an industry-wide basis on these initiatives. Hedge funds should recognise that the substantial pressure on cost reduction for the hedge fund of funds industry will be substantially eased to the benefit of everyone in the alternative investment industry - if the industry as a whole continues to move towards STP solutions.
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The need to develop such a system became increasingly apparent as institutions and investment consultants started to allocate to the asset class. Institutional investors have been used to quick and efficient settlement, paperless administration, automated NAV reconciliation and automated data upload for a number of years in traditional assets. Moving from a settlement system based on T+3 to T+25 is just one example of the shock that awaits the first time allocator to the asset class. The first time allocator also finds a surprising reliance on spreadsheets for portfolio management. This is problematic, because research has shown that 90% of audited spreadsheets contain errors. In a typical hedge fund of fund operation only one or two people are engaged in the format and update of such spreadsheets which adds to likelihood of increasing errors. The complexity of managing and valuing hedge funds which have varying lock ups, notice periods and settlement schedules increases the necessity for a hedge fund of funds business to move to a more automated system.
The move to automated systems also makes it possible to begin to implement STP to electronically connect funds of funds with their administrators and with the hedge funds in which they invest. STP will enable hedge funds of funds and their administrators, as well as hedge funds, to exchange data electronically, eliminate duplicate entry, refresh results instantly, entry data rapidly and in bulk - including of prices, trades, and capital transactions - interface to administrators and banks for reconciliation, and reduce reliance on phone calls, faxes, and emails.
If hedge funds of funds want to attract institutional investors and investment consultants, STP and all that goes with it must move up the list of priorities. Institutional investors will undoubtedly put pressure on the industry to improve the administrative issues. They will increasingly want to see a reduction in errors right across the back office functions. A back office which is still reliant on multiple spreadsheets is no longer going to be acceptable to this sort of investor.