Emerging two-tier hedge fund system needs new operational model

A report by Investit Intelligence into the operational efficiencies of setting up and running a hedge fund product in an existing long-only or ‘mixed’ fund management company has revealed that firms choosing to go down the mixed route must be prepared to adopt a new operational model.

The report Hedging Your Bets – Mixing long-only with long-short investment conducted a survey of leading fund management houses representing over 40% of mixed-environment hedge funds, administrators, prime brokers, pension consultants and fund of hedge fund managers in Europe[1] into the implications of traditional long-only fund managers entering the world of hedge funds. The report found that the mixed environment has been successful in a range of companies and that there exists the possibility for the market to split to support a two-tier system where a less constrained but still risk- and fee-aware ‘hybrid’ hedge fund product could appeal more strongly to the increasing influx of institutional money.

The report found that the hedge fund ‘triangle of responsibilities’ between offshore administrator, prime broker and fund manager can be very difficult for a new entrant from the long-only side to understand because it cannot be moulded to fit within their existing infrastructure. Being prepared to adopt a new operational model was therefore a critical success factor for firms choosing to go down the mixed route. Many long-only firms interviewed had to fundamentally adapt their robust set of procedures, which were capable of managing highly-regulated funds, to integrate this new set of service providers who are used to very different operational procedures.

While a hedge fund is approximately the same price as a unit trust to structure and launch, the hidden cost to mixed firms of bringing in the necessary infrastructure and operational procedures to support it represents a significant business risk if not taken into initial consideration. A much deeper understanding of complex instruments than the long-only side is required of operations; in some cases this requires the formation of a local support team for trade processing which has no equivalent on the long-only side. Some respondents had allocated separate system resources to the hedge fund area to allow it to develop more quickly.

Very few mixed firms interviewed had however been willing to delay their entrance into hedge funds in order to put robust technology in place from the start. The IT department usually needed to adopt a three-phase approach: implement some necessary systems, construct as many interfaces as possible to be extended over time and build a robust platform once the business could justify it.

While the need to adopt a new operational model presented significant challenges to mixed fund management companies, most were found to already have the foundations of a significant commercial advantage by benefiting from the routine operational procedures already in place for their long only funds. Mixed firms found four major points in their favour when selling to the emerging institutional market for hedge funds:

A culture of integrity, strong compliance and clear segregation of duties
Operational excellence in pricing, procedure, infrastructure and disaster recovery
Comprehensive risk oversight – operational risk as well as investment risk, and with the risk team independent of the investment team
A sophisticated client interface with dedicated client service and a willingness to provide transparency

Mixed firms found that these ‘operational reassurance’ factors could be exploited when selling to institutions to counteract the ‘headline risk’ factor which 34% of institutions said prevented them from investing. In addition, mixed firms were seen as being more likely to be able to support a range of different hedge fund strategies successfully at the same time reducing the reliance on one ‘star’ manager.

"In Europe by mid-2004, mixed firms made up around 15% of the European hedge fund market. Our report investigates the drivers behind a firm’s move into running ‘hybrid’ hedge fund products and looks at the operational issues which ultimately determine the mixed firm’s success," said Catherine Doherty, Principal at Investit and coordinator of the Investit Intelligence service.

"To foster a compliant environment capable of running such a mixed range of products, firms must be prepared to adopt a new operational model which integrates a new set of suppliers. Success will not be measured by the number of strategies run, but by a mixed firm’s ability to support, promote and develop good funds. The survival of a mixed firm ultimately depends upon how quickly it is able to evolve to implement new systems to support these different hybrid strategies and risk management techniques as they continue to develop apace."

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