Warehouse system to tidy up hedge funds

The Bank of New York’s hedge fund servicing department, which counts 104 hedge funds running $63bn as clients, has been more than usually busy of late, with the introduction of a data warehousing system for funds of funds. The bank is also about to launch its third-party valuations capacity for complex derivatives. But the unit’s managing director, David Aldrich is the first to point out that this is not a cure-all administrative solution for all the back office problems the administration of hedge funds throws up. “Our system is not a miracle worker, but rather a starting point,” believes Mr Aldrich. “Our clients can now see where things are at. By increasing transparency and by partially automating the process, the margin for error is reduced.” What Mr Aldrich is sure about is that his proposition has developed in a more coherent way that some competing services, having grown organically and developed proprietary systems, rather than simply acquiring a hedge fund servicing capability. Key to the latest initiative, is the bank’s investment in up-to-date technology. The data warehousing proposition is designed specifically for funds of funds and addresses the multiplication of an already complex relationship between the manager, the prime broker and the administrator. As the most popular route into hedge funds for both private clients and institutions, the fund of funds structure is a particularly attractive one for wealth managers to penetrate. But dealing with a fund wrapper that invests in a whole multitude of other funds makes life complicated when it comes to trade executions, as sub funds are each likely to have their own transfer agent (TA), with its own execution system. This is where date warehousing comes in, capturing and tracing all instructions and displaying them to clients. Housed within the bank’s technology platform, Praeeo, the new product covers the full range of reporting and transactions required by a fund of hedge funds and its various transfer agencies. It also maintains contact information for parties of interest and can act as an electronic filing system for business records, allowing clients to store data about their fund structures, financial statements and dealing forms. “We are looking at extreme complexity in the amount of investment instructions going in and out of the fund and its underlying components,” says Mr Aldrich. “You might get something like 200 TAs operating within a typical fund of funds, all operating with their own processes, payments instructions, deadlines and the like. There is no straight through processing (STP) and orders are still largely reliant on a fax machine.” The bank’s next launch is to be third-party valuations for complex derivatives, due out in March. The system should offer managers the option to use the bank’s figures which will be based on third-party agents to value on either a daily, monthly or weekly basis and then to calculate net asset values. Indeed a common complaint is that current systems are heavily dependent on manual processing and the bank often needs to go between the various agencies coming up with different prices, before deciding on the right one and then agreeing that price with the hedge fund manager. “Fund managers are judged on monthly valuations, so how that is calculated is a sensitive matter. There’s increased focus on this and having it done transparently and independently is seen by most as a necessity,” says Mr Aldrich, adding that the bank has used industry standards to ensure quality of proprietary systems wherever possible. One such example is the bank’s deployment of Sungard’s fund accounting system, InvestOne Enterprise. There are also proprietary systems in place for performance fee calculations, transfer agency, trade executions for funds of funds and reconciliation. “What we’re trying to do is standardise and automate the various processes common to all hedge funds. This is how you achieve reliability and can introduce proper procedures around manual processing,” says Mr Aldrich. “Hedge funds tend to be unique and so for the managers there are issues around scalability. So outsourcing to someone like us with our own systems that address issues common to all hedge funds makes good sense.” But there is a strong need to convince hedge fund managers, many of whom are ignorant of or at best ambivalent about back office issues, of the need for back office progress. “With hedge fund set ups, their basic raison d’être is to create alpha and the manager basically believes that he or she can make more money doing it him or herself than by doing it for a big fund house,” says Mr Aldrich. “So what we’re dealing with is boutique fund managers who don’t really care that much about infrastructure issues – as long as everything is working for them.” This is why the bank aims to support hedge fund managers in everything outside of their core activity of creating alpha, except prime brokerage. “Often the manager knows that they need help but has only a scant understanding of the various solutions. But because we are a big operation. we have the breadth and depth to help.” Mr Aldrich comes from a long-only background and has evolved with the hedge fund market. But does servicing the hedge funds arena require an entirely different skill set or is a case of appropriating the best bits of the bank’s long-only proposition and tweaking it to fit hedge funds needs? He believes one of the main differences between servicing the two investment disciplines is that when it comes to administration, hedge funds work by using a performance fee and also appoint a prime broker to provide custody and use the funds’ assets to leverage and raise collateral. Administering a hedge fund becomes a three-way relationship and the bank will work with prime brokers that it has recommended to the hedge fund, or will gain a client on recommendation from a prime broker. Understanding how to keep the relationship between the three as smooth as possible is imperative. “It would be foolish to consider it as anything but an evolving process demanding constant innovation and updates,” says Mr Aldrich.

Aldrich: system not miracle worker, but a good starting point