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Investors Demand Hedge Fund Transparency

Institutional investors are already demanding more transparency from hedge funds. Not to be outdone, regulators are readying new rules for hedge fund reporting.

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Why It's Important: When Lehman Brothers failed and AIG was on the brink of collapse in September 2008, the systemic risk associated with a collectively overleveraged financial industry was painfully apparent. Add in the Bernard Madoff ponzi scheme, and investors and regulators suddenly realized that maybe transparency is important after all.

Where the Industry Is Now: By now investors are demanding more transparency from hedge funds, which can provide the necessary information only by leveraging automated systems. Luckily, the industry is long past the wild-west days, when many hedge funds were run on spreadsheets alone. "Whether the fund is small or large, we are well beyond the spreadsheet-only days," says Dave Csiki, managing partner at INDATA, a provider of buy-side trade order management, compliance and portfolio accounting software. "We are seeing a lot of transparency demands from investors, and real-time reporting is very popular."

Hedge funds, rocked by the volatile markets and record redemption rates, have risen to the challenge. "There has always been a need for transparency, but when a fund is beating the market, investors don't ask [questions]," says Nael Farsakh, solutions partner at EMC Consulting. "That has changed. We never used to hear hedge funds talk about transparency and compliance, but now they are making sure they have the right infrastructure in place."

In addition to investor demands for more transparency, regulators are looking to avert another global financial by detecting risks before they grow to systemic levels. The only way to provide the necessary level of reporting and transparency to investors is to deploy systems that can track and report assets' values.

Focus in 2010: "Most proposed legislation is focused on monitoring systemic risk before it occurs," says Keith Bliss, SVP at Cuttone & Co., an introducing broker. "Regulators are worried about systemic risks, and the only way hedge funds are going to be able to handle the regulatory demands is through automation." The regulations are not anywhere close to finalized -- and may not be until mid- or late-2010 -- but that doesn't mean hedge funds can wait to continue automating processes.

"Already, the minimally accepted requirements by investors for portfolio analytics and risk management has gone up dramatically," reports Mike Rosen, managing director and principle at Concept Capital, a mini-prime broker. "And NAV [Net Asset Value] 'Light' isn't going to cut it anymore. The trend is going to be daily NAV, and it will be a check box in the due-diligence questions" that institutional investors require hedge funds to complete, Rosen adds.

Having an independent third party, such as a prime broker, and accepted technology solutions from a proven vendor can help hedge funds meet some of the due diligence requirements of investors. "We are seeing more investors coming in and doing due diligence on our clients and technology," says Nigel Kneafsey, CEO of Options IT, an infrastructure service provider that counts more than 100 hedge funds among its clients. "Running a hedge fund on a fully in-house built system is not going to be acceptable going forward."

Industry Leaders: Introducing brokers, such as Cuttone & Co., Merlin Securities, Concept Capital and Shoreline Trading Group, all provide services and technology to hedge funds that can help meet future regulatory requirements and current demands for transparency and reporting from investors. Larger prime brokers also offer similar services.

Technology Providers: Too many to list. Most introducing brokers and prime brokers offer automation technology along with their services. Technology providers that cater to hedge funds also have emerged recently. "A few years ago, all you could find were front-office solutions," says INDATA's Csiki. "Today there are custody and back-office functions available as well."

Price Tag: Too many variables. Depending on the level of sophistication and size of the hedge fund, and whether the hedge fund is running its own technology or relying on a prime broker's functionality, the price varies widely.

Greg MacSweeney is editorial director of InformationWeek Financial Services, whose brands include Wall Street & Technology, Bank Systems & Technology, Advanced Trading, and Insurance & Technology. View Full Bio

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