Opening a Hedge Fund is Popular Move but Running One Requires Specific Technology

Most people agree that the days of amateur stock picking and 100-point-a-day gains are well behind us. To many investors, that means traditional investing is also not what is used to be. And while waiting for your stocks to slowly rise may still be the best method of ensuring long-term wealth, that simply means frustration for those used to the high-flying markets of the late '90s.

Enter hedge funds, with their ability to make money on the downside of a market, as well as more money on the upside. Those characteristics are just what is prompting many traditional-financial institutions to launch their own hedge funds, thus providing that option for affluent investors who might take their money elsewhere.

But launching a hedge fund means more than just collecting the cash and operating off traditional money-management technology. Hedge funds are a special breed of investment vehicle and, as such, require advanced technologies to operate. One reason for this is the fact that hedge-fund managers need sophisticated accounting to manage the esoteric financial instruments and unorthodox investment techniques they employ.

Learning about such technology from active hedge funds, however, is rather unlikely because they have traditionally been exceptionally secretive, even with their investors. Those investors, again traditionally, have been willing to accept such treatment in exchange for handsome returns in what amounted to a "Don't ask. Don't tell" policy of investing.

"Hedge fund managers don't want to be bothered with having to keep their investors in the loop," says Rob Hegarty, director of investment-management technology research for TowerGroup, which recently released a report on hedge-fund technology.

Traditionally the domain of the highly-affluent, sophisticated investor, more and more money is now flowing into hedge funds through "fund of funds" (funds composed of multiple hedge funds) which allow the average investor into the hedge-fund world. That easy access means a larger, less-savvy and more demanding community of investors. More investors means that technologies which hedge funds could previously ignore, such as client reporting and customer-relationship management software, now demand serious consideration.

Back when the hedge fund Fenchurch Capital Management got started in 1985, there wasn't much technology in the marketplace to choose from, says Michael Griffin, the firm's chief operating officer from inception till the doors were closed in 1998. Griffin, who managed the $100 billion fund's operations, systems development and overall technology, says the dearth of readily-available technology prompted Fenchurch to build its own IT department, develop systems in-house, and even self-clear.

Sixteen years after Fenchurch opened its doors, however, nascent hedge funds have many more technology options at their fingertips. TowerGroup's study, which highlights the growing popularity of hedge funds and the technology used to support them, says those options range from the less popular model of self development to outsourcing operations with a prime broker or third-party administrator.

Griffin says the in-house model is a difficult road to travel, especially in today's environment of rapidly evolving technology. "I would probably look to outsource most of the (operations) because technology is constantly changing," he says. "My impression is that the wave is (for the hedge fund) to manage the portfolio and outsource most of the technology."

The most poplar model employed by hedge funds today is to work with a prime broker for technology and lending needs. Because hedge funds have a tendency to leverage their cash-on-hand for greater returns, they have significant borrowing needs which prime brokers can fulfill. Often, that means prime brokers offer free accounting and other back-office services, generating their revenues primarily from loans.

To keep hedge-fund clients close to those lending services, prime brokers have developed significant technological capabilities. According to TowerGroup's report, Morgan Stanley, Bear Stearns and Goldman Sachs account for 70 percent of the prime-brokerage market, servicing much of the hedge-fund community. Goldman, for example, uses Advent's Geneva system for portfolio accounting.

Rick Eng, product manager for Geneva, says that with a price tag over $1 million, Advent's product speaks well to large hedge funds with at least $500 million under management and prime brokers who serve multiple hedge-fund clients.

The usual outsourced model, says Eng, sees hedge funds notifying their prime broker of trading activity from an in-house trade-order management system (Eze Castle, for example) through an upload or interface. "In Goldman's case they have a standard format that feeds Geneva," he says.

Though Geneva has reporting capabilities, Eng adds, many hedge funds that desire advanced-reporting capability tend to build a data warehouse (from an Oracle or Sybase database) where incoming data from Geneva is molded into sophisticated reports using, for example, Crystal report-writing programs.

Deciding whether to outsource to a prime broker or take a system like Geneva in-house has a lot to do with the hedge fund's size and resources. A larger hedge fund, which usually works with multiple prime brokers, may choose to retain its portfolio accounting in-house for a complete picture of its holdings.

Another popular method used to support hedge-fund operations is working with a third-party administrator like Bisys, which uses SunGard's InvestOne system for fund accounting and Advent's Partner system to calculate tax allocations. In total, Bisys can provide hedge funds with financial administration, investor record keeping and investor-accounting services.

Nimish Bhatt, senior vice president with Bisys, says hedge-fund portfolio managers usually FTP (file-transfer protocol) trades to his company which are then automatically fed into SunGard's InvestOne system. Bhatt says Bisys can work with funds at all levels of technological sophistication. "We can accept trade information through the Internet or by fax," he says.

There is an important distinction between outsourcing to a prime broker as opposed to a third-party administrator. Namely, prime brokers do not hold investor records and thus do not have fiduciary responsibility to those shareholders, while third-party administrators do hold such records and, therefore, assume the added responsibility. Some say that means individuals are more comfortable investing in funds which use third-party administrators, feeling they provide an extra level of assurance that the usually-secretive hedge fund is staying true to its prospectus.

An additional level of comfort might be added by investing in hedge funds listed on a Web site like HedgeWorld.com, which promises to perform due diligence on all the funds it lists. HedgeWorld, however, says the final responsibility for diligence is still with the buyer, "Ultimately, the subscription is between the hedge fund and the investor," says Johann Wong, president and founder of HedgeWorld.

As the popularity of hedge funds grows, industry insiders wonder when the curiosity of the Securities and Exchange Commission will be roused, prompting greater examination of hedge-fund practices and, possibly, greater regulation.

In a speech made earlier this year, Paul Roye, director of the Division of Investment Management with the SEC, describes hedge funds as "the new craze in the pension plan world." Roye emphasizes that hedge funds are secretive and therefore risky investment vehicles. "Managers can change investment strategies and their investors would never know," he warns.

Hedge-fund managers, however, feel they need that element of secrecy to operate effectively. Griffin, who now runs Spectrum Synergetic Systems, a hedge-fund technology consultancy, says his managers at Fenchurch were the same way. "Our managers were extremely secretive," he says. "They were concerned that if the markets knew our positions that would work against them, especially if (the positions were) highly leveraged."

For those firms looking to get into the hedge fund business, TowerGroup's Hegarty, author of its recent hedge-fund report, suggests taking a look into the marketplace before building anything in-house. "The exciting thing is the opportunity that new technologies are presenting," he says. "There is a ton of technology out there that hedge funds need to look at and understand."