Trading Gets Exotic

As the search for higher returns and diversification has sparked a surge in alternative investments, firms are working to establish a technology infrastructure capable of managing an acceptable balance between risk and reward.

Why It's Important: Introducing alternative investments has become a priority for many institutional investors and investment managers. But, for investors rooted in a long-only tradition, that requires a change in skill set and mind-set, and the deployment of technology that can trade exotic products, measure risk, value the portfolio and settle the instruments.

Where the Industry Is Now: Much of the industry is at least testing the alternative investment waters. The average U.S. pension fund allocation, for example, now is approximately 63 percent equities, 27 percent fixed income, 5 percent real estate, 3 percent private equity and 2 percent hedge funds, according to TowerGroup.

With their potential as risk mitigation tools, derivatives, in particular, are experiencing explosive growth -- according to the International Swaps and Derivatives Association (ISDA), the notional amount outstanding across all product types was $218.7 trillion as of June 2005, up 26 percent from the previous year. However, the current backlog of credit derivative confirmations has highlighted the difficulties firms face in processing these transactions and the operational risk that ensues.

Focus in 2006: Having made commitments to regulators in September to tackle the credit derivatives processing problem, the industry will have to make good on its promises in 2006. Automation will be key, whether through greater use of electronic trading platforms or of the DTCC's Deriv/SERV matching and confirmation service.

In the hedge fund space, regulatory changes mean managers must register with the SEC as investment advisers by Feb. 1, 2006, after which they will need to have basic compliance controls in place and improve disclosures to investors. And after the generally lackluster performance of the hedge fund industry in 2005, the focus in the coming year will be on more-aggressive risk management and cost control, and deploying the technology to help achieve that.

Industry Leaders: Among plan sponsors, the California Public Employees' Retirement System (CalPERS) has long adopted a diversified asset allocation strategy, which currently targets 8 percent in real estate and 6 percent in alternative investments. Meanwhile, the Ontario Teachers' Pension Plan is one of the most innovative plan sponsors -- it actively manages more than half of its assets, which, alongside equities and fixed income, are invested in hedge funds, real estate, commodities, and infrastructure and timber.

As for investment managers, UBS, Goldman Sachs and JPMorgan each have a strong presence in the alternatives space. Meanwhile, Barclays Global Investors and State Street Global Advisors, traditionally big index players, have seen success in shifting to alternative portfolio offerings and hedge fund strategies.

Technology Providers: Alternatives remain primarily a proprietary/build world. However, Advent's Geneva accounting system has seen traction in the hedge fund arena (15 of the 25 largest global hedge funds, seven of the top 10 prime brokers and six of the top 10 fund administrators use its products, according to Advent's Web site). SunGard's Reech, which provides pricing, OTC derivatives portfolio valuation and risk management, is targeting the tricky derivatives valuation space.

New entrants in the credit derivatives area include trading platforms MarketAxess and Thomson TradeWeb CDS -- which list all the leading dealers as clients, including Lehman Brothers, Merrill Lynch and Morgan Stanley -- and T-Zero, which provides its affirmation tool to Goldman Sachs and JPMorgan.

The Price Tag: The investment required varies widely depending on a firm's existing infrastructure, but the cost for the requisite software, whether an order management or portfolio accounting system, typically is six or seven figures. <<<