When it comes to hedge fund risk management, catastrophe usually springs to mind as the memory of the Long Term Capital Management fiasco is slow to fade. But these days hedge funds are garnering attention as the latest target for risk management tools and services. And what better way to offer risk than as an ASP through the hedge funds' prime broker? Morgan Stanley is doing just that-taking the next step in providing risk management services to its prime brokerage hedge fund clients. The surge in risk interest at hedge funds may be related to the stagnating economy, regulatory changes and, of course, the growing trend toward quality risk management as a distinguishing factor.
But yet another reason risk management is picking up speed at hedge funds is an overall increase in the number of firms coming to market. "The number of hedge funds out there is obviously increasing and a lot of people joining these funds in management positions and actual asset management positions have come from fairly large institutions that have had pretty good size IT budgets. So they've had some very sophisticated tools at their disposal in their prior lives and they've gotten used to that," says Peter Keppler, senior research analyst in the risk management service at Meridien Research. He adds that when joining smaller, more boutique-like hedge funds, asset managers and those above them in upper management positions are looking for ways to get similar sophisticated risk management tools but without the hefty cost and time-consuming technology implementations.
One offering that aims to meet the needs of hedge funds without the expense and the time is Morgan Stanley's AlgoLink. Building upon its ongoing relationship with Algorithmics, Morgan Stanley, which also owns a part of the risk vendor, is further enhancing the functionality of its AlgoLink risk management services and extending them out to hedge fund clients as an ASP solution. The new ASP version of its current AlgoLink risk services-AlgoLink Interactive-is in development and should be ready for client use early next year, says Stuart Bohart, executive director responsible for risk management in prime brokerage and stock loan at Morgan Stanley.
The AlgoLink risk service available is a service bureau-type of offering where users give their position data to Morgan Stanley to be aggregated and risk assessed. Reports are then submitted back to the client. AlgoLink provides Morgan Stanley Prime Brokerage hedge fund clients with risk exposures by industry, sector and index as well as Value at Risk (VaR) reports and stress testing capabilities, using historical and discrete scenarios. Morgan Stanley Portfolio Accounting (MSPA) software clients can use the AlgoLink services for positions held with Morgan Stanley or other prime brokers. While these reports and risk services are important and convenient for Morgan Stanley's hedge funds clients, there is still a concern about confidentiality from many. "Clients are concerned about showing any one group or any one person all of their positions," says Bohart. Morgan Stanley's solution to this problem? Give the clients control over their data aggregation across multiple prime brokerages at the site with the ability to run risk analysis as they see fit.
TAKING ALGOLINK A STEP FURTHER
AlgoLink Interactive will enable users to aggregate positions at their site-away from Morgan Stanley. With data aggregation at the client site, the users can then access the AlgoLink engine with their own file data for customized analysis. Users will be able to define and maintain their own stress test libraries and customize the content and format of their risk reports. "Clients would have to use a specific file format and download it into software, but nothing will be installed at the client site," explains Bohart. He adds that AlgoLink Interactive will be user friendly with pull down menus.
Key to the success and client adoption of AlgoLink Interactive is the client's ability to control the aggregation of their position data from multiple custodians and to add and adjust positions and scenarios on an intra-day basis. "During the course of the day users can add a put position into their portfolio and send it in and get results back saying 'if I had that put position, here is the impact on all of my stress tests and my risk profile,'" notes Bohart.
AlgoLink Interactive will also allow users to control their own stress tests. "For example, a client that has a lot of exposure to options may want to have stress tests based solely on levels of implied volatility," says Bohart. "So they could design a stress test specifically for that and they could get the results of the custom stress tests every day."
The custom reports available through AlgoLink Interactive are also new to the AlgoLink offering. "This will allow users to control the look and feel of their reports," says Bohart. Additionally, users will be able to create reports for investors with various levels of transparency. "Reports may not have CUSIP level data for example and just show gross exposures by industry or by liquidity," says Bohart. "The report may show the biggest positions but without identifying the exact position. So the hedge fund can now satisfy the investor demand for transparency without showing their whole hand."
WHAT MAKES HEDGE FUNDS DIFFERENT IN TERMS OF RISK?
Hedge funds have unique risk management needs, says Bohart, which makes them ideal candidates for this type of ASP service. "They trade instruments that are far more complex. They trade many non linear instruments both long and short," he points out. "It's a matter of developing the skill set to deal with the complexities of the portfolios." In addition, Bohart says hedge funds are looking for risk management in areas outside some of the traditional risk management tools such as short exposure and leverage in portfolios. "Those aren't as complex an issue, but they're something that Morgan Stanley has embraced and dealt with from the beginning," he says.
Bohart explains the expense of installing a system on site and the daunting task of gathering data also make an ASP solution such as AlgoLink Interactive an attractive solution for risk management. "We can assemble all of the data, we can assemble all of the analytics so it's just a matter of the client coming in with the secure file positions and using the capabilities to get the results back," says Bohart. "Even the largest hedge funds generally don't have the data feeds that would enable them to do these kinds of calculations."
Meridien's Keppler agrees that risk ASPs are a good fit for hedge fund clients, "because they've got either the custodian or the broker and they have so much of the data already." He sees this as an ongoing trend that broker/dealers and custodians will be offering risk services out to their clients. In the custodian case he points out, "it's very competitive and if there is an added service offered such as risk analytics on top of whatever other traditional services that have been there, they essentially have one more leg up." In time though, Keppler envisions even these types of risk ASP offerings becoming more commoditized as a standard. While the market place is not there yet, "eventually it's almost like they're going to have to offer these types of things," he says.
"Hedge funds are essentially just another class of asset management and asset management in general has only recently started to adopt these sort of sell-side risk-management tools," says Keppler. "They are looking for additional ways to distinguish themselves, to differentiate themselves from the competition." He adds that while asset managers have traditionally competed on the return side or the income side of the spectrum in gaining market share, they are now starting to add risk management as a competitive advantage, pointing out that comparable returns can be achieved, but with variable risk coverage. "If they can illustrate earning the same return consistently and with a recognizably smaller level of risk, that's what they're looking for."
The beta version of AlgoLink Interactive will be launched to a select number of clients in the first quarter of next year, says Bohart. In terms of the pricing structure, Morgan Stanley will be charging their Prime Brokerage hedge fund clients a licensing fee, which will be paid to Algorithmics for use of AlgoLink Interactive. Bohart adds that Morgan Stanley is ultimately looking to "assist our clients and our client's clients with understanding risk and reward in the hedge fund marketplace."