Searching for alpha
As conventional managers continue to enter the alternatives space, servicing new product lines provides difficult operational challenges for fund managers, according to Sylvain Privat (pictured), Senior Product Manager, Misys…
“When it comes to servicing alternatives products, the requirements for increased transparency, better risk management and regulatory compliance add an unwanted administrative burden for investment management companies,” says Sylvain Privat, Senior Product Manager, of Misys. “Combine that with an asset mix that typically includes OTC and listed derivatives, equities, FX and fixed income across the wider business and the challenge becomes even more complex to tackle.”
Ever since the financial crisis asset managers have faced a perfect storm of low returns from conventional product lines, more demanding investors who require a wider range of services and greater transparency, and a slew of regulatory reform with which to comply.
As clients, such as insurers, face wide scale re-risking based on regulations like Solvency II, they are demanding new types of products from their providers. These must cater specifically to the changing balance sheeting and asset allocation requirements that the reforms have created.
“The changing rules regarding capital requirements will lead to a reshuffling of asset allocation. There are opportunities for some smart strategies to meet the new demands with innovative products. However, stronger governance requirements might deter small and medium insurers to consider alternative investments. Therefore, investment companies will have to enrich their offer with the right services and level of transparency to enable insurers to implement efficient supervision and optimize their solvency capital requirement (SCR),” says Privat.
Further drivers for change are provided longer-term structural changes in the industry, such as the shift in focus away from assets and towards liabilities among pension plans. This has driven the rapid expansion of liability-driven investment (LDI) and the growing popularity of target date funds.
This provides a further spur for managers to move beyond their traditional product lines. “Many asset managers are looking for greater returns for these investments because of the increased challenge of meeting their liabilities,” says Privat.
As a result of these factors institutional investors have led a shift into alternative investments, such as hedge funds, that have reached record levels. Asset managers are responding by increasing their ranges in this space, further incentivized by the significantly higher margins available from alternative products. Other asset owners, such as insurers, with investment management arms in-house are developing their own solutions.
But the new products impose considerable operational demands on fund managers. While managers typically focus on how to repackage their investment skills into the construction of new funds, the operational challenges can be a source of both cost and performance drag.
The Sophis VALUE system was designed to provide a fully integrated cross-asset solution for the complete trading life cycle from portfolio management to middle- and back-office operations, to risk management. But it has proved especially popular with managers introducing innovative cross-asset strategies into their portfolio. Particularly valuable to managers is the support provided with the difficult pricing and risk management challenges that emerge from this shift.
For Ville Helske of Ilmarinen Mutual Pension Insurance Company, the preferred choice was to build an alternatives product internally, rather than go to an external manager. He tells Hedgeweek about the decision to select the Sophis VALUE solution from Misys and the benefits it provided…
HW: Can you describe the process by which you chose to create an alpha fund internally?
Ville: When I joined Ilmarinen in 2003, many of our peers were increasing their allocation into HFs. But our management was worried about the lack of liquidity and transparency and the costs associated with high fees.
So we considered implementing some of these strategies internally. When it came to liquidity, certainly the instruments that we would hold on our books might not be 100% liquid every day. But we could avoid the long lock-ups that were common among external funds – typically six months or a year back then, for most of the funds that the manager had invested. This meant that we could not respond quickly if the market turned significantly worse or if favoured people in a fund left.
The lack of transparency was even more concerning. It was almost impossible for investors back then to get access to the books of the hedge funds into which they invested, so you really did not know what you were buying. At best, you could see what the fund was holding three months previously, but it may have changed its holdings completely since then.
When it came to the cost, the amount that we saved on external management and performance fees, which added up to a significant sum of money, could go a long way internally investing in people and systems.
HW: Can you describe the strategy and explain how many people you employ to run the fund?
We have greater flexibility when it comes to investment strategy, which is a combination of macro and relative value. Over the last two years our asset mix has been relatively evenly spread between fixed income, FX and equities, although we have some strategies in commodity markets. We’ve hired fairly constantly over the last eight years and now have ten portfolio managers, as well as a number of risk managers and back-office staff. We share the back-office with the traditional long only fund, but in all our risk and middle-office numbers ten and the back-office and bookkeeping staff another 15 to 20.
HW: When you decided to develop the fund, how were you thinking about servicing it?
When we started developing the fund in 2003, we already had an external system provider. They were strong in the plain vanilla equity and FX instruments but, as the fund expanded and the range of positions grew, it became clear that we needed a system that was more responsive across the other asset classes so that we could get full coverage.
HW: How did you formulate your requirements of the technology solution?
There were four main pieces of functionality that we were looking for. One of the key requirements was that the system should be able to integrate with our existing middle- and back-office infrastructure.
We also wanted the system to be able to price and value all instruments, including the more exotic ones. We discovered that even with a relatively mainstream product like a correlation swap, there were actually relatively few providers who could provide proper pricing and risk analytics. Finally, it was important to us at this time that we could use the system when we were outside the office.
We sought references from existing users of Sophis VALUE – there were several firms we knew who were already using the system – and we spent a lot of time talking through the pros and cons with them. It became clear quite soon that this was the right solution for us. In particular it showed particular flexibility when it came to accommodating new instruments.
HW: In what area have you found Sophis VALUE to be most useful?
Perhaps the main benefit has been the ability to see aggregated data for all positions in the one system. This makes it easier to see the overall risk profile of the fund. I’m able to see how the risk combines across the several portfolio funds, which means that I can spot where the risk is concentrated.
I think there’s a tendency when managers communicate so much with each other that risk does concentrate in certain areas. With the visibility that I get with Sophis VALUE, I’m able to tell the manager to take off risk, or to hedge it myself. The point is that I have the option in a way I didn’t before. With this broader view, I get a clearer view of the exposure of the portfolio to movements in, for example, interest rate curves, that was hard to spot before.
HW: What specific benefits have you noticed in the areas of operational efficiency?
When it comes to operational efficiency we’ve definitely seen the benefits in terms of integration with the middle- and back-office. We’re able to feed data straight into Sophis VALUE from our order management systems; this takes away the manual element, which reduces our costs as well as cutting out part of the process that exposes us to the risks created by human error. Precisely what our cost savings have been is hard to measure. Certainly, we’ve made savings by being able to combine roles, meaning that we have been able to avoid hiring a couple of times. When it comes to errors, many times an error doesn’t lead to a significant cost but there is always the risk that it might.
The transparency benefits have been very valuable. We don’t have an external mandate, so there are no investors to report to per se, but it makes it much easier for me to provide information for my manager and the risk management department. Here it is simple for me to print a report from the system and send it out to them. Then there are the regulatory reporting benefits, which Sophis VALUE is providing. We plan to use the Sophis VALUE system for reporting of short positions required by EMIR and also for compliance with the rules around naked CDS positions. Certainly we wouldn’t be able to report in these areas without Sophis VALUE.
Sophis VALUE will also be a big help as central clearing rules come into place under EMIR in Europe and, from the US, Dodd-Frank. For futures and shares traded through electronic venues this type of reporting has been normal practice for many years but we must now move towards the compulsory regulatory reporting around credit default swaps and interest rate swaps (IRS). In time, there will be reporting requirements around electronic trading of these products, too, where we will have to provide information on the timing requirements on confirmations. Trade confirmation of IRS is already a big benefit that we get from Sophis VALUE.
HW: You’ve opted to roll out Sophis VALUE beyond the alpha fund. Can you tell me how far along you are and what benefits you expect?
The rollout of the Sophis VALUE product into our long-only fixed income portfolio is now complete. The next step is to extend it to our equity portfolio and, simultaneously, into different parts of our risk management department.
Part of this is driven by regulatory requirements, but we’re also looking for the more detailed risk management data that it will provide, including Value at Risk (VaR) calculations. We’ll also get the same benefit of the broad risk view of the entire portfolio, in the same way that, working with the alpha product I’m able to view the aggregated risk data.
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