Clear objectives critical in paving the way for startup hedge funds

By A Paris – “A lack of clarity could put the brakes on any journey to success” – these words, uttered by behavioural scientist Steve Maraboli, offer concise advice for any aspiring hedge fund manager. Although the road to success is far from straightforward, startup hedge funds need to have clear objectives and a definite, coherent understanding of who they are as investors and more importantly, who they want to be.

The academic paper entitled, Dollars versus Sense: Investor Demand, Managerial Skill, and Hedge Fund Startups, argues that new hedge funds which are skill driven, rather than created on the back of investor demand deliver better performance. The paper finds skill-driven inceptions outperform demand-driven ones by 4–5 per cent per year in terms of risk-adjusted return.

A key aspect of emerging hedge funds which was not included in this study is the vital role played by infrastructure, technology and third party partners in a startup’s journey to success. 

All investment managers have numerous priorities to juggle at any one time – from compliance with regulation, to keeping up to date with new technologies and ensuring their investors a smooth experience, from an operational perspective. These all chip away at the time they have to perform their title role of managing money.

Striking a balance

Industry experts say startup hedge fund managers need to understand how they’re going to allocate their time. There are so many hours in the day and for a new launch, figuring out how they’re going to allocate their time between raising money, running the portfolio and running the operations is a tricky one to balance. The ideal situation for them is one where they’ve picked providers who can help them do this effectively.

Picking the right providers to assist is crucial. Bob Shaw, VP of Technical Architecture at Eze Castle Integration notes: “As a hedge fund startup, you need to choose the right managed service providers to work with; someone who knows your industry. A firm outside the industry could get you up and running but they may omit critical security layers required by regulators and investors which could increase the probability of an outage or security event where data is lost or stolen.”

“Most funds would agree that their experience with a fund administrator primarily comes down to client service, accurate and timely delivery of services and cost,” says Jorge Hendrickson, SVP Head of Sales and Marketing at Opus Fund Services. “Automation and Straight-through-processing (“STP”) are what allows, or prevents, these from happening.”

Appointing third party partners harks back to the importance of having clarity. Although at the outset a startup hedge fund may not need much in terms of technology infrastructure, or fund servicing and administration requirements, this will change. As the fund gathers assets, its needs are bound to become much more complex and that complexity needs to be accounted for at inception.

A matter of scale

“In terms of technology, startup managers want to be able to partner with a vendor able to scale with their business. Their partners need to deliver what they need now and continue to meet those needs as their business changes, over the next five to ten years,” stresses James Baxter, head of institutional sales efforts at SS&C Eze.

Hendrickson, at Opus adds: “Managers are realising that handling fund administration tasks internally no longer makes sense from a time, resource, cost and independence perspective. Their investors are also realising that they prefer to invest with managers who are working with technology driven fund administrators.” 

One of the main components in the ability to scale a hedge fund business is technology. Shaw, at Eze Castle Integration elaborates: “People should decide which way they want to lean in terms of technology – should they start simple but secure with less bells and whistles or something more complex with advanced security features. Clients are often concerned about cost and scalability, but a scalability doesn’t always come with a high cost. While protecting your sensitive data is key, you need to focus on building a secure foundation which can be scaled upon. You can build a technology platform, typically fully managed in the cloud, which is secure with flexibility to grow. To meet this challenge, managers can balance the price against what they need to get done now and what can be done later. All while keeping their company secure.”

Technology overlay

Security should be at the top of an emerging hedge fund’s agenda and advancements in cloud technology are allowing this to be the case. Baxter explains: “The last couple of years have seen a focus on information and cyber security. A big driver of why we’re seeing people looking at cloud technology more is because they are now comfortable with the security that’s been built into it.”

The cloud industry has developed considerably in the past five to 10 years. “Hedge funds wouldn’t have had the access to this tech a few years ago. The cloud industry has evolved. Going back 10 years, the advancements around the technology out there didn’t exist. And it’s only going to get better,” Baxter continues.

When considering cloud technology, Shaw warns that managers originating from larger hedge funds should be wary of trying to replicate the systems at their previous place of employment: “In some cases the legacy items would see managers implementing a convoluted and expensive cloud solution when they may be able to benefit more from a lower cost SaaS based or public cloud alternative. 

Targeted intentions

The potential cost of having service providers who can’t meet a growing fund’s needs could lead to considerable pain at a later date.

No fund wants to change providers in the future, so getting this right is key. Startup managers need to understand where their operational risks lie – the third parties they appoint should have a synchronised relationship.

To hark back to the notion of clarity, hedge fund managers can risk making the mistake of reducing their costs at the outset while failing to fully capture the requirements of their fund. This can leave them to do something most would dread – making changes once they’re established. Most industry commentators agree that big operational changes are the last thing a manager wants to do once a fund is up and running. 

The growth of outsourcing has been driven by the need for money managers to focus on their core strength – that is, their investment expertise. All other aspects of their business can be delegated to professionals in their respective fields.

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