As hedge funds’ business functions grow in complexity, more managers are turning to technology in order to execute a growing number of tasks.
New research conducted for this report highlights the extent of automation across hedge funds’ back- and middle-office business operations, with hedge funds across strategy sizes increasingly tapping into technology to handle the core components of a trade, predominantly at the allocation, risk, and reconciliation stages.
Leading the way are those firms managing assets of $1 billion or more, who are adopting automation more extensively than those with AuMs of under $1 billion, Hedgeweek data shows (see Fig. 1.1). A majority – 57% – of $1 billion+ hedge funds surveyed have now fully automated their trade allocation functions, with the same percentage having also fully automated their trade limits/restrictions functions. Research shows that 44% of $1 billion+ funds have fully automated reconciliation, and 43% have also fully automated their risk attribution and trade monitoring processes.
While automation is less comprehensive among smaller and mid-sized hedge funds, many managers in this space are nevertheless already on the journey towards increasing implementation. Specifically, close to 60% of $250-999 million hedge funds, and almost a third of managers with $250 million or less, have now fully automated their trade matching functions. On trade allocation, one-third of hedge funds with $250-300 million managers have fully automated, while the same can be said for 39% of managers with under $250 million in assets.
In contrast, managers appear to be less keen to automate more sensitive processes surrounding cash payments and margin, as well as compliance and mandate disclosures, with automation markedly less widespread in such functions.
So what are the main drivers of this tech advance within the industry’s engine rooms? Hedge fund COOs on the frontline observe how part of the push stems from a growing need for efficiency in this era of lower fees, with technology seen as key to helping to reduce time and resources across a range of business functions, while also allowing under-the-hood operations to completed more safely and securely.
“There are certainly upfront costs, and it can take time to implement – but once it’s up and running, those costs are hugely outweighed by the benefits,” says Chris Scarlata, COO and CFO, New Holland Capital, adding that automation affords COOs a “considerable comfort level” and a “long-term plus for the budget.”
Nicholas Pepe, managing partner and chief operating officer at Mill Hill Capital, says the prevalence of compressed fees in the asset management industry means it is now critical for managers to run the most efficient businesses across the board, in order to strengthen competitiveness on fees, and help drive better net returns.
“We definitely have a big focus on streamlining, and that’s getting easier and easier to do with the advent of new technology,” Pepe tells Hedgeweek. “We recently underwent a fairly comprehensive process, revamping a lot of our operations and ensuring a lot of our trades were processed straight through, and we see that the time, effort, and potential for mistakes is minimised by utilising the enhanced technology.
Overhaul
Overall, 50% of all hedge funds surveyed by Hedgeweek say long-term cost savings are one of the top three reasons to automate. But even more point to the ability to complete tasks in a safe and secure way (58%) and ensure tasks are executed quickly and efficiently (78%).
Delving deeper, while saving money over the long term is proving a major factor for the switch to automation among larger managers, smaller and mid-sized firms ability to better execute tasks quickly, efficiently and more safely appears to be just as important for smaller and mid-sized managers.
Asked about the top three motivations behind their decision to automate, the ability to compete tasks quickly and efficiently was the most common reason among smaller ($<250 million) and medium-sized ($250-999 million) managers, followed by completing tasks in a more safe and secure way, and long-term cost-saving. Meanwhile, for bigger hedge funds with assets of more than $1 billion, completing tasks in a safe and secure way, and saving money over the long-term, appears to be the bigger driver.
Hedge fund ops professionals note how certain reporting processes that previously took almost a full day are being cut down to around half an hour as a result of automation.
Scarlata – who oversees New Holland’s operational due diligence when investigating potential investments in the hedge fund space, focusing on non-investment capabilities and structures – points to one hedge fund COO who overhauled their firm’s reporting process using data warehouses. The move allowed the firm to significantly cut down on time and resources to produce reports while also mitigating manual errors.
“Reporting has become an increasingly large burden for COOs, and this COO had the tools and the people around him understanding it,” Scarlata says. “So even though he may not have known how to spin up a SQL database or architect the data structure that was going to serve the firm, he knew enough to ask the right questions and best coordinate between all the groups – the compliance people, the investment side, the investors – to determine the output needed from creating the data warehouse.”
Nicholas Pepe meanwhile says the effort going into booking, settling and reconciling cash differences at the trade level has improved as a result of tech implementation, with a marked shift in trade processing and settlement and reconciliation process over the past four of five years. “We have built a really healthy tech infrastructure here,” Pepe says of the firm’s automation experience.
Pivot
Industry professionals also note how the move towards automated systems helps ease the key person risks that hedge funds faced in the past. “If you suddenly lose, for example, an ops person, or an accounting person, if the process is already automated then other people can more easily step in their place,” explains Scarlata. “There is lower risk arising from individuals leaving the firm; with automation, you don’t have to worry about redundancy and replacements as much as you did in the past when it was just all manual.”
The sustained push for automation, particularly among bigger hedge fund players, may also be explained by the fact that many larger and more established managers built their infrastructure in their formative years and are now playing catch-up with regards to tech and systems. “They built their infrastructure in the old world and they had to pivot and shift. In some ways, the lift was a much bigger tax on those organisations,” Scarlata says.
So is the increased use of technology helping to level the playing field – at least at the operations level – between resource-rich hedge fund behemoths and smaller boutique managers with tighter budgets?
“Over the last few years, we have been doing a lot more with emerging managers, and we have seen that in some ways it’s a lot easier for them to launch, because there is a lot more off-the-shelf technology, and they are able to bring in a COO that can manage all the different facets of getting them up and running, but also outsource selectively,” says Scarlata.
He adds: “It’s a logical way to get up and running much quicker, allowing them to focus internally on their trading, reporting, and their data warehouses, and utilise certain middle- and back-office services that have become more commoditised. “Every COO will tell us that the investment in technology is worth it; that the pain they often go through figuring it out is definitely a tax on the organisation, and it takes some time and investment. But once it’s done, the shop can scale in ways that it couldn’t before.”
Pepe says: “Previously, what was possible for the much larger asset managers compared to smaller ones was a much bigger divide. Now, though, if you’re willing to spend the money, you can basically get almost anything you want, which is a major difference from the past.”
Detail
Turning to the potential challenges or hurdles confronting COOs looking to streamline their operations, industry experts acknowledge there is ultimately no ‘one-size-fits-all’ approach to automation, noting some strategies and models are less adaptable to automation or outsourcing than others. Specifically, certain hedge fund firms may have a more vanilla operational infrastructure, trading a small number of mid-to-large cap equities long and short, for instance, this means that control functions can easily be embedded and automated. In contrast, more complex strategies involving trading many different types of OTC products may be less readily adaptable to tech-led processes.
Indeed, Hedgeweek’s research found that around one in four managers believe a major reason for not automating is that they have automated as much as they currently need to as a business.
“You could have 30 different hedge fund firms and not one of them will be the same in terms of infrastructure, in terms of risks, in terms of focus, in terms of what the COO is doing on a daily basis. That is one of the major challenges,” says Phillip Chapple, COO, Monterone Partners.
Chapple notes how COOs ultimately look to improve control and develop an infrastructure where risk is reduced and ensure processes and functions run and easily and smoothly as possible. On the flipside, however, there is always a risk of unforeseen consequences. “When you’re looking at these processes you’re really trying to determine if there is a net gain.
There’s no point in putting something in place for the sake of it, and it ends up actually reducing control,” he explains. “As you grow as a firm, you will potentially add different pieces of technology as you find different providers with different products. How do they talk to each other? How do you reconcile between these different systems? They are all moving at different paces, and they all do slightly different things. Where these systems don’t work is where they actually create more work than they are worth, or they’re not properly wired in.
“You can’t afford to spend money or implement things that don’t work, but until it’s up and running, and really working, there is always an element of not knowing whether something will be effective.”
