Amid sustained economic upheaval and investment volatility, operations specialists discuss the major trends and themes that are reshaping hedge funds’ business infrastructure.
The unprecedented turmoil brought about by the coronavirus pandemic over the past two years heralded far-reaching changes to hedge funds’ infrastructure and business models, with cyber risk, network security and virtual due diligence emerging as a front-and-centre challenge as firms pivoted to remote working. Now, against a backdrop of ongoing regulatory change and sustained market dislocation, managers of all sizes and strategies remain alert to new, emerging and future operational risks, with many acknowledging the key role played by tech and automation in adapting to an increasingly unpredictable business landscape.
Indeed, some 40% of all hedge fund managers surveyed by Hedgeweek said futureproofing their business is one of the top three drivers behind their decision to automate (see Fig. 3.1). That number rises to 50% among medium-sized hedge funds with between $250-999 million in assets, while one in three of the largest managers with more than $1 billion AuM also see futureproofing as a key automation driver.
Regulation
The current direction of travel among market authorities – reflected in the US Securities and Exchange Commission’s planned new private fund reporting and disclosure requirements, as well as potentially tighter curbs on managers subject to the EU’s AIFMD and MiFID II rules – means regulation now forms an ever-larger part of COOs’ workloads, particularly in balancing evolving operational compliance with day-to-day trade clearing and reconciliation.
“So much of the challenge now is driven by regulation,” Phillip Chapple, chief operating officer, Monterone Partners, observes. “Whenever you go through any kind of industry stress, more regulation tends to follow. Sometimes those proposals disappear, in other cases they don’t – so you end up spending a huge amount of time trying to determine whether it’s something about.”
This lack of clarity from regulatory authorities may also serve to impede active measures to address such challenges through automation or outsourcing, according to ops professionals. Chapple explains: “Once regulation is properly disseminated and understood, you can then build rules around it, and technology can certainly provide a lot of solutions around certain challenges after there is clarity around what the interpretations are, and over longer periods of time.
“But the issue tends to be during that initial phase of a new regulation, where everybody’s trying to work out how it affects them, and what it actually means. At that point, you may not yet have the tech in place to handle it. You can talk to consultants and service providers, and that’s very useful, but ultimately you have to make the call yourself.”
At the same time, many COOs are increasingly have to say ‘no’ to their CIOs and portfolio managers as a result of increasingly complex regulatory and tax restrictions, anecdotal evidence suggests. “Often they are having to say to their PM, ‘Sorry – you can’t trade this due to regulatory restrictions’ or ‘you cannot do this in this way due to tax reasons’,” Chapple notes. “This is something that has really changed from 10 years ago for the ops side – the regulation tail didn’t really wag the dog. It’s now becoming a lot more restrictive, there’s more regulatory complexity. If a PM wants to trade something, there is often a whole quagmire of wiring to get through to see if it’s even possible.”
Cybersecurity
With increased automation, more functions migrating to the cloud, and remote working remaining prevalent in the aftermath of the coronavirus pandemic, cybersecurity continues to be key issue for hedge funds’ operations chiefs, particularly as the SEC and other regulators look to ramp up disclosure requirements and strengthen preventative measures to protect investors.
More than 90% of hedge funds say they intend to move to a multi-cloud model over the next two years, according to recent research by Agio. The 2022 Hedge Fund Managed IT Trends Report – which surveyed technology, cybersecurity, operations, and compliance professionals in the hedge fund industry during Q1 – found that better security for remote users is the main driver of this shift (66%). In addition, improved disaster recovery procedures (52%), and the desire to separate production and development environments (44%) were also key motivating factors for moving to a multi-cloud model.
Market professionals say the desire for even the largest hedge funds and asset managers to move more of their systems into the cloud now makes the oversight of business operations and risks a pressing issue, especially in light of the continued threats of data leaks and cyber-attacks.
“With enhanced technology comes a bigger need for cybersecurity,” observes Nicholas Pepe, chief operating officer, Mill Hill Capital. “While there are efficiencies that have been created by the digital world, it has also brought new risks.”
With hybrid and remote working models remain prevalent even as the worst of the Covid-19 pandemic recedes from view, the importance of utilising technology in tightening up disparate networks and curb business risks is seen as critical.
“Cybersecurity is paramount in making sure that if people are working from remote locations, that doesn’t pose a threat to our business. The other part is making sure we are getting everything we can from our team, and ensuring that remote work allows us to actually improve productivity,” Pepe adds. “For smaller managers it is tougher to be fragmented and working from different places – it’s important that we are all in the office as much as possible. With that said, the new reality is that we have been able to cut down time on travelling; we can meet with investors, service providers and counterparties virtually as often as we need to. The ability to work remotely – even if it is in a sporadic way – has enhanced efficiencies and increased our ability to operate as a full team all the time.”
He adds: “The issue of cybersecurity, and cyber-threats, is something that has evolved much faster than other challenges in the past. It’s a threat we are constantly focused on, and spending more resources on, in order to minimise it. This is one place we have definitely ramped up our spend.”
Alternative data
While much of the focus around hedge funds’ increased use of alternative data has centred on its ability to strengthen investment ideas or trading themes (‘investment alpha’), industry research suggests firms are also beginning to lean into the so-called ‘operational alpha’ opportunities offered by alt-data. A study published by the Alternative Investment Management Association and SS&C (‘Casting the Net’) in 2020 found that hedge funds are using alternative data as a tool to improve certain business development decisions around skills and output and help combat operational risk. More than one-third of all manager respondents surveyed by AIMA & SS&C – and close to a quarter of market leaders – are now using alternative data to help improve risk management and compliance models.
“Regarding alternative data, COOs are increasingly getting involved in ensuring the way data is pulled in and structured is going to end up in as usable output,” says Chris Scarlata, COO, New Holland Capital. “Internally, the COO is getting involved in implementing analytical tools such as Tableau or Power BI and being able to work with a team to make sure that everybody can utilise those tools most efficiently in-house.”
