Despite the boom in third party service provision, hedge funds’ ops infrastructure remains a mix of outsourced, cloud- and in-house processes, as COOs are keen to maintain oversight over key business functions.
The expansion in the range and quality of outsourced business functions and third-party service providers has shaken up the way the hedge fund industry assembles its operational infrastructure. The lockdowns and remote working models brought about by the Covid-19 pandemic accelerated the already-gathering momentum of outsourcing, underpinned by a growing ‘digital-first’ approach built around looser constellations of trading and operations networks with technology and automation at their core.
Yet survey data gathered by Hedgeweek suggests most hedge funds remain keen to maintain a balance between the creative ‘ideas factories’ of physical trading floors and the benefits of off-site remote technology and outsourced services.
Nimble
Outsourcing has come into particularly sharp focus within the start-up and emerging hedge fund manager sphere in recent times, with the sustained ramp-up in the volume and quality of service providers coming against a backdrop tightening budgets. Industry professionals observe how the expansion of affordable third-party offerings for a range of middle- and back-office processes has proven a particularly important enabler for many hedge funds, mainly at the smaller end of the scale, allowing them to outsource key functions and avoid the often-considerable upfront tech spend on certain processes, at a time when the barriers to entry within the industry have never been higher.
“What’s interesting about the hedge fund world is that there are now so many third-party providers that have commoditised certain things,” Chris Scarlata, COO and CFO, New Holland Capital, says. “If you now want to get an off the-shelf reconciliation tool that can handle all trades, all cash, these sorts of things, you don’t have to build that, you don’t have to hire three in-house people to do that anymore. You can get it off the shelf for a lot of strategies.”
Andrew Beer, managing member and co-portfolio manager at Dynamic Beta Investments, says the service provider space has seen strong growth and development since the late 2010s, which has transformed automation and outsourcing for hedge funds, and ripened business opportunities for third party firms.
“The outsourced CFO, the outsourced COO, and outsourced compliance generally is so much better than it had been 10 years ago,” Beer observes. “Each of these little areas and functions have these dynamic industries, where smart people are going in and starting new businesses, taking market share, and becoming more responsive, more nimble and pricing things in a more economic way.”
Balance
Overall, smaller- and medium-sized hedge fund firms generally run a mix of outsourced, cloud-based and in-house ops functions. In contrast, larger managers running more than $1 billion in assets mainly keep a primarily traditional or stack-based infrastructure (see Fig. 4.1). Among emerging hedge funds specifically, more than one-third of managers’ operations infrastructures are now predominantly cloud-based, with about 20% having a primarily outsourced ops infrastructure (see Fig. 4.2). In the perennially-tricky launch phase, some boutique hedge funds have gone even further, contracting out most or all of the operations functions to an outsourced COO – usually also involving a high degree of automation – so that managers can focus on managing the portfolio and growing the business.
“Service providers offer you an evolutionary path along which to start out, using them initially and then shifting as AuM and profitability allows,” says Scott Radke, CEO of New Holland Capital. “Eventually, as those managers grow, they tend to become dissatisfied with the one-size-fits-all third-party service providers, and they end up bringing it in-house.”
“People are your biggest expense when you are starting up a hedge fund – you’re trying to keep it at a break-even level to give yourself the best chance of success,” says Phillip Chapple, COO of Monterone Partners. “There are a lot of very good outsourced COOs, but even they typically expect firms to move to a full-time COO once the external money beyond friends and family starts to flow in.”
Stringent
So as hedge funds continue to grapple with a battery of challenges spanning cost squeezes, business risk, fee pressures and patchy returns, the question of how far managers should go in outsourcing of ops functions, while also maintaining oversight of potential risks, continues to divide industry opinion. While firms may outsource accounting, or certain compliance functions, for instance, some industry specialists sound a note of caution on a fully-outsourced ops system, and underline the importance of COOs serving as an ever-present ‘big picture’ check on everything.
Supporting this perspective, Hedgeweek survey data reveals that across the entire hedge fund AuM spectrum, only 14% of managers have a primarily outsourced operational infrastructure, while one-third have a primarily cloud-based set-up. By comparison, 25% of all managers have mix of cloud-based, outsourced and stack-based infrastructure, with an additional one-in-four firms having a traditional in-house set-up.
“If somebody needs to do a reconciliation, or someone needs to strike a NAV, or somebody needs to test a compliance programme – the more administrative, block-and-tackle, daily things – these things you can outsource. But you absolutely cannot outsource a senior level, non-investment person who we rely on to be independent within the firm that we are investing in,” says Chris Scarlata.
Expanding on this point, he says: “They need to be there every day; they need to be interacting with the team members. They need to know what’s going on in the trading systems, and know the needs of the firm.” Andrew Beer says: “Certain things we continue to do in-house, such as on the trading side, though our trading is fairly automated so it’s not as taxing as if you’re, for example, a merger arbitrage strategy.
“Following a year-long process of identifying areas, we materially reduced the number of people we had in-house. We outsourced our finance function, we didn’t have a CFO anymore. We got an outsourced chief compliance officer. “The conclusion was that, in general, outsourcing had become so much better that we didn’t need a lot of people in-house. Instead of having a jack-of-all-trades, what we really needed was a jack who would manage all trades. There has been a profound improvement in how we run on a day-to-day basis.”
He continues: “Part of the reason for doing it in-house was that you always had more control. If my chief compliance officer is inhouse, I can walk over to them and we can have a conversation about something. It’s very different than when you’re dealing with someone in the outside. From my perspective, there was always a question when you’re dealing with outsourcing over whether you can get enough of their time, whether they are responsive.
“But on the other hand, these service providers are all competing with each other to try to have the most knowledge about best-in-class practices, and to update their technology and infrastructure and reporting and all these things to make themselves even better. So we feel we’ve been a real beneficiary.”
