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Service providers see opportunities as industry grapples with downturn

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The evident risk management failings laid bare by the hedge fund industry’s troubled performance over the past year are opening up a wide range of opportunities for providers of systems and service

The evident risk management failings laid bare by the hedge fund industry’s troubled performance over the past year are opening up a wide range of opportunities for providers of systems and services that enable managers to identify, monitor and manage the risks inherent in their business, according to software firms and other providers of risk tools for which the alternative investment industry is a key market.

While many large firms with billions of dollars in assets under management have long maintained institutional-style structures that include comprehensive risk management departments, tools and procedures, even they are re-examining how well these arrangements performed during a year in which the average hedge fund reported performance losses of around 20 per cent and some did very much worse.

Meanwhile smaller managers that in the past may have largely paid lip service to risk monitoring and management, and that often rely on IT systems cobbled together in-house, are now under pressure from investors to demonstrate that they possess and use effective risk capabilities. At the same time, providers are offering tools that may lack the bells and whistles of top-of-the-line applications but that are tailored to the budgets of hedge fund managers that do not have unlimited resources.

Almost half of all respondents interviewed for an investment management risk survey commissioned by Copenhagen-based research institution SimCorp StrategyLab says they expect to see increased investment in IT platforms and applications that are key to improving risk management – with pressure coming from both investors and industry regulators.

‘Right now huge swathes of the market are recognising that they need some kind of risk management infrastructure, whereas before it was never a concern,’ says Ittai Korin, president of New York-based Portfolio Science, whose RiskAPI product offers a low-cost risk engine for hedge fund managers via the internet. ‘Investors are demanding risk management, and regulators are talking about it.’

Korin believed the future is bright for providers of risk management solutions even though he expects significant contraction in the hedge fund industry over the next six to 18 months. ‘We still see growth because such a small portion of the industry is equipped with effective risk management tools,’ he says.

‘Many of those that are disappearing never had them to begin with. Typically the kind of managers that come to us are early adopters who realised that this was an issue and that they needed a risk management system before the crisis started.’

Investors are examining more closely the capabilities available to managers and the role they play in their investment decision processes, according to Paul Compton, head of product management with SunGard Alternative Investments in London. ‘You can define risk much more widely to include operational integrity and Madoff-type situations,’ he says.

‘There’s no doubt that well in advance of regulators getting their act together, both hedge fund and other fund management businesses are under much more pressure to demonstrate that they have sound operations and that funds are valued using transparent and good methodology – basically that there’s operational strength and transparency behind it.’

In turn, the spotlight is being turned on providers of risk management systems and services to demonstrate that they can deliver upon their promises, Compton acknowledges. ‘Last year has given research teams a wonderful experimental test-bed to put risk vendors such as ourselves under pressure and identify the winners and losers according to people’s ability to stand up to the stresses of 2008 from a risk point of view.

‘People are really wanting to dig into how the numbers are calculated, what are the assumptions, and look at the performance of risk forecasts. You can talk about who has the best methodology, but what matters is empirical performance – comparing forecasts as of December 31 and March 31 with what actually happened in the following quarter. It’s normal for people looking at our product to back-test how it does. We expect to have to justify our performance.’

SunGard offers a range of risk products to different segments of the industry, including Front Arena, a front-to-back trading system that also enables portfolio managers to carry out real-time cross-asset class risk analysis, and RiskHedge, an ASP outsourced risk solution aimed primarily at smaller hedge fund managers as well as administrators that want to offer risk reporting services to hedge fund clients. And last year the group acquired APT, a specialist buy-side risk analytics product with a 20-year track record and a following among managers of hedge funds and funds of funds as well as traditional asset managers and institutional investors.

Compton says the firm is seeing new business flowing both from managers that in the past have tried to carry out risk management using in-house tools and those that have been disappointed by the performance of other third-party vendors. ‘We’re seeing green-field business from fund managers around the world that previously didn’t have a third-party risk vendor in place, but equally managers who have been using products that let them down last year,’ he says. ‘We are aware of a number of people reviewing their existing products.’

In addition, managers are not only devoting a larger share of operational resources to risk management in response to investor and regulatory concerns but considering new approaches that may become desirable or even essential in the future. ‘Firms that have taken risk seriously in the past have tended to focus on first, measuring risk, and secondly, attributing it,’ Compton says. ‘Arguably there needs to be a third pillar of risk management, stress testing.’

This is an area on which SunGard is concentrating product development resources. ‘We’ve just released a version of APT that offers scenario analysis functionality out of the box for the first time, and we’re doing a lot of research on stress-testing methodologies,’ he says. ‘For example, we’re doing research on the way price relationships break down in crises, focusing on the periods immediately following the collapses of Bear Stearns and Lehman. One question is whether a 50 per cent collapse should be treated like a 10 per cent fall, just five times as large, or whether the knock-on effects are qualitatively different.’

A different product philosophy is embodied in Portfolio Science’s RiskAPI, which by virtue of an application programming interface accessible through a standard Excel spreadsheet application allows users to generate customised risk analysis calculations.

Hedge fund clients are generally faced, says Korin, with a choice between an expensive customised installed product and more basic web-based applications that give the user few options in terms of how they use the system or view the results. By contrast, RiskAPI ‘is a hybrid approach that allows outsourcing of a critical solution with an amazing amount of flexibility’, he argues.

With fee income in the doldrums, many managers are getting ‘sticker shock’ at the cost of traditional risk management systems and are daunted by their complexity and installation lead time. ‘We tell them RiskAPI is easy, affordable and offers everything that big institutions are demanding because of the way we’ve structured it,’ he says. ‘Whereas some competitors charge USD50,000 or more a year for one user, our simplest product, the RiskAPI Add-In, starts from USD300 a month for our US equities package. That’s less than many managers would spend on lunch in a city like London.’

Since the launch of RiskAPI in 2001, the scope of the product has expanded from US equities to a broad range of asset classes, and the approach has started to attract other types of client, including investment bank proprietary trading desks but also prime brokers and hedge fund administrators.

The RiskAPI Enterprise product involves a software component that can be dropped into any programming language and enables the software developers used by clients to move beyond the constraints imposed by the Excel environment to offer risk management capabilities for an entire firm. Says Korin: ‘We were approached by service providers such as fund administrators, prime brokers and execution brokers that already provided some sort of reporting to their hedge fund clients but wanted to supplement their reports with risk information.’

Meanwhile, the Madoff case and a slew of subsequent revelations about Ponzi fraudsters masquerading as hedge fund managers have alerted industry members to the value of enhanced due diligence, and of third-party service providers that do not come with the conflicts of interest that may affect in-house staff.

‘Outsourcing is cost-effective and takes advantage of outside expertise – most companies don’t have the international reach required to conduct due diligence globally,’ says Doug Nairne, head of enhanced due diligence operations at risk screening and research firm World-Check. ‘In addition, using a third party also ensures that due diligence is conducted impartially. As a vendor we have no conflict of interest regarding a business transaction. Within a company there may be competing interests between the compliance department and the business unit pushing a deal.’

A few years ago the focus of due diligence was countering money laundering and the financing of terrorism, but with systems and procedures to highlight these risks now well bedded in, corruption and fraud have become a larger area of concern. ‘Companies are paying much more attention to where they are putting their money and who their business partners are,’ Nairne says. ‘Even the basic background checks can often find a problem. Although you can never be certain of finding every skeleton in the closet, you do yourself a disservice by not finding the obvious ones.’

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