Digital Assets Report


Like this article?

Sign up to our free newsletter

Strong partners in a storm

Related Topics

By A Paris – They say you should never let a serious crisis go to waste and the latest wave of turbulence caused by the global Covid-19 pandemic is certainly testing the hedge fund industry to understand how to make the best of a difficult situation.

The fortunes of hedge funds have been mired in chaos. The HFRX Global Hedge Fund Index, lost 7.76 per cent by the last week of March yet the in the same breath, the Eurekahedge Hedge Fund Index registered its strongest outperformance relative to underlying markets since October 2008, outperforming the MSCI AC World Index by 9.22 per cent in March. Some big name funds saw their assets plummet while others witnessed gains in the coronavirus sell-off.

Over the course of this bumpy period, the notion of having strong third-party partners is taking on elevated importance as hedge funds look to navigate the storm. Managers are being advised to reach out to critical service providers to ensure they have business continuity plans in place to help them continue to function with as little disruption as practically possible.

Many dimensions of an investment business have come into stark relief in the first quarter of 2020. One such example is cybersecurity, which is now being given even more prominence. The coronavirus crisis has led to higher levels of remote access to core systems and as a result, investment management firms may find themselves more vulnerable and facing additional threats.

PwC recommends managers consider re-evaluating their enterprise risk management framework to address the new and enhanced risks that Covid-19 is creating, such as technology and operational risks, which include the cybersecurity element.

Crucial cyber focus

The subject was already under the lens at the end of 2019, as a result of the European Commission’s consultation on digital operational resilience. “A dedicated approach to enhance what can be referred to as the digital operational resilience of financial institutions is even more relevant in the context of the increase in outsourcing arrangements and third-party dependencies (e.g. through cloud adoption),” the Commission says.

In the current environment, the prominence of having robust digital infrastructure supporting an investment proposition, which includes strong third parties, is being further underscored.

The Commission notes: “While this [outsourcing] brings significant opportunities, it may also create new risks for financial entities and specifically may relocate existing operational, ICT, security, governance and reputational risks to third party technology providers. Furthermore, it can lead to legal and compliance issues, to name just a few, that can that can originate at the third party or derive from ICT and security vulnerabilities within the third party.”

Managers themselves have been at the forefront of progress when it comes to adopting strong controls in this regard. The European Fund Management Association notes: “Recognising the global, pervasive and ever-changing nature of such threats, asset management companies have responded by adopting a variety of preventive measures to protect their clients, as well as their own business and reputation.”

In its response to the EC, the Managed Funds Association (MFA) which represents the global alternative investment industry writes: “Alternative investment fund managers are fiduciaries to their investors and have an obligation to safeguard their resources. As such, they invest heavily in both operational resilience and cybersecurity. In addition, financial services firms are already subject to a number of legal and regulatory requirements relating to operational resilience.”

The MFA’s recommendations to the EC include enhancing security by building on the existing regulatory framework and enhancing the public sector’s stewardship of sensitive financial services data.

In a white paper discussing the role of third-party vendors in asset management, BlackRock stresses cybersecurity should be a critical component of the firms’ business models. Former SEC chair Mary Jo White had said: “cybersecurity is… one of the greatest risks facing the financial services industry and will be for the foreseeable future”.

Cyber security consulting firm Nicholas Bray says: “The loss of confidential client information from a cyber security attack can cause substantial reputational damage to a hedge fund, leading to current and future fundraising issues. In addition, the theft of proprietary trading strategies, algorithms and code has become more prevalent – in some cases perpetuated by financially motivated insiders or competitors – and can lead to significant losses.”

In October last year, hedge fund Arena Investors hit the headlines after being victim of a phishing attack. This and other such events only sharpened the focus by regulators across the globe to cement the need for robust cybersecurity measures within financial institutions and other players in the broader ecosystem. 

George Ralph, managing director at RFA gives advice on how to improve security in the current environment. His top two recommendations include re-writing policies and providing corporate devices for staff, wherever possible. “Most firms will need to rework existing documents to suit the very specific circumstances surrounding Covid-19. Also, by providing company approved devices, you can ensure they are properly configured with appropriate AV software and endpoint protection,” he explains. 

Broader implications

The enhanced need for a cyber focus has further underscored the role outsourced providers play in the hedge fund value chain. As pressure on fees and increasing cost due to regulatory requirements persist, managers are always on the lookout for ways to streamline, improve efficiency and delegate functions to enable them to focus on their core competencies. 

“Outsourcing non-investment related functions affords portfolio managers the opportunity to remain laser focused on security selection and portfolio management, and avoid being distracted with managing internal personnel and infrastructure,” notes Jack Seibald, managing director, Cowen.

Delegating these functions can also support a manager’s distribution efforts. For example, late last year, Wellington Management partnered with Artivest, an open-architecture digital platform to expand the reach of its alternative investment solutions across the financial advisor and high net worth investor market.

In the statement announcing the move, Chris Kirk, CFA, President of Wellington Alternative Investments, says: “At Wellington, we are dedicated to using our specialised investment management expertise and skillset to help our clients surpass their goals. We’re looking forward to partnering with Artivest to expand the current distribution of our alternatives strategies to a broader group of qualified high-net-worth investors and the advisors who serve them.” 

The LHoFT Foundation, a public – private sector initiative driving technology innovation for Luxembourg’s financial services industry provides insight into the role technology progression and outsourced providers play in the distribution of investment management solutions:

“Forces shaping the future of financial services include platforms, cost commoditisation (automation, mutualisation and externisation), Profit re-distribution (dis-intermediation), Regulatory divergence, data monetisation, and customer experience ownership.

“There will likely be a break-up in the value chain, with clear distinction between product manufacturers and product distributors. Hyper-scale and/or hyper-focus will be core to success in manufacturing, while breadth of products and customer experience key to distribution — e-commerce will become the next distribution battleground with the mega tech brands potentially in the driving seat.”

Machine learning

In reaction to the pressure they face, hedge funds are looking to find new ways of gaining a competitive edge. Machine learning is playing a key role in this, both on the investment side and also on an operational dimension. In fact, the use of machine learning and artificial intelligence can be seen to draw together the outsourcing trend which sees the use of third parties moving into the front office.

In a white paper called The Third Wave of Outsourcing: A Tipping Point for Outsourced Trading in the United States, Northern Trust highlights the benefits of outsourcing front office functions, particularly trading, saying it can help investment managers in their drive for operational alpha. 

“Outsourcing front office functions like the trading desk was once considered off-limits, but we believe this ‘third wave’ is likely to establish a new status quo across the industry,” said Dan Houlihan, head of Asset Servicing, Americas at Northern Trust. “We are seeing asset managers of all types beginning to outsource up the value chain. In doing so, investment firms are mitigating risk, more easily attaining compliance with complex regulations, increasing transparency, enhancing scale and efficiency and, ultimately, reducing their costs.” 

Christian Edelmann, partner at Oliver Wyman describes how the focus on data is leading managers to look beyond their internal teams. He writes: “Open source analytical and code libraries are proliferating, and access to the massive amounts of data created by the online world is increasingly open.

“This entails a declining dependence on armies of in-house coders and data scientists, and a greater use of ready-made tools and external resources.”

BlackRock investment professionals further outline the role of technology in the world of asset management and outsourcing: “Technology underpins many functions in asset management and has for decades. Virtually all asset managers utilise technology, either developing their own tools or outsourcing specific functions to a third-party provider. Simply processing large quantities of data from portfolio managers, exchanges, custodians, rating agencies, and pricing services requires some level of automation to ensure efficiency and accuracy.”

This need for precision is a further acknowledgment of the role technological progression plays in the relationship between asset managers and their partners, supporting the motivation for outsourcing. Delegating such processes to external parties allows these tasks to be performing to a high standard while giving the manager the ability to concentrate on managing the investments.

“Today, AI and ML are being employed to improve the customer experience, increase the efficiency and accuracy of operational workflows, and enhance performance, supporting multiple aspects of the investment process,” BlackRock continues.

Indeed, industry data shows more hedge fund managers are deploying artificial intelligence and machine learning technologies to stay ahead of the competition. “AIML funds have outperformed the wider hedge fund market and other systematically traded hedge funds on a three- and five-year annualised basis. Nearly a quarter (23 percent) of systematic hedge funds launched in 2019 use AIML, which is more than double the proportion that did so in 2016,” according to Preqin.

The data provider’s hedge fund report for 2020 finds managers are also increasingly applying these techniques to improve operational efficiencies and boost returns. The most publicly lauded exercise of the sort was undertaken by Ray Dalio, hedge fund manager of Bridgewater Associates. The algorithmic system in place at Bridgewater serves a few different purposes including maximising employee efficiency, organising management and cutting costs.

AI and operations

Managing operational expenditure is crucial for managers to overcome the hurdles created by increasing regulation, fee pressure and diminishing yield. In a paper discussing the use of artificial intelligence in the asset management world, consulting firm Deloitte says: “Many firms are undertaking large transformation programmes with a focus on outsourcing and process automation. 

“The advancement of AI is also serving as a catalyst for firms to turn traditional operational centres of excellence into services which can be offered as a service to competitors. Non-core activities can in turn be externalised to specialist providers.”

Service provider Societe Generale Securities Services (SGSS) outlines other reasons managers should consider delegating the part of their business which heavily involves technology. SGSS says: “IT systems cost more and more. Regular investments are required, and only the largest players can afford to do this. 

“Indeed, systems need frequent upgrades to newer versions, and there are numerous technological innovations to cope with too like Robot, Big Data, Artificial Intelligence, etc.”

Working with a third-party vendor relieves managers of most of these pressures, generally in a more cost effective manner than if they have to invest on building internal systems. 

The value of operational strengthen is further expounded by Stephen Van de Wetering, founder & CEO of outsourced operations firm Empaxis. According to him, most hedge fund collapses are a result of operational failures. “Fund managers have enough on their plate dealing with investment management; operations management is another beast.

“Due diligence being your guide, invest in a strong operations and compliance team, hiring staff of reputable background. Assign a chief operating officer and compliance director to ensure monitoring of the day-to-day activities.

“Consider outsourcing for hedge fund operations as a way to reduce costs and increase workflow efficiency,” he concludes. 

Like this article? Sign up to our free newsletter

Most Popular

Further Reading