Hedging Their Bets

Date: Friday, January 5, 2007
Author: Tim Clark, Financetech.com

A rising number of hedge funds and fund managers are outsourcing middle and back-office functions in an effort to focus on core competencies.

As competition forces hedge funds to move into more-complex instruments in search of higher returns, middle- and back-office functions also are becoming more complex and cumbersome. Combined with the pressure to comply with corporate actions regulations and Sarbanes-Oxley, the growing burden is leading a rising number of hedge funds and fund managers to outsource middle- and back-office functions, thus allowing investment managers to focus on what they do best: turn profits for clients.

"As hedge funds move more aggressively into OTC instruments, the infrastructure necessary to manage the entire life cycle of the investment process can be quite cost prohibitive," explains Sang Lee, analyst, Aite Group. "Fund administrators are in perfect position to alleviate this issue so that hedge funds can continue to focus on their investment strategy and leave the middle-office and back-office operational complexity to the fund administrators."

In light of the rising popularity of the OTC derivatives space, which currently retains some $360 trillion worth of outstanding contracts, according to analyst estimates, leading fund administrators, such as JPMorgan and Citigroup, are building out their fund administration services. "Removing the distraction of running a middle and back office can help investment managers trade more effectively, which can increase their revenue," says Peter Salvage, product head, hedge fund operations, JPMorgan Worldwide Securities Services. "A hedge fund manager doesn't necessarily have the people, processes and expertise in place to really put its systems and processes through the ringer every day like we do on our side."

"Fund administration is an area that has typically been viewed as a back-office space and is now getting more and more front-office oriented," says Chandresh Iyer, managing director, North American head of securities and fund services, Citigroup Corporate and Investment Banking. "The OTC derivatives space is causing a need for the back-office infrastructure to scale to growth and provide more-sophisticated capabilities for managing risk, reconciliation of complex securities and pricing of hard-to-value securities."

Citi Builds Administration Capabilities

Citigroup's Funds Administration operation takes a firm's business function and places it onto a Citigroup platform, which Citigroup manages and operates, according to Colin Stewart, managing director, global transaction services, Citigroup. This migration method, he contends, is much easier than farming out IT personnel to customize specific applications for different clients. While Stewart declines to elaborate on the specifics of how Citigroup's Funds Administration operates, he says that Citigroup has "invested quite heavily in the tech platform," a proprietary system that powers the service.

Among the firms that have signed up for Citigroup's Funds Administration is Standard Life Investments, which handed over its middle- and back-office procedures to the firm. Citigroup also supported Resolution Asset Management with a portion of that firm's mergers and acquisitions activity.

Citigroup bolstered its fund administration capabilities, while adding new clients, in 2003 with the acquisition of Forum Financial Group, a provider of fund administration services for more than 18 years. The acquisition began Citigroup's strategic focus on meeting the fund administration service needs of global fund managers, according to a company release.

In 2005, Citigroup reached a 10-year agreement to provide fund administration services to AGF Management Ltd. in the Canadian market. With approximately $41 billion in total assets under management, AGF serves more than 1 million investors with more than 50 mutual funds. "We looked at numerous partners and determined that Citigroup was the right choice for AGF," said Blake Goldring, AGF's president and CEO, in a release. "By partnering with such a large global provider like Citigroup, we can drive further economies of scale and give our clients access to the best in professional client services and administrative processing."

JPMorgan Funds the Future

Like Citigroup, JPMorgan also is building out its fund administration capabilities. The firm currently is devoting time and resources to the hedge fund sector by buying boutique firms and making technology modifications to their solutions when necessary, according to JPMorgan's Salvage, who adds that customer feedback was a key factor in JPMorgan's decision to build out its hedge fund administration business.

"By getting close to our customers, we realized there was a gap in the marketplace around the middle-office services," says Salvage. "Our customers were coming to us explaining that they have a lot of middle-office style processes that were becoming more difficult for them to handle internally."

A key middle-office service that JPMorgan handles is the processing of corporate actions, according to Salvage. The middle and back offices are responsible for identifying all corporate actions and notifying the manager of those actions, for ensuring that the manager makes an election, and for notifying the broker who holds the security on behalf of the customer of that election. "It can be a difficult administrative process to complete," says Salvage. "It's also a risky process. ... It's something a lot of our customers struggle with, which is why it is one of the components of our service."

To help build out that service, JPMorgan acquired the middle- and back-office operations of Paloma Partners Management Co., part of a privately owned investment fund management group based in Greenwich, Conn., in February 2006. "This acquisition allows us to immediately offer our hedge fund clients a high-quality option -- built on top of a hedge fund-specific platform -- for outsourcing their daily operations," said Liz Nolan, global head of alternative investment services for JPMorgan Worldwide Securities Services, in a release.

According to the firm's Salvage, firms that outsource their middle- and back-office processes are removing the distractions associated with running these time-consuming and vital areas of operation. In addition to helping investment managers trade more effectively, this also can reduce their cost because fund administrators such as JPMorgan offer economies of scale when it comes to technology investments, he asserts.

Salvage also says that consumers who invest in hedge funds are provided with a certain comfort level in knowing that a large firm such as JPMorgan is servicing their fund. "They feel more comfortable that everything is being done to an industrial strength level and their money is less susceptible to operational errors," he contends. "That makes them more comfortable putting money into a hedge fund, so it can lead to hedge funds being able to attract money more easily."