Software firms target growing workload of multiple funds

A report from Boston-based consultancy Aite Group estimated funds of hedge funds’ assets were more than $1.3 trillion (€864bn) last year and are expected to grow to $2.2 trillion by 2011, a 16% average annual growth rate.

While business at funds of hedge funds has grown in the shadows of hedge funds to become a powerhouse, the asset class has lagged in areas such as technology infrastructure.

As a result of increased buyside interest, competition between funds of hedge funds is becoming more aggressive. A differentiator for funds of hedge funds is having technology infrastructure so best practice procedures may be shown.

The rapid growth of these vehicles has given rise to a new breed of technology solutions, from software that helps in choosing the hedge funds to tools for managing and optimising portfolios and reporting performance to clients.

Denise Valentine, an analyst at Aite Group specialising in institutional asset management, hedge funds and technology, said funds of hedge funds have been around for years but have been overshadowed by direct hedge funds.

She said: “Funds of hedge funds are more conservative, a diversification play, they have been popular with larger pension plans, endowments and foundations.” She added that the institutional pension market, as well as a broader sector of wealthy individuals, is moving into funds of hedge funds as the US dollar entry barriers are lowered.

Market scandals involving hedge funds, such as the collapses of Amaranth Advisors and two hedge funds belonging to Bear Stearns, along with the increasing attention of global regulators on the market, have made it difficult for institutions to justify investing in them. But funds of hedge funds offer a less risky, more conservative investment vehicle for these institutions as they continue to seek higher returns.

Ian Headon, vice-president, product management, at custody bank Northern Trust in Dublin, said institutions want exposure to the hedge fund sector to achieve risk diversification. He said: “They are putting their toes in the water and entering via funds of hedge funds to get access to 10 or 12 hedge fund managers. But that also means they can get exposure to risk.”

Managing a fund of hedge funds’ investments starts with research, analysis, due diligence and selecting the hedge funds, then building and implementing a portfolio and managing risk. Risk management for funds of hedge funds, unlike mutual funds, involves total fund risk as well as individual hedge fund risk.

Managing most of these tasks is mainly manual, with spreadsheets the only technology at many funds of hedge funds. Valentine said: “There is a long way to go before technology penetrates this market.”

Technology vendors are getting a handle on funds of hedge funds, with a smattering of front-office analytics and due diligence products, some middle-office portfolio management products, and a few that straddle the two. Most back-office operations at funds of hedge funds are done by custodian banks, which also have to manage large amounts of manual entry and paperwork.

Headon said Northern Trust acts as the back office for its funds of hedge funds clients as well as private equity firms and mutual funds. He said: “We are the back office, we keep track of who the investors are and the regulatory requirements. We track and calculate the net asset value and the capital balance of the fund’s partners.”

The bank also sends monthly valuation reports to each client.

Headon said that if a fund of hedge funds client wants to invest in a hedge fund, Northern Trust acts as the fund’s representative and contacts the hedge fund. What follows is a flurry of faxes, e-mails and PDFs, which the bank collects to build a history of the fund’s business.

Northern Trust has formed a partnership with YouDevise, a provider of financial applications, to provide an online system for the bank’s customers to view their portfolio management data on a timely basis. The bank is adopting YouDevise’s Hedge Information Provider online portfolio management system developed for funds of hedge funds.

Headon said the online system is “the way of the future” because many fund of hedge funds do not have – and do not want – the technology infrastructure to manage the applications themselves.

Meredith Jones, managing director at investment analysis software firm PerTrac Financial Solutions, said it is working to help automate the workflow for funds of hedge funds. He said: “The fund of hedge funds industry is extraordinarily under-automated, and technology has lagged.”

As they matured, funds of hedge funds focused on raising capital and technology infrastructure was left behind. Krassen Draganov, chief executive and co-founder of investment software provider Netage Solutions, said that as they mature, funds of hedge funds require more operational efficiency and need special software.

Netage started providing software for managing relationships and investments to private equity and venture capital firms 10 years ago. Then, six years ago, Netage signed a big prime brokerage client that wanted a hedge fund product. Draganov said: “We leveraged our venture capital knowledge for hedge funds, from an investment management standpoint the processes are similar.”

Although many hedge funds consider a lack of transparency a benefit in their business, they have to change to gain institutional assets. Draganov added: “As funds of hedge funds pull in more institutional assets, they require more structured operations. For operational risk and due diligence they require more software and systems.”

Serge Berger, vice-president of sales for the Americas at hedge fund vendor AlternativeSoft, said: “They use our software so they can invest the optimal amount in hedge funds. Institutions want to see an investment process in place.”

This has opened the market for technology vendors. Berger said: “The fund of funds business was traditionally the domain of high net worth individuals. Now it is also the domain of corporations, pension funds and university endowments. This created a large group of institutional investors that are using our software.”