How To Start, And Run, A Hedge Fund

Date: Tuesday, January 31, 2012
Author: Tom Groenfeldt, Forbes

As the Volcker Rule cuts down on proprietary trading at large investment banks, skilled traders are leaving and setting up their own alternative investment funds, and looking for the technology they need to trade and to report to their investors.

“A lot of employees who worked at prop desks are now at hedge funds or starting their own,” said Kaleigh Alessandro, director of strategic partnerships at Eze Castle Integration, a Boston-based provider of technology services and even full service office space for hedge funds. “Hedge funds can be very lucrative depending on how you staff them and how you find the right partners for operational efficiency and reducing overall costs like trading and research.”

The hedge fund business has become more complicated on both ends. Pre-crisis, many firms relied on a single prime broker to handle their transactions and record keeping. With the crash of Lehman, hedge fund operators realized the business had changed; many decided they needed more than one prime broker to reduce their risks.

“One hedge fund we worked with went from a single prime broker to five based on the trading desk and the trading location,” said Alessandro. That means going from one set of records to five sets, and trying to track assets, trades and hedges in a more complex operation. No longer could a fund depend on prime broker because its business was spread across several. Many large hedge funds had moved away from a single prime broker earlier so no single broker could see all their positions.

On the other side, the big investors in hedge fund are now institutions with much more rigorous reporting requirements than hedge fund managers had to deal with in the early days when their investors tended to be wealthy individuals or families.

The Volcker Divide

The Volcker rule, part of the Dodd-Frank legislation, which says that deposit-taking banks (as most investment banks scrambled to become in the financial crisis so they would have Fed access) cannot run proprietary trading desks.

Kevin Roose at the New York Times recounted recently how Citi is winding down is prop trading effective Feb. 6.

Citigroup had planned to close the desk since a section of the Dodd-Frank Act known as the Volcker rule, which will effectively ban proprietary trading by commercial banks, was signed into law in 2010.”

The proposed rule has come under attack from U.S. investment banks which say it would put them at a competitive disadvantage and reduce liquidity.

At the Davos conference in Switzerland, Bank of Canada Governor Mark Carney said U.S. efforts to prevent deposit-taking banks from trading with their own money could damage markets in government bonds and other securities unless the plans are revised, according to Bloomberg Businessweek.

“The [Volcker] rule is scheduled to take effect in July, but regulators have not yet agreed on a final draft,” reported Roose, who said that Citi would have to reduce its stake in Citi Capital Advisors from the current 5 percent to 3 percent or less under the rule.

If Citi prop desk traders decide to set up shop as a hedge fund, Eze Castle Integration is ready for them. The company even has a spot on its web site for “How to Start a Hedge Fund.”

“To raise money, you will need a partnership with a company like us,” said Alessandro. Firms investing millions want to see more substantial infrastructure than a couple of traders working on Excel. Small funds with $250 to $500 million in assets under management can move into an Eze office or work through the private cloud which the company calls the Eze Virtual Office which lets the traders work from a home office with remote connectivity. The company also has managed suites in midtown Manhattan which can hold from 4 to 20 employees.

“We have had some clients for a couple of years, other firms come in for a couple of months and then move out and leverage our cloud from another location. It takes about a week to provision a fund.” Services include a standard back office with an order management or execution management system, email and file services, compliance, archiving — all the applications and monitoring that investors and regulators require and all of it managed by Eze.

New government rules for asset managers will require them to review their operations and improve their processes over what was acceptable five or six years ago, he added.

“We’ve been brought in several times to evaluate the existing state of a fund’s business and put together a strategy to ensure they are streamlined for government regulators and institutional investors whose due diligence has increased exponentially,” he added.

“A lot of firms are outsourcing or moving their existing infrastructure to the cloud because it reduces costs,” added Alessandro. “With connectivity being what it is today, there is no latency for the end user; they feel like they have their own infrastructure in-house.”

He is talking about normal trading latency, not the millisecond or microsecond latency that high frequency traders (HFT) pursue. HFT was hot before 2008, Alessandro added, but he hasn’t seen new or existing funds ramping up for it. Eze does see a lot of algorithmic trading and analytical tools to look at a portfolio on a regular basis, but that doesn’t necessarily translate to high frequency trading.