A Double-Edged Sword

The flow of institutional money into the alternative asset management space may not be a recent phenomenon, but it is an exciting opportunity for hedge funds. For example, Scandinavian-based pension funds, including certain state-run funds, have been allocating as much as 15 percent of their assets to hedge funds over the years. This figure pales in comparison to the interest in hedge funds shown by their industry cousins--the funds of hedge funds--which accounted for as much as 80 percent of the institutional money that flowed into the hedge fund industry last year.

For the majority of hedge fund players--especially those that have recently been launched and which need to attract new capital simply to survive--additional capital flowing into the industry is a reason to celebrate. Not only does this represent an inflated pool of assets from which to derive profits through management fees and overall profits, it’s also an endorsement that the alternative space is where investors’ expectations of healthy returns are most likely to be realized.

But like most too-good-to-be-true propositions, there’s a catch. Capital allocated to hedge funds by institutional investors or their investment advisors is an entirely different prospect compared to that of a high net-worth individual. Hedge funds have been the exclusive domain of the high net-worth individual, and have traditionally led a laissez-faire existence in terms of not being obliged to provide reports that aim to clarify their opaque operations.

This has changed over the past three years due to the efforts of the US Securities Exchange Commission (SEC) and the Financial Services Authority (FSA) in the UK championing the investors’ causes. This is by no means a legal obligation on the part of the individual funds to provide their institutional investors with transparency into the way a fund is managed. However, hedge funds looking to attract new capital or retain capital increasingly have the onus placed on them to provide the most basic levels of transparency. Herein lies the challenge.

In order to provide detailed performance and attribution reports, hedge funds need to build or buy technology that underpins this aspect of their business. Any hedge fund IT manager will tell you that these challenges cannot satisfactorily be addressed merely by throwing dollars at them. Even if the average hedge fund had the cash to implement "off-the-shelf" reporting and performance measurement systems, there is no guarantee that these systems will meet their requirements. The build option is equally unattractive, especially for the smaller funds with limited IT resources, as is the inevitable "time to market" latency, which makes most in-house projects economically unviable.

Just ask Jim Trotter, a consultant at London-based investment management consultancy Investit and former head of performance at Merrill Lynch in London. "Users’ expectations are always dampened," Trotter says, referring to a recent study his firm published on performance measurement in the long-only asset management sector. "When a company looks to buy a new piece of technology, the implementation and the cost of the implementation always take a lot longer than they anticipate. The key is finding the right vendor that they think will support them properly and actually deliver what they say they will deliver."

This illustrates the Catch-22 situation facing funds on both sides of the Atlantic, although it has permeated other areas of the business including compliance, risk management and decision support in addition to performance measurement and attribution. Attracting new capital is crucial, but gone are the days when investors are prepared to commit financially and then sit and wait for their quarterly reports. Hedge funds must work a bit harder for their money than that.