Can and Should Asset managers Integrate Hedge Fund Technology With the Buy Side's Existing Systems?

It's easy to start a hedge fund these days. All one needs is a spreadsheet, a telephone, an execution management system (EMS) and a prime broker to finance the positions. Prime brokers even have special consultants who provide advice to hedge funds on setting up technology and finding office space.

And, according to a Jan. 2 article in The New York Times, a few large investment banks are leasing office space to hedge funds, even providing receptionists, espresso machines and consultants to run the hedge funds' computer systems. (These so-called "hedge fund hotels" have caught the attention of William Gavin, the Massachusetts secretary of state, since these services are being offered for free as an inducement to trade with the brokerage firms. Can you say, "soft dollars"?)

Still, the success of hedge funds often is determined by their proprietary trading technology, including models and algorithms. And now that traditional asset managers are edging their way into the alternatives business, the question is: Can and should they integrate the hedge fund technology with the buy side's existing systems?

The trading desk doesn't appear to be a major problem, as many firms run their hedge fund trading desks independently from their traditional asset management desks [see cover story, page 24]. But what about the middle- and back-office infrastructure that's required to run multiple-strategy hedge funds, such as portfolio management tools, data warehouses, analytics and pricing engines? Does a buy-side firm want to run two or three of everything?

According to Sameer Shalaby, CEO of Paladyne Systems, a provider of technology solutions to the hedge fund and prime brokerage industry, hedge funds typically don't come with much middle- and back-office technology baggage, as the trend among hedge funds is to outsource these functions - such as valuation, portfolio accounting and intraday P&L calculations - to third parties, including prime brokers and fund administrators. "Most hedge funds don't view several of their technology components as their competitive differentiation," Shalaby says.

At some point, however, an asset manager that acquires a hedge fund would need to aggregate all the data, run consolidated P&Ls and monitor total exposures. This could turn into a painful systems integration exercise. But, "It's not just a technology challenge," asserts David Quinlan, president of Eze Castle Software, a leading OMS provider to hedge funds. In the front office, for example, compliance officers could raise red flags over sharing information on long and short sales on the trading desk. And if a firm were to integrate its trading desks, it could end up with an asset manager earning $300,000 a year sitting next to a hedge fund manager who gets $15 million, Quinlan suggests. "It's definitely compensation, legal and compliance," he says. Yet with institutions such as pension funds pumping money into alternative investments, traditional asset managers must offer products such as hedge funds, fund of funds and private equity vehicles. According to a McKinsey & Co. report, "The Asset Management Industry in 2010," traditional asset managers continue to lose ground to alternative players - their share of new order flows has dropped from 93 percent to 78 percent over the past four years. "All of this will put enormous pressure on traditional players to break out of their long-only strategies and take on more alternative characteristics," the study predicts. Meanwhile, hedge funds are invading the long-only business to appeal to institutions and affluent investors. McKinsey expects hedge funds to roll out new "'lower-octane,' higher-capacity products that are designed to have lower volatility than the typical hedge fund but still employ many of the same characteristics."

Clearly, the lines between traditional asset managers and hedge funds are blurring. But commingling these businesses won't be easy.