The How-To's of Hedge Fund Outsourcing

Hedge funds are increasingly relying on service providers to support a range of core operations. Driven by the recent economic downturn, outsourcing trade support and processing activities is seen as a major strategic tool to mitigate risk, attain operational efficiency and reduce overhead costs. Outsourcing services create value by providing access to global best practices at a rate that can be directly tied to assets under management (AUM).

The decision factors concerning which services are prime candidates for outsourcing are always unique. Non-core activities that are essential to business are the low-hanging fruit, but increasingly, hedge funds are looking beyond the basics in order to derive more value across the enterprise.

The Next Wave The last decade has seen outsourcing transform from a tactical quick-win to a strategic necessity. Financial firms, such as hedge funds, are no longer looking at outsourcing simply as a way to cut costs. The process is now an integral part of a firm's business strategy. Consequently, the capability of modern service providers has expanded ahead of the growing demand.

Compared with the first wave of outsourcing, which was popular on the sell-side, hedge funds are just now actively implementing this option for functions in the front-to-back office. In terms of Front Office Support, this means trade capture, broker recap review, trade enrichment, and so on. For Middle Office Support, this would include trade booking, broker/blotter reconciliation, internal system reconciliation, internal vs. third-party reconciliation, trade amendment investigation, chasing and resolution, static data review, etc.

When it comes to Back Office Support, managers must consider settlements, portfolio reconciliation and resolution, collateral and cash management, and more. And finally, there is Ancillary Services Support, which means regulatory/investor reporting, reference data management, expense management, and so on.

Customized Solutions for Unique Issues Outsourcing is not just about offloading all operations to a third party. An increasing number of financial services firms, including hedge funds, temporarily outsource operations while they resolve in-house issues or implement strategic improvements. This buys time and provides a stopgap solution while in-house systems are prepared for a new regulation, or perhaps a complete system overhaul.

Focus on Core Competencies Outsourcing trading operations, either partially or en masse, allows hedge funds to refocus on their core competencies while being supported by more timely and accurate information. Employing up-to-date trading technology (without the up-front costs), coupled with improved process control matching international best practices, enhances the overall customer service offered at a reduced cost. But which decision factors must be considered before embarking on such a critical strategic move? Before jumping in feet-first and selecting an outsourcing vendor, when should you commit to an outsourcing strategy, and how ready are you to proceed?

Are You Ready? Initially, all options are open to negotiation and all processes are potential candidates for outsourcing -- from core competences and capabilities, to the most menial of background administrative tasks. The skill is in knowing where to draw the line; what stays in-house and what gets offloaded.

Many factors influence the suitability, as well as the ease with which a process can be outsourced. Are the process and procedures delivering quality with the tools available, or is there a need for in-depth analysis and re-engineering? Does the process need to be available continuously, or is it sensitive to large fluctuations in traffic volume? What levels of data and information security is needed?

Taking the Leap Few trading operations can maintain excellence throughout the end-to-end process. Issues and bottlenecks are as inevitable as the potential to improve each process. The fact remains that specialized vendors offer the domain expertise and improved process control for a better price. With established resource pools at most financial services firms operating at high costs, often with built-in dependencies on individuals or departments, the opportunity to outsource operations with strict service level agreements is attractive.

Size Matters in Decision Factors The size of the hedge fund plays a big role in its decision to outsource. Through strategically offloading certain or all processes, a smaller fund has the ability to operate on a level playing field. Smaller hedge funds now have the ability to implement sophisticated risk controls and gain a more thorough level of transparency via outsourced processes, and hence attract more sophisticated and demanding investors. Larger hedge funds face their own set of challenges when looking to outsource. By outsourcing specific, commoditized functions -- such as post-trade processes or the affirmation/confirmation functionality -- firms have the human resources and capital to focus on their core competencies.

A rich functional capability must be augmented by excellence in process workflow to attain the savings and market agility that outsourcing promises. Whether opting for a full front-to-back office system and trading service encompassing capture, validation, enrichment, settlement and margins, or just a tactical outsourcing of one element in the trading lifecycle, the process orchestration is the key to success.

Hedge funds, and other buy-side firms, are now increasingly turning to outsourcing as an integral part of their business operation planning and growth strategy. Before, financial firms viewed outsourcing simply as a way to offload non-essential tasks. However, in its new phase of evolution, outsourcing can provide business critical solutions, while allowing the financial institution to focus on what they do best. By outsourcing functionality across the entire trade life cycle, including trade capture, reconciliation and collateral management, hedge funds are better able to not just stay competitive, but grow and mature.

Alberto Corvo is managing principal of the financial services division at eClerx Services Limited, a capital markets and investment management consulting and outsourcing company.