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Paul Allen
Paul Allen
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Many Firms Lack the Processing Infrastructure to Support Growth in Alternative Investments

Many firms lack the processing infrastructure needed to support the huge growth in alternative investments.

The rise of alternative investments continues to be one of the most talked about trends on Wall Street. But while the lust for sources of alpha spurs remarkable innovation in instrument development and front-office trading strategies, the processing infrastructure needed to support the growth is struggling to keep up.

Cutting-edge organizations -- including hedge funds, investment banks, and pioneering pension plans and endowments -- are seeking out alternative investment opportunities wherever a healthy return is to be found, whether that comes from over-the-counter (OTC) derivatives, commodities, precious metals, real estate, art or any number of private equity deals. But, "The productization of these instruments has raced far ahead of ops and tech, and they're not necessarily going to wait," according to Tom Secaur, managing director with Citisoft, an investment management consulting firm.

So where are the technology challenges? Trade capture and matching for esoteric instruments has been a manual process for years, says Secaur, although he notes that Omgeo's Central Trade Manager is making strides to rectify that. Cash management is another pain point where firms may have difficulty in projecting cash flows, and even understanding current cash flows, on some of these instruments, he adds. And performance measurement and attribution tends to be a very manual process as well, Secaur continues.

The critical stumbling block is data management, says Secaur. "Whether you're talking about pricing, about a failed trade, the security setup or the general understanding of these esoteric instruments, it all comes back to data management," he asserts.

"The first thing you need before going into a new space is to find the appropriate data," says Daniel Abitbol, business development manager, VALUE, with Paris-based Sophis, one of the many sell-side vendors that has crossed over to the buy side. "You can have any type of pricing engine, but if you don't have the input, you don't have an output. And finding good data on an OTC product is not easy," he adds, noting, however, that new data vendors, such as Markit, are emerging.

But even with good data, pricing complex instruments can be a challenge. "You need to find good quants that have programming skills and that want to work for you," Abitbol suggests.

It requires "a lot of people and manpower to keep these instruments tracked and valued properly," notes Peter Salvage, product head, hedge fund operations at JPMorgan Hedge Fund Services. But, he adds, there generally is a lack of talent in the marketplace that knows how to properly value and handle such assets, the volume and complexity of which are growing continually. As a result, pricing continues to be the biggest operational challenge facing the hedge fund world, Salvage contends.

Of course, it is not only hedge funds that are piling into the alternatives space. A slew of pension funds, insurance companies and traditional asset managers also have been upping their asset allocations to alternatives, whether by investing directly or through exposure to hedge funds.

This institutionalization of the alternatives arena brings with it a demand for more-robust operational processes and technology solutions. Whereas a firm could manage its long-only equity trading using an Excel spreadsheet, once it moves into the derivatives space, the technology implications are huge, according to Sophis' Abitbol. "With the leverage effect, the financing leg, the collateral you have to put on the side to guarantee your investment -- the calculations become a lot more complex."

Having the technology to support that complexity, though, does not mean just bolting on additional functionality, stresses Abitbol. Rather, it requires a complete review of a firm's internal processes and often requires a total infrastructure overhaul. "If it's a failure, their whole business is at risk," Abitbol notes. "It's not only costly, it's strategic."

Firms not willing to spend the requisite dollars risk the futures of their businesses. If an asset manager isn't willing to invest in the technology and operations capabilities to support a swaption, for example, it may be forced to walk away from that product strategy, says Citisoft's Secaur.

The Sky's the Limit

One alternative to investing in an in-house technology suite is to use the services of an application service provider (ASP). Sky Road, for example, was spun out of Geneva, Ill.-based hedge fund Ritchie Capital Management in 2005. The firm uses Calypso Technology's platform for its core framework, with proprietary technology and marketplace connectivity built on top to provide clients with a custom-hosted solution offering multistrategy, cross-asset-class capabilities, relates John Borse, Sky Road's president and former chief technology officer at Ritchie.

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