Hugging the frontier of technological sophistication has helped hedge funds blaze a $1.4 trillion path into the investment world. But the latest innovations may make them more attractive to institutional clients by upgrading the way they do business without changing how they generate alpha.
Technology vendor Paladyne Systems announced a licensing deal Wednesday with Connecticut-based Chilton Investment Company, a $4.5 billion hedge fund manager, for a high-tech alternatives platform, Paladyne Security Master. The product gives managers real-time portfolio alerts while also offering advanced search and reporting capabilities. That should help Chilton maintain its front-to-back-office securities data in one system, rather than across “disparate” sets of applications, Chilton CIO Jerry Goersch says in a statement.
Experts say such applications will likely make hedge funds even more appealing to institutional investors.
Paladyne CEO Sameer Shalaby says he’s seeing a growing demand for the firm’s technology suite, which may signal a trend among alternatives firms toward the technological maturity seen in larger, more traditional asset managers. One-stop platforms that minimize error, facilitate portfolio monitoring and streamline pricing bring transparency and consistency to an investment field with few direct regulatory barriers. Institutional clients are taking note.
“What we’re starting to see now is that hedge funds are being asked all the time in the due diligence process by these big institutional investors certain demands – whether they be a certain transparency, reports, how they are managing their business, what systems they are using – to make sure that they are comfortable that these guys are running their business in a responsible manner,” says Shalaby.
It’s not unusual to find small hedge funds slow on the uptake of new technology, especially in the back office, says a spokeswoman for research and consulting firm Celent. With the focus on the front office and day-to-day trades, many hedge funds still rely on basic spreadsheets to keep track of their clients, investment positions and returns.
But market pressure may put an end to those low-tech days. In the absence of government scrutiny, Shalaby says the buying power of a large institutional client enables it to ask a lot more from a portfolio manager. “A lot of these investors are coming in and asking these serious questions,” he says. They see the spreadsheets and either walk away or demand the fund implement a new system.
Adam Sussman, a senior analyst with the TABB Group, says the evolution to better technology is part of the convergence of hedge funds and traditional asset managers. “That’s certainly a trend that we’ve been seeing over the last 18 months.”
He adds: “As hedge funds look to attract more assets from pension plans and other more highly regulated organizations, it’s becoming more of an issue, because the pension plans themselves have fiduciary obligations under the [Employee Retirement Income Security Act] to make sure that they do due diligence.”
Established alternatives managers like AQR Capital Management and DE Shaw have even begun managing long-only assets for their institutional clients, he notes. Now their back offices are beginning to resemble those of their traditional forebears.
Paladyne offers a fully-hosted platform that streamlines hedge fund operations; the firm boasts of potential efficiency gains and cost savings for its clients. Six modules come in the complete suite, with functions including real-time profit-and-loss, performance tracking, automated pricing, data aggregation, client relationship management and accounting. Security Master, picked up by Chilton, includes a centralized terms-and-conditions repository, allowing managers to track securities that may have different names on different exchanges. Large clients with existing in-house technology might also integrate products a la carte into their own systems.
“An overarching trend that we are seeing is an overall maturity in this industry,” says Shalaby. Investment in technology has exploded, with novel platforms quickly becoming necessities. With few competitors offering an all-in-one, turnkey suite, Paladyne has seen its customer base balloon, Shalaby says. “To run their business, they need it. To attract more capital from their investors, they need it.”
Sang Lee, of the Boston-based research and advisory firm Aite Group, says the rewards of such technology are tangible, whether the objective is transparency, consistency or regulatory compliance. “Whenever you can automate your overall process, there’s a better chance of eliminating or reducing risk of errors,” says Lee. “And that really is the core benefit of electronic trading overall. Otherwise, it’s completely useless.”
Paladyne, while a young firm, is well-positioned in a niche market, catering to hedge funds who might be dissatisfied with one-size-fits-all products from larger vendors, Lee says. “As clients become more sophisticated – and as hedge funds get very sophisticated – there’s a certain need for providing full support in various areas, and that’s what I think Paladyne is trying to do.”
Aggregate assets in the hedge fund industry are now approaching $2 trillion, with a growing share coming from institutions. That number was $300 billion in 1990. A 2006 Bank of New York and Casey Quirk & Associates study says institutions alone expect to triple their hedge fund allocations to more than $1 trillion by 2010. That growth – along with its high-profile risk – has led to worries about the impact on the global economy of Amaranth-style implosions occurring industry-wide. Scrutiny has risen along with profits.
European regulators have threatened to require more stringent portfolio disclosures, but the U.S. government has taken a laissez-faire approach, often regulating indirectly through requirements on investors. The Security and Exchange Commission saw defeat in court after trying to force the registration of managers. And Federal Reserve Chairman Ben Bernanke recommended in April that federal oversight of the industry should remain light.
“The government’s argument about not regulating this business has been: ‘Why bother when the investors are going to be the ones regulating the business?’” says Shalaby.
Historically, hedge funds started out on the same technology platforms as their long-only counterparts but found the established systems lacking. “It turns out, most of the systems that were built for the long-only side just have absolutely no relevance in this space,” Shalaby says.
Paladyne was formed through the acquisition of its technology platform by a large multi-strategy hedge fund. While some of Paladyne’s modules are available from competitors, Shalaby says his firm is essentially alone in rolling these products into one system.
Lee mostly agrees, highlighting Paladyne’s partnership with San Francisco-based Advent Software to fold an accounting module into its hedge fund suite. “Paladyne is sort of a new breed of competition within this marketplace, going aggressively after the hedge funds,” he says. “And last time I chatted with them, they were getting pretty decent traction.”
But the firm does have significant competitors, Lee adds, such as order-management system provider Eze Castle, which teamed up with Bank of New York last summer to launch BNY ConvergEx Group. And some of the vendors selling isolated modules are much larger and more established. That explains Paladyne’s approach to marketing, Lee says: approaching funds from the top of the food chain through fund administrators and prime-brokers.
