Hedge Fund Software

Investors are Demanding Funds Switch from In-house to Independent Administrators
Over 50% of Hedge Funds to Require Daily NAV Calculations within 12 Months

NEW YORK & LONDON–(BUSINESS WIRE)– With a post-Madoff world fixed firmly in the rear-view mirror and new regulations on the horizon, a new report from TABB Group describes how the role of fund administrators is now among one of the most important of hedge fund counterparties, perhaps second in importance only to prime brokers.

What investors want today, says TABB in a new research report, is more transparency and greater asset safety, which requires improvements in infrastructure for middle- and back-office operations, enhanced reporting to stakeholders and independent verification of portfolio values. This shift in investors’ priorities is significantly altering the role and responsibilities of fund administrators and, by extension, the processes by which administrators are selected.

According to Paul Rowady, senior analyst, and Adam Sussman, director of research, who co-authored the report, “(Hedge) Fund Administration: The Selection Criteria for a New Market Reality,” administration is no longer centered simply on back-office functions dealing with accounting, valuation and share registration. “Fund administration can now be defined as everything after the trade.”

Facing high switching costs, fund managers tell TABB they are keenly aware of how important it is to make the correct administration selection. With managers in Europe as well as the US becoming more sensitive to investor’s increasing demands, TABB Group estimates that from 2009 to 2010 the frequency of daily NAV (net asset value) calculations will increase to 56% of hedge funds, up from 46% in 2009. Operational integrity, says Sussman, is crucial to a fund’s survival, especially when faced with this increase demand in fund performance. “Hedge funds are seeking the best possible resources, including people, processes and technology, so they can meet and exceed the demands of the industry’s changing landscape.”

Prior to 2008, the fund-administrator selection process was straightforward and largely handled by managers, a check-the-box type of exercise that revolved around fund administrators’ brands and fees. The problem with relying too heavily on brand awareness, says Rowady, is that a brand’s quality was often correlated with size. “But size and brand do not ensure that an administrator deploys the most reliable technology, SAS Level II certified processes, domain expertise and scalability, not only in terms of size but the funds ability to adapt its operation to changing technology, regulations and market conditions.”

TABB details three administrator models in the report: custodian-owned, broker-owned and independent/hybrid independent. Although the independent model strives to minimize conflicts of interest that could influence the administrator’s asset valuation and verification practices, “The hybrid independent model enjoys arm’s-length operating independence combined with the financial backing of a larger entity and this may represent the best model,” says Rowady.

As firms move to validate their processing and servicing partners, TABB Group believes that the traditional method of choosing administrators by brand or reputation will be replaced by a selection process that prioritizes due diligence. “This shift should benefit boutique administrators more than many of the traditional providers,” maintains Rowady.

The authors believe the industry is seeing an end to the era in which funds manage their processing internally with a “trust me” nod to their investors. “We see more investors pushing hedge funds to migrate their processing and valuation responsibilities to qualified third parties, firms that will need to expand their processing capabilities to be more on demand, more responsive and more global.” Selecting an administrator is a complex and resource-intensive process, says Sussman. “The good news is, there are clues that investors and managers can use to make well-informed selections based on their needs and the ability of an administrator, regardless of size, to meet those needs.”

The 21-page report with 6 exhibits covers the changing market landscape for both alternative and traditional fund managers, how this new market reality serves as a driver for the broadening spectrum of administrator service offerings, enhances the importance of fund administrators – and the outlook for the fund administration business – and details how fund administrators are now instrumental to the long-term success of funds. The report describes the strengths and weaknesses of the three primary business models of fund administrators, including a discussion of the optimal model. The report also covers the fund administration landscape, pinpointing as many as many as 70 administrators globally, and details a comprehensive list of selection criteria with focus on the two factors that have replaced brand and size as the most important selection drivers.

The report is available for download by TABB Group Equity Research Alliance clients and all pre-qualified media at https://www.tabbgroup.com/Login.aspx. For an executive summary or to purchase the report, visit http://www.tabbgroup.com or write to info@tabbgroup.com.

Other recent related TABB Group hedge fund research includes “Prime Brokerage 2009: The Hedge Fund Perspective,” which provides the capital markets industry with an in-depth analysis of hedge fund/prime brokerage relationships, and “US Hedge fund 2009: Fees, Redemptions and Managed Accounts,” covering hedge funds’ challenges dealing with fees, redemption policies, including lockups, advanced notification and frequency of redemptions, plus managed accounts, gate provisions and fund launches.

About TABB Group

TABB Group is the financial markets industry’s only research and strategic advisory firm focused exclusively on capital markets, with offices in New York and London. Founded in 2003 and based on the proven interview-based research methodology of “first-person knowledge” developed by founder Larry Tabb, TABB Group analyzes and quantifies the investing value chain from the fiduciary, investment manager and broker, to exchange and custodian, helping senior business leaders gain a truer understanding of financial markets issues. For more information, visit www.tabbgroup.com.
Press Release Contact Details:

martinrabkinink Martin Rabkin, 914-420-5739 mrabkin@martinrabkinink.com

1st December 2009, London, Syncova Solutions, the specialist provider of margining and financing solutions to the Prime Broker and Hedge Fund markets, has signed a new client in Daiwa Securities SMBC Europe, the European arm of leading Japanese investment bank Daiwa Securities SMBC Co Ltd. The firm has deployed Syncova’s OPTIMA/Broker platform, with a global license, for its expanding Synthetic Prime Brokerage business line.

Daiwa will use the flexibility of the Syncova OPTIMA/Broker platform, to deliver enhanced risk based margining and full cross asset margining of its client’s Synthetic Prime Brokerage portfolio and integration to in-house product lines. Additionally, Daiwa clients utilising the Syncova OPTIMA/Funds platform will benefit from improved flexibility and transparency.

Richard Smither, Head of Structured Portfolio Trading at Daiwa SMBC Europe said: “In a rapidly evolving market, following market events of 2008, one of the key challenges in expanding our product offering at Daiwa is to be able to offer our wide range of clients not only flexibility but full transparency in terms of margin solutions. Syncova’s Optima/Broker allows us to achieve both of these aims without the need to rework or redevelop any of our systems. It has the added benefit that where one of our clients is also using Optima/Fund, we can interface directly without the need for external reports. ”

Liam Huxley, CEO Syncova Solutions added ‘We are delighted that Daiwa Securities SMBC Europe has selected OPTIMA/Broker. As the only margin platform designed specifically for Prime Brokers it enables them to leverage and benefit from a powerful and flexible cross margin calculation engine that supports all margin models and methodologies. Unifying all product types via a single platform will enable Daiwa to efficiently offer a best of breed comprehensive margining facility to its clients.

Syncova Solutions
Syncova is an established, specialist provider of solutions for the Prime Broker and Hedge Fund markets. Its in-depth experience and knowledge of the business needs and operational requirements of the market have informed the development of a range of innovative solutions that bring real benefits to the Prime Broker and Hedge Fund community.
The OPTIMA range includes OPTIMA/Broker, a market leading Prime Broker Margin Management platform and OPTIMA/Fund which provides a unique tool for Hedge Funds to manage and optimise their leverage and funding costs.
Syncova has a growing global client base and has worked with some of the largest Prime Brokers and Hedge Funds operating across the full spectrum of Alternative Investment and Asset Management. Its Hedge Fund clients on aggregate manage assets in excess of $70 USD billion.
For further information please contact:
Sylvia Mead
Head of Market Communications
Syncova Solutions
Tel: +44 (0) 20 7847 4854
Email: smead@syncova.com

Daiwa Securities SMBC Europe Limited

Daiwa Securities SMBC Europe Limited is a wholly owned subsidiary of Daiwa Securities SMBC Co. Ltd., currently an investment banking joint venture 60% owned by Daiwa Securities Group Inc. and 40% by Sumitomo Mitsui Financial Group Inc. On January 1st 2010 it will become fully owned by Daiwa Securities Group Inc and be renamed Daiwa Capital Markets.

Daiwa Securities SMBC Europe Limited offers a wide range of services from its main business areas:

• Equity
• Fixed Income
• Derivatives
• Debt & Equity Capital Markets
• M&A and other Corporate Finance advisory services are provided in Europe by our subsidiary, Close Brothers Corporate Finance

For further information please contact:
Paul Lyon

Director, Daiwa Securities SMBC Europe Limited
Head of Communication & Marketing
Tel: +44 (0)20 7597 8109
Email: paul.lyon@daiwasmbc.co.uk

Press Release Contact Details:

Sylvia Mead Head of Market Communications Syncova Solutions Tel: +44 (0) 20 7847 4854 Email: smead@syncova.com

BOSTON–(BUSINESS WIRE)– As hedge fund managers look forward to coping with expected tighter regulation and reporting requirements of the Obama Administration, they should be prepared to collect and extract much of the same client and investment data that traditional asset management firms now furnish to the Securities and Exchange Commission, according to Boston-based consultant Jane M. Stabile.

Constant pressure to keep costs low while producing high-quality compliance reports has made large asset managers adept at data sourcing, storage and retrieval. Hedge fund managers would do well to develop similar skills and techniques, which should not be difficult or expensive if done systematically, maintains Stabile, principal of IMP Consulting.

Large firms mine compliance-related data from several sources, including order management systems, custodians, portfolio/accounting systems, and the market. Their annual reviews ensure that they employ to full advantage the information and systems they already have, thereby avoiding duplication of effort and excessive data vendor fees.

Hedge fund managers tend to focus on gain/loss and profitability, but much of the same information they use for assessing funds and making trading decisions can be redeployed to produce the reports that the SEC will likely require under new laws such as the Hedge Fund Transparency Act of 2009. Maintaining complete client records and protecting confidentiality will remain critical requirements as well.

Most of the systems already in place at hedge funds can be upgraded and augmented to meet these new demands satisfactorily, said Stabile in assessing the major points of the U.S. Treasury Department’s recently published report, Financial Regulatory Reform, A New Foundation. Hedge funds will soon have to register with the SEC and begin collecting, mining, and reporting on information in much the same way that larger firms have done for several years.

“One clear and recurring theme of The Treasury’s report is the need for more complete and timely information,” she said. “Hedge funds may not have the IT staff or compliance staff of an asset manager with $100 billion under management, but they can still leverage many of the same technologies used by such firms to keep data quality high and costs low.”

“Few financial services firms use their full IT capacities until the market or the government demands it. Hedge funds are going to need higher levels of performance from their systems as the new regulatory regime takes shape. Fortunately, there’s already a lot of available expertise within the industry to help them do it,” concluded Stabile.

Additional examples of probable new regulatory strictures cited by Stabile include:

Stabile will present her data and systems recommendations for hedge funds in the new regulatory environment at the Infovest21 Seminar: Obama Administration/Hedge Fund Regulation on September 21 in New York. Other speakers are attorneys Benjamin Haskin of Willkie Farr & Gallagher; Lance Friedler of Sadis & Goldberg; and CPA Marty Lax of McGladrey & Pullen.

IMP Consulting exhibited at Technology Solutions for Asset Management (TSAM 2009) in Jersey City, NJ on September 17th. The company’s new white paper on Entity Risk is available on request by emailing info@impconsults.com.

About IMP Consulting

IMP Consulting is a boutique firm of investment industry experts – traders, portfolio managers, compliance officers, and operations and IT professionals – established in 2003 to enable asset management firms to derive maximum performance and full potential from investment systems. IMP’s customized solutions include strategic advice; system selection, implementation, integration, and upgrades; order management and execution management systems audit; compliance; and accounting.

Photos/Multimedia Gallery Available: http://www.businesswire.com/cgi-bin/mmg.cgi?eid=6053168&lang=en

Advises Hedge Funds to Draw on Techniques Developed by Large Asset Managers for SEC Compliance

BOSTON–(BUSINESS WIRE)– As hedge fund managers look forward to coping with expected tighter regulation and reporting requirements of the Obama Administration, they should be prepared to collect and extract much of the same client and investment data that traditional asset management firms now furnish to the Securities and Exchange Commission, according to Boston-based consultant Jane M. Stabile.

Constant pressure to keep costs low while producing high-quality compliance reports has made large asset managers adept at data sourcing, storage and retrieval. Hedge fund managers would do well to develop similar skills and techniques, which should not be difficult or expensive if done systematically, maintains Stabile, principal of IMP Consulting.

Large firms mine compliance-related data from several sources, including order management systems, custodians, portfolio/accounting systems, and the market. Their annual reviews ensure that they employ to full advantage the information and systems they already have, thereby avoiding duplication of effort and excessive data vendor fees.

Hedge fund managers tend to focus on gain/loss and profitability, but much of the same information they use for assessing funds and making trading decisions can be redeployed to produce the reports that the SEC will likely require under new laws such as the Hedge Fund Transparency Act of 2009. Maintaining complete client records and protecting confidentiality will remain critical requirements as well.

Most of the systems already in place at hedge funds can be upgraded and augmented to meet these new demands satisfactorily, said Stabile in assessing the major points of the U.S. Treasury Department’s recently published report, Financial Regulatory Reform, A New Foundation. Hedge funds will soon have to register with the SEC and begin collecting, mining, and reporting on information in much the same way that larger firms have done for several years.

“One clear and recurring theme of The Treasury’s report is the need for more complete and timely information,” she said. “Hedge funds may not have the IT staff or compliance staff of an asset manager with $100 billion under management, but they can still leverage many of the same technologies used by such firms to keep data quality high and costs low.”

“Few financial services firms use their full IT capacities until the market or the government demands it. Hedge funds are going to need higher levels of performance from their systems as the new regulatory regime takes shape. Fortunately, there’s already a lot of available expertise within the industry to help them do it,” concluded Stabile.

Additional examples of probable new regulatory strictures cited by Stabile include:

Stabile will present her data and systems recommendations for hedge funds in the new regulatory environment at the Infovest21 Seminar: Obama Administration/Hedge Fund Regulation on September 21 in New York. Other speakers are attorneys Benjamin Haskin of Willkie Farr & Gallagher; Lance Friedler of Sadis & Goldberg; and CPA Marty Lax of McGladrey & Pullen.

IMP Consulting exhibited at Technology Solutions for Asset Management (TSAM 2009) in Jersey City, NJ on September 17th. The company’s new white paper on Entity Risk is available on request by emailing info@impconsults.com.

About IMP Consulting

IMP Consulting is a boutique firm of investment industry experts – traders, portfolio managers, compliance officers, and operations and IT professionals – established in 2003 to enable asset management firms to derive maximum performance and full potential from investment systems. IMP’s customized solutions include strategic advice; system selection, implementation, integration, and upgrades; order management and execution management systems audit; compliance; and accounting.

Press Release Contact Details:

Graber Associates Tom Burke, 617-323-5694 tom@graberassociates.net

Lets say you want to start a hedge fund. Its not that complicated though you would need some tools and processes set up to run your operations. Off course the variety of tools and processes would depend on the your knowledge and complexity of your strategies.

Though a vanilla hedge fund would need at least the following to exist:

1) Disclosure document.

2) A securities license. (Free)

3) Registration with the NFA or SEC, depending on what you are going to trade and the size of your startup.

4) Private Placement Memorandum, Operating Agreement, Subscription Agreement. If you have a lawyer do this for you it will cost about $15-20k.

5) A broker. IB isn’t a Prime Broker, just a broker. A Prime Broker would be someone like GS, MS, MER, and such. These guys feed you research, steer clients to your fund, and if you are really good and swing a big stick you get inside information. I’m not kidding about that.

6) Auditor - allegedly they are suppose to have passed some licensing exam specifically focused on investments - not some one-clown shop located in the sticks (yes I am referring to Madoff, how he got away with his auditors is beyond me). Cost: $5-10k / year.

7) Administrator - you can have someone in house to take care of your IT infrastructure and accounting. You also can outsource that to a hedge fund administrator who would do all that for you.

10) Have a Bloomberg terminal.

11) You must be self sufficiently funded.

12)  You must have A LOT of experience in all four markets ( Equity, Bonds, FX and Commodities ), plus futures and options.

* If you want to manage money for clients who live in California you have to be a Registered Investment Advisor in that state, regardless of the amount of money you are managing. You have to know the specific laws of each state you have a client in. It’s good to work with an attorney who can keep you out of those nets.

** I would say an audited track record became a must it today’s realities.

*** All together start up fees are going to run 75k+/-.

Curtain Raiser

Like any other set of engineering products, software products are also oriented towards the customer. It is either market driven or it drives the market. Customer Satisfaction was the buzzword of the 80’s. Customer Delight is today’s buzzword and Customer Ecstasy is the buzzword of the new millennium. Products that are not customer or user friendly have no place in the market although they are engineered using the best technology. The interface of the product is as crucial as the internal technology of the product.

Market Research

A market study is made to identify a potential customer’s need. This process is also known as market research. Here, the already existing need and the possible and potential needs that are available in a segment of the society are studied carefully. The market study is done based on a lot of assumptions. Assumptions are the crucial factors in the development or inception of a product’s development. Unrealistic assumptions can cause a nosedive in the entire venture. Though assumptions are abstract, there should be a move to develop tangible assumptions to come up with a successful product.

Research and Development

Once the Market Research is carried out, the customer’s need is given to the Research & Development division (R&D) to conceptualize a cost-effective system that could potentially solve the customer’s needs in a manner that is better than the one adopted by the competitors at present. Once the conceptual system is developed and tested in a hypothetical environment, the development team takes control of it. The development team adopts one of the software development methodologies that is given below, develops the proposed system, and gives it to the customer.

The Sales & Marketing division starts selling the software to the available customers and simultaneously works to develop a niche segment that could potentially buy the software. In addition, the division also passes the feedback from the customers to the developers and the R&D division to make possible value additions to the product.

While developing a software, the company outsources the non-core activities to other companies who specialize in those activities. This accelerates the software development process largely. Some companies work on tie-ups to bring out a highly matured product in a short period.

Popular Software Development Models

The following are some basic popular models that are adopted by many software development firms

A. System Development Life Cycle (SDLC) Model
B. Prototyping Model
C. Rapid Application Development Model
D. Component Assembly Model

A. System Development Life Cycle (SDLC) Model

This is also known as Classic Life Cycle Model (or) Linear Sequential Model (or) Waterfall Method. This model has the following activities.

1. System/Information Engineering and Modeling

As software is always of a large system (or business), work begins by establishing the requirements for all system elements and then allocating some subset of these requirements to software. This system view is essential when the software must interface with other elements such as hardware, people and other resources. System is the basic and very critical requirement for the existence of software in any entity. So if the system is not in place, the system should be engineered and put in place. In some cases, to extract the maximum output, the system should be re-engineered and spruced up. Once the ideal system is engineered or tuned, the development team studies the software requirement for the system.

2. Software Requirement Analysis

This process is also known as feasibility study. In this phase, the development team visits the customer and studies their system. They investigate the need for possible software automation in the given system. By the end of the feasibility study, the team furnishes a document that holds the different specific recommendations for the candidate system. It also includes the personnel assignments, costs, project schedule, target dates etc…. The requirement gathering process is intensified and focussed specially on software. To understand the nature of the program(s) to be built, the system engineer or “Analyst” must understand the information domain for the software, as well as required function, behavior, performance and interfacing. The essential purpose of this phase is to find the need and to define the problem that needs to be solved .

3. System Analysis and Design

In this phase, the software development process, the software’s overall structure and its nuances are defined. In terms of the client/server technology, the number of tiers needed for the package architecture, the database design, the data structure design etc… are all defined in this phase. A software development model is thus created. Analysis and Design are very crucial in the whole development cycle. Any glitch in the design phase could be very expensive to solve in the later stage of the software development. Much care is taken during this phase. The logical system of the product is developed in this phase.

4. Code Generation

The design must be translated into a machine-readable form. The code generation step performs this task. If the design is performed in a detailed manner, code generation can be accomplished without much complication. Programming tools like compilers, interpreters, debuggers etc… are used to generate the code. Different high level programming languages like C, C++, Pascal, Java are used for coding. With respect to the type of application, the right programming language is chosen.

5. Testing

Once the code is generated, the software program testing begins. Different testing methodologies are available to unravel the bugs that were committed during the previous phases. Different testing tools and methodologies are already available. Some companies build their own testing tools that are tailor made for their own development operations.

6. Maintenance

The software will definitely undergo change once it is delivered to the customer. There can be many reasons for this change to occur. Change could happen because of some unexpected input values into the system. In addition, the changes in the system could directly affect the software operations. The software should be developed to accommodate changes that could happen during the post implementation period.

B. Prototyping Model

This is a cyclic version of the linear model. In this model, once the requirement analysis is done and the design for a prototype is made, the development process gets started. Once the prototype is created, it is given to the customer for evaluation. The customer tests the package and gives his/her feed back to the developer who refines the product according to the customer’s exact expectation. After a finite number of iterations, the final software package is given to the customer. In this methodology, the software is evolved as a result of periodic shuttling of information between the customer and developer. This is the most popular development model in the contemporary IT industry. Most of the successful software products have been developed using this model - as it is very difficult (even for a whiz kid!) to comprehend all the requirements of a customer in one shot. There are many variations of this model skewed with respect to the project management styles of the companies. New versions of a software product evolve as a result of prototyping.

C. Rapid Application Development (RAD) Model

The RAD modelis a linear sequential software development process that emphasizes an extremely short development cycle. The RAD model is a “high speed” adaptation of the linear sequential model in which rapid development is achieved by using a component-based construction approach. Used primarily for information systems applications, the RAD approach encompasses the following phases:

1. Business modeling

The information flow among business functions is modeled in a way that answers the following questions:

What information drives the business process?
What information is generated?
Who generates it?
Where does the information go?
Who processes it?

2. Data modeling

The information flow defined as part of the business modeling phase is refined into a set of data objects that are needed to support the business. The characteristic (called attributes) of each object is identified and the relationships between these objects are defined.

3. Process modeling

The data objects defined in the data-modeling phase are transformed to achieve the information flow necessary to implement a business function. Processing the descriptions are created for adding, modifying, deleting, or retrieving a data object.

4. Application generation

The RAD model assumes the use of the RAD tools like VB, VC++, Delphi etc… rather than creating software using conventional third generation programming languages. The RAD model works to reuse existing program components (when possible) or create reusable components (when necessary). In all cases, automated tools are used to facilitate construction of the software.

5. Testing and turnover

Since the RAD process emphasizes reuse, many of the program components have already been tested. This minimizes the testing and development time.

D. Component Assembly Model

Object technologies provide the technical framework for a component-based process model for software engineering. The object oriented paradigm emphasizes the creation of classes that encapsulate both data and the algorithm that are used to manipulate the data. If properly designed and implemented, object oriented classes are reusable across different applicationsand computer based system architectures. Component Assembly Model leads to software reusability. The integration/assembly of the already existing software components accelerate the development process. Nowadays many component libraries are available on the Internet. If the right components are chosen, the integration aspect is made much simpler.

Conclusion

All these different software development models have their own advantages and disadvantages. Nevertheless, in the contemporary commercial software evelopment world, the fusion of all these methodologies is incorporated. Timing is very crucial in software development. If a delay happens in the development phase, the market could be taken over by the competitor. Also if a ‘bug’ filled product is launched in a short period of time (quicker than the competitors), it may affect the reputation of the company. So, there should be a tradeoff between the development time and the quality of the product. Customers don’t expect a bug free product but they expect a user-friendly product. That results in Customer Ecstasy!

I saw an estimate of average yearly software related costs of a hedge fund with about 300 mln under management:

Statistical Software Licencse Fees - $30,000

Data Feeds - $80,000

Back Office Software (accounting, CRM, etc) - $50,000

Total Comes up to about: $160,000 / year

Interactive Brokers.

Patsystems.

IQ Feed.

eSignal.

SmartQuant.

Genesis.

tick-TS TradeBase.

Trading Technologies.

MetaTrader.

FXCM.

FIX Connectivity.

The environment that nutures creative programmers kills management and marketing types - and vice versa. Programming is the Great Game. It consumes you, body and soul. When you’re caught up in it, nothing else matters. When you emerge into daylight, you might well discover that you’re a hundred pounds overweight, your underwear is older than the average first grader, and judging from the number of pizza boxes lying around, it must be spring already. But you don’t care, because your program runs, and the code is fast and clever and tight. You won. You’re aware that some people think you’re a nerd. So what? They’re not players. They’ve never jousted with Windows or gone hand to hand with DOS. To them C++ is a decent grade, almost a B - not a language. They barely exist. Like soldiers or artists, you don’t care about the opinions of civilians. You’re building something intricate and fine. They’ll never understand it.

BEEKEEPING

Here’s the secret that every successful software company is based on: You can domesticate programmers the way beekeepers tame bees. You can’t exactly communicate with them, but you can get them to swarm in one place and when they’re not looking, you can carry off the honey. You keep these bees from stinging by paying them money. More money than they know what to do with. But that’s less than you might think. You see, all these programmers keep hearing their parents’ voices in their heads saying “When are you going to join the real world?” All you have to pay them is enough money that they can answer (also in their heads) “Geez, Dad, I’m making more than you.” On average, this is cheap. And you get them to stay in the hive by giving them other coders to swarm with. The only person whose praise matters is another programmer. Less-talented programmers will idolize them; evenly matched ones will challenge and goad one another; and if you want to get a good swarm, you make sure that you have at least one certified genius coder that they can all look up to, even if he glances at other people’s code only long enough to sneer at it. He’s a Player, thinks the junior programmer. He looked at my code. That is enough. If a software company provides such a hive, the coders will give up sleep, love, health, and clean laundry, while the company keeps the bulk of the money.

OUT OF CONTROL

Here’s the problem that ends up killing company after company. All successful software companies had, as their dominant personality, a leader who nurtured programmers. But no company can keep such a leader forever. Either he cashes out, or he brings in management types who end up driving him out, or he changes and becomes a management type himself. One way or another, marketers get control. But…control of what? Instead of finding assembly lines of productive workers, they quickly discover that their product is produced by utterly unpredictable, uncooperative, disobedient, and worst of all, unattractive people who resist all attempts at management. Put them on a time clock, dress them in suits, and they become sullen and start sabotaging the product. Worst of all, you can sense that they are making fun of you with every word they say.

SMOKED OUT

The shock is greater for the coder, though. He suddenly finds that alien creatures control his life. Meetings, Schedules, Reports. And now someone demands that he PLAN all his programming and then stick to the plan, never improving, never tweaking, and never, never touching some other team’s code. The lousy young programmer who once worshiped him is now his tyrannical boss, a position he got because he played golf with some sphincter in a suit. The hive has been ruined. The best coders leave. And the marketers, comfortable now because they’re surrounded by power neckties and they have things under control, are baffled that each new iteration of their software loses market share as the code bloats and the bugs proliferate. Got to get some better packaging. Yeah, that’s it.

In the light of the latest events in the world economy, financial crisis and the role of the hedge fund industry in it I am writing this paper on the topic hedge fund disclosure of their risk information.

The last two decades experienced a real boom in the hedge fund market, which grew from approximately $500 billion in 2000 to the estimated over $2 trillion as of 2008 (Lo, 2000, p.1, Rummel, 2008). Investopedia defines hedge fund as an “aggressively managed portfolio of investments that uses advanced investment strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns” (Investopedia). An important feature of hedge funds, which commonly separates it from other investment vehicles, such as mutual funds for instance, is that they are very loosely regulated in terms of money allocations. As a result, despite the fact that hedge funds normally disclose their strategies, the risk associated with the investments is almost never known to the public. Such a policy of nondisclosure of risks associated with the investors’ money is unacceptable and hedge funds should fully disclose all risk information regarding their portfolio allocations to the public.

Hedge funds have always represented a lucrative form of investment for sophisticated money holders as double and triple digit returns in the unprecedented bullish market in the late 1990s created a true euphoria regarding hedge funds as new forms of fixed asset allocation (Lo, 2000, p.1). However, the Long Term Capital Management’s (LTCM) multi-billion dollar crash in 1998 which caused a significant market debacle, in financial markets proved that hedge funds did not represent a risk-free investment. In his speech at the Federal Reserve Bank of Atlanta in May 2006, Chairman Bernanke mentioned that the collapse of LTCM “precipitated the first in-depth assessment by policymakers of the potential systemic risks posed by the burgeoning hedge fund industry.” The more recent collapse of the two multi-billion dollar Bear Stearns hedge funds once again confirmed the fact that hedge funds are quite often take too much risk in their investments.

The current situation with the transparency of hedge markets is based on the Securities Act of 1933 and the Company Investment Act of 1940. According to the Securities Act, hedge funds are sold as private investments and, thus, any information regarding them is not subject to public scrutiny (Securities Act, 1933). At the same time Company investment Act of 1940 grants hedge funds a special status under which they can operate under more loose conditions than other funds (Company investment Act, 1940). Thus, legally, hedge funds are much less regulated by the government agencies and are able to undertake riskier investment strategies. Government’s attempt to monitor hedge funds’ activities in the beginning of the century was challenged in the court and in July 2006 the case was overturned by the court of appeals (Goldstein vs. SEC, 2006).

Nevertheless the excessive risk parameter that is involved in mutual funds’ money allocation is quite often beyond any reasonable limits. The Working Group assigned by the Federal Reserve Commission stated that a new regulation environment should be fostered in order to limit extreme leverage and risk taking by hedge funds (Bernanke, 2006). There are several major reasons from the investor’s point of view why hedge funds should disclose risk information regarding risks involved in their strategies.

First of all, hedge funds, as any other investment vehicles, should realize to the full extent the risks involved with the market exposure of each particular investment or manager. All these risks should be aligned with the fund’s overall strategy in the market openly declared and available for public review. At present, this is far from being the reality with the hedge funds. Oftentimes, separate trades in the funds are taking on very risky positions attempting to gain on total fund’s leverage. Most of the times, investors have no idea what is going on, even if the overall report regarding hedge fund activities is available to them. In 2006, Amaranth hedge fund collapsed asserting $6 billion losses due to natural gas speculations: one specific kind of trade that was too excessive (Rummel, 2008).

Another reason for public risk disclosure lies in the fact that there is a certain proportion of risk-return that each investor is comfortable with. Most of the hedge funds are providing results of their performances based only on the return they provide, while the risk taken in order to provide these returns is quite often beyond the acceptable range of the investors in the fund. Such an approach inevitably leads to higher risk exposures and highly leveraged allocations which would oftentimes be unacceptable in the ordinary equity or fixed income market. LTCM had the highest disproportion of real assets and obligations in 1998. The level of risks undertaken by the fund was oftentimes several times higher the acceptable return, what in the end resulted in a cascade margin calls from the creditors which were nothing to cover with (Coy and Woolley, 1998). Despite the fact that current hedge funds are not operating under such leverages as LTCM, the degree of risk-return is estimated to be much higher than in other types of investments.

Finally, as Lo (2006) put it, hedge funds, as institutions require “stability, and consistency in a well-defined investment process that is institutionalized, and not dependent on any single individual” (p.2). In other words, the complete risk assessment should not only be derived from individuals’ (management’s) prospective. Quite often investment strategies undertaken by hedge funds ignore potential requirements of the investors for steady and reliable returns on their money. This goal is going to the second plan while the short-term profit chase ensues. Thus, the very aspect of relative investment stability is undermined from the investors’ prospective, while hedge fund managers are free to play with the investments at their own preferences. Such inconsistency between the goals of management and investors’ intentions would not be possible should investors have the risk information prior to their investments. On the other hand, this, obviously, would result in the loss of a significant part of potential depositors in the hedge fund, which is the last thing hedge fund managers would like to see.

Risk disclosure for the hedge funds is not the issue that has only proponents of the idea. There are, as a matter of fact, many professionals in the financial area who believe that regulations requiring hedge fund risk disclosure cannot help the situation and, therefore, should not be adopted. For instance, Matthew Lynn, the head of a hedge fund based in London, argued that disclosure of risk information would be detrimental to the very existence of hedge funds as investment entities (Lynn, 2007). His main arguments against detailed risk disclosure are based on the facts that: a) risk parameters for hedge funds are central to its line of business (the same as formula for Coca Cola); b) disclosure of risk would undermine some strategies of the hedge funds such as secret buyout of securities; c) up to this point, hedge funds have not made markets unstable under current conditions and imposing extra limitations on them would suppress innovation and mobility (Lynn, 2007). However, there are counterarguments to all these statements.

It is inappropriate to claim that risk parameters are of the same value to hedge funds based on the same notion of comparison to the other companies’ core products or services. Rather, it is more appropriate to compare them to the company’s financial statements, which help investors determine whether the company is worth investing to. After all, risk disclosure does not require hedge funds to disclose their structure of operations or provide detailed list of investments. Secondly, secret buyouts of the securities could not be significantly affected by risk disclosures since they are going to be revealed only in the end of the certain period. Therefore, it would be impossible to recognize any buyouts conducted by the hedge fund until that time. Finally, the claim that hedge funds did not cause any market disruptions is simply absurd: in 1998 the Government had to create a special bailout Commission to guarantee LTCM astronomical obligations which threatened to send negative ripples throughout the entire financial system (Coy, Wooley, 2007). The same thing happened in 2007 with the Bear Stearns hedge funds. Almost every time a large hedge fund collapses, the interconnected financial structure of the market is at risk, and, if the level of this interconnection is fairly high, the government has to step in. Therefore, hedge funds do cause significant market disruptions, which are the direct consequence of their credit risk policies.

Hedge funds’ risk transparency has been on the issue since the late 1990’s when the first major collapse of a hedge fund occurred and threatened to bring the entire financial system to a halt. Despite certain steps undertaken by the government agencies towards transparency in hedge funds risk exposures, the situation is still far from being settled. Nevertheless, each time a hedge fund goes down due to unjustified high risk exposure, it takes down the investments of many stakeholders who would not invest in the fund had they enough information regarding its risk-return ratio. A possible regulation requiring hedge funds disclose their risk involvement would not turn away the aggressive investors who are willing to take additional risk for a higher return possibility. At the same time it would ensure that those who are not willing to take on such a risk are protected from the failures that the current system yields. Therefore, legislators should devise a special regulatory framework that would make hedge funds reveal their risk parameters.

References

Bernanke, B. S. (2006, May 16). Hedge Funds and Systemic Risk. Speech at the Federal      Reserve Bank of Atlanta’s 2006 Financial Markets Conference, Sea Island, Georgia    Retrieved March 15, 2008 from http://www.bis.org/review/r060522a.pdf

Coy, P. & Wooley, S. (1998). Failed Wizards of Wall Street. Business Week Online. Retrieved           March 15, 2008 from http://www.businessweek.com/1998/38/b3596001.htm

Goldstein vs. SEC. (2006). Retrieved March 30, 2008 from     http://www.seclaw.com/docs/ref/GoldsteinSEC04-1434.pdf

Lo, A. W. (2000). Risk Management for Hedge Funds: Introduction and Overview. Retrieved        March 10, 2008 from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=283308

Lynn, M. (2007, October 17). Hedge Funds Can’t Reveal Secrets and Do Business: Matthew   Lynn. Bloomberg. Retrieved March 30, 2008 from            http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aABI8tRBTVkU

Rummell, N. (2008, February 25). GAO: Hedge funds have improved disclosure, but concerns             still exist. Financial Week. Retrieved March 10, 2008 from             http://www.financialweek.com/apps/pbcs.dll/article?AID=/20080225/REG/33290841/10         36

Hedge Fund Definition. Retrieved March 30, 2008 from            http://www.investopedia.com/terms/h/hedgefund.asp

University of Cincinnati. General Rules and Regulations Promulgated under the Securities Act         of 1933. Retrieved March 30, 2008 from   http://www.law.uc.edu/CCL/33ActRls/rule501.html

Fung, W. & Hsieh, D. A. (2005). The Risk in Hedge Fund Strategies: Theory and Evidence from    Long/Short Equity Hedge Funds. Retrieved March 5, 2008 from http://finance.wharton.upenn.edu/~rlwctr/DHsieh.pdf

A very good paper on different types of risks involved in certain hedge fund strategies is written by two professors specializing in hedge funds and (Duke and London School). A number of other scholars provided great primary statistical data for the paper as well.

Jagannathan, R., Malakhov, A., Novikov D. (2006, January). Do Hot Hands Persist among   Hedge Fund? Retrieved March 5, 2008 from     http://www.usc.edu/schools/business/FBE/seminars/papers/F_10-6-06_JAGANN-            HedgeFund.pdf
The paper contains a hand-on empirical evaluation of personal factors driving hedge funds’ decisions. Peer-reviewed and presented at the USC Financial seminar.

Ding, B., Getmansky, M., Liang, B., Wermers, R. (2006, November). Market Volatility, Investor      Flows, and the Structure of Hedge Fund Markets. Retrieved March 5, 2008 from             http://www.isenberg.umass.edu/finopmgt/uploads/basicContentWidget/15365/Getmansky%20paper.pdf