As regulators become much more aggressive about detecting financial risks in the global system and seek visibility into investment returns, hedge funds are facing intense scrutiny and multiple requests for their data. Shocked by the Bernard Madoff scandal, investors and advisers are also demanding more transparency into private funds' financial results, their technology and their governance.
As a result, once-secretive hedge funds find themselves besieged by new requirements for collecting data, calculating risks, financial reporting and records retention. Many of these business processes are new for these funds, and they will need to file reports with multiple regulators in the United States and overseas, depending on which securities or derivatives they trade.
The proliferation of regulations has put pressure on hedge funds not only to collect data on their investments, but to produce risk metrics on their credit and counterparty risks.
Some of the largest hedge funds have already begun to comply under Dodd-Frank with Form PF from the Securities and Exchange Commission. But several other regulatory-driven reporting rules are in the pipeline.
"It's the dawn of a new era for the alternative industry," says Jayesh Punater, CEO of Gravitas, an outsourcing provider of technology, risk analytics and investment research for hedge funds, alternative funds and private equity firms.
The new push for transparency is also a reaction to the financial crisis in 2008 as well as the Madoff Ponzi scheme. "Prior to that, transparency and risk analytics and governance were not in vogue," says Ranjan Bhaduri, chief research officer at AlphaMetrix Group, a Chicago-based open architecture platform that provides transparency for institutional and high-net-worth investors into nearly 200 hedge funds.
However, this is also happening because the alternative investment industry is maturing, says Punater. Institutional investors, including pension funds and endowment funds, are embracing the industry like never before, he says. The demand for transparency is coming from investors; advisers to investors, including fund of funds; consulting firms; and the regulators.
"They're saying we need more transparency, more reporting. We need to understand your risk profile. This in turn is creating a big need around data management," explains Punater. But one of the biggest issues this industry faces is creating scale in terms of expanding their technology capacity to handle growth in new clients, assets under management, geographies, new products and strategies. "They need to scale differently than the sell side because they don't have unlimited resources," he says.
While data management used to be more a humdrum activity, hedge funds are looking at dealing with data as a critical issue within their business model. It's not only defensive from a risk and reporting angle, but it can be offensive from the ability to help generate alpha, says Punater. By maintaining proprietary data on an investment theme, management of front-office data is seen as key to investment returns and can yield a competitive advantage, says Gravitas' CEO. The defensive part involves producing reports on performance and concentration risk, which hedge funds must do to cater to both investors and regulators.
However, many hedge funds are still wrestling with the data and reporting requirements of Dodd-Frank's Form PF, which stands for private funds and applies to SEC-registered investment advisers. "It's a massive data aggregation process," says Hannah Correll, a director at Advise Technologies, a software-solutions provider for global regulatory compliance. "That said, there are a number of interpretations in the process as well."
"Some of the data has to be aggregated, so not only are customers pulling data from their administrators, counterparty questions, borrowings, etc., they're really having to go to multiple sources to collect this data," Correll says. Some funds have hired risk management vendors to help them with risk calculations, she adds, citing RiskMetrics as an example. When a customer has mutual clients, RiskMetrics is able to give clients a data file that feeds seamlessly into Advise's Consensus RMS. Some hedge funds are grappling with the challenge of dealing correctly with tons of data, because they have never before dealt with massive amounts of data for reporting purposes.
"Technology, transparency and risk go hand in hand," says AlphaMetrix's Bhaduri. However, transparency can lead to information overload, he cautions. "You really need to have technology that synthesizes information in an intelligent way," he says. AlphaMetrix takes daily files from the prime brokers of the hedge funds, which it then reconciles against what the hedge funds' records show was traded. "It's trust but verify," explains Bhaduri, who sees the new push toward transparency, risk monitoring and risk analytics as a reaction to what happened with the Madoff fraud. For example, his firm maintains a 24-hour risk desk to monitor hedge fund trading.
AlphaMetrix feeds that data into its risk system, he says, noting that risk analytics and risk reporting are all about data integrity. To prevent a Madoff-type fraud, AlphaMetrix is seeing all of a fund's positions and making sure that the trades are congruent to what they're supposed to do, he says. The firm has a suite of statistical metrics that it applies. But the analytics can also be as simple as "counting contracts," he says.
So what types of data do hedge funds need? According to Gravitas' Punater, hedge funds need to organize three types of data: investment data, which includes their own positions; client data; and their own company data, which could be all the companies they would consider investing in as well as market data on those companies. This could be for equities or credit derivatives, if they are investing in illiquid instruments. All of this data can approach terabytes in size, he says.
"A big part of running a risk system is data management," concurs Kirk Wylie, CEO atOpenGamma, an open source risk management and analytics platform that caters to hedge funds. A big part of how firms set up their risk environments is making sure they have the right data processes and that the data is free of mistakes, he says. "It really is a case of garbage in and garbage out," says Wylie. For instance, a lot of the data is from their portfolios, he says. Firms must reconcile their positions with their counterparties to make sure they have the right trade details. "To meet the risk requirements, they have to maintain their own data to a suitable standard," Wylie says.
In addition to internal data and data from counterparties, there is a lot of data that has to be purchased. For instance, securities reference data, such as the coupon of a bond and maturity, is important. Funds will also need to purchase other historical data, real-time data and holiday data, notes Wylie. Very often, up to 50% of hedge funds' annual technology spend can just be on data, he says.
Outsourcing Or Co-Sourcing To save costs and comply with regulations and meet investor requests, many hedge funds are turning to outsourcing providers. "What they're finding is that the old models where they would just hire all the people and model all the technology doesn't work because it's too expensive," says Punater.
Instead, firms are looking to service providers that can manage their data and applications on a private cloud. Those not comfortable giving their data to an Amazon or Google prefer to work with a private cloud company that specializes in apps, systems and data, Punater says. Rather than spending hundreds of thousands of dollars on their own data centers, many private cloud providers that specialize in financial services offer integration of hardware, software and managed service levels. Gravitas offers these types of services. "It's a utility we manage for them. They can scale up or down," says Punater. "The trend is to move into a cloud environment so it's accessible 24/7 and maintained by a service-level agreement." For a flat fee, clients of Gravitas receive the data center, unlimited support and maintenance of their computing environments, notes Punater.
A second approach, known as co-sourcing, allows a firm to access, for example, risk technology, market data, a risk analyst, and some data warehousing and reporting technology, all bundled as a service. Gravitas provides this type of service with Algorithmics, providing clients with customized risk software and dedicated reporting.
To deliver its co-sourcing service, Gravitas is working with a team of risk analysts in Mumbai, India, who help clients solve their problems. Gravitas' risk analysts use IBM Algorithmic software and data as a basis for risk analytics and reporting. Their ability to normalize and analyze aggregate data from multiple sources is seen as a key benefit to using the risk services. A hedge fund with $1 billion to $5 billion in assets can save 30% to 50% on the cost structure, depending on fund complexity, Punater says.
Meanwhile, some technology providers are developing applications that may make it easier for hedge funds to comply with the steady stream of government regulations and investor requests for transparency. In 2012, Imagine Software, a provider of portfolio and risk analytics, built a platform, similar to Apple's iTunes, that lets Imagine, its clients and other third parties around the world build apps that can be extended to users' desktops or mobile devices. One such app enables hedge funds to comply with a new short sale position rule required by the European Securities and Markets Authority.
Standardized Risk Calculation
Another wrinkle for hedge funds is that many investors, confused by various ways to calculate risk, are pressuring hedge funds to use a standard methodology for their risk calculations. Some investors are supporting an industry initiative, known as the Open Protocol Enabling Risk Aggregation standard, that will enable hedge funds to report their risk numbers in the same way. The project -- backed by an industry consortium whose leaders are Albourne Partners and Thomson Reuters -- standardizes reporting procedures for collection, collation and conveying hedge fund risk information, according to its website.
"The idea there is around data and consistency and also to help investors [in hedge funds] to aggregate their risks," says Steven Harrison, president and COO of Imagine, which built an app to support the Open Protocol. "Once clients put their portfolios in Imagine, we take that data and massage it into a format that is in line with the new reporting standards."
Meanwhile the list of regulations seeking information from hedge funds keeps growing. "The forms that exist or are in the process of being finalized show that regulation is not going away," says Correll of Advise Technologies. "It's been a burden for hedge funds until they can streamline the process," she says, adding, "Hopefully, their alpha generation won't be affected while they fill out these forms."
Top Regulatory Hurdles for Hedge Funds
Global regulatory bodies are issuing a slew of new regulations that require hedge funds to collect data from multiple parties, normalize it and report risk exposures.
Mandated under Dodd-Frank, hedge funds that are registered as investment advisers are required to file Form PF for private funds with the SEC. It asks for data on positions, liquidity and credit counterparty risk. Large hedge funds (with $5 billion and up in regulatory assets under management) filed last summer. Fund managers with $1.5 billion in RAUM have to file by March 1, 2013. Those with $150 million to $1.5 billion have a deadline later this year.
-- The Commodity Futures Trading Commission and the National Futures Association proposed a new reporting form for commodity pool operators and commodity trading advisers.
-- Hedge funds are bracing for reporting requirements from the EU's Directive on Alternative Investment Fund Managers.
-- The European Securities and Markets Authority will require short position reporting for hedge funds.
-- The EU regulation Undertakings for Collective Investment in Transferable Securities, known as UCITS IV, requires risk reporting such as value at risk to protect investors and detect systemic risk.