Multi-asset Portfolio Systems: Serving the Growth of Hedge Funds
Even if buy-side firms are not currently engaged in a high volume of over-the-counter (OTC) trades, they are aware that further down the road a change may take hold. To that end, buy-side firms are querying technology vendors on the solutions’ current and future derivative processing capabilities.
The Bank for International Settlements reported that trading of OTC derivatives reached US$415 trillion at the end of December 2006. Clearly, sell-side firms and hedge funds are already very familiar with these instruments, and the traditional money manager will become more so in the coming years.
Headline-making news on derivatives and the role of hedge funds will continue. Although some firms may pull back in light of the current credit crisis, over the long haul derivatives are an important option to money managers. Market participants will carve out their participation successfully based upon their ability to assess risk.
Keep in mind that there are different uses of derivatives and a great variety of instruments. They are helpful risk management tools, in addition to good investor tools. A wide variety of financial institutions and money managers are utilising derivatives as shown in the following table.
In spite of its gaining popularity, the derivatives market has issues that must be addressed. Structurally, it needs better transparency and more automated processing and monitoring, particularly because these contracts are complex, multi-party and, at times, frequently traded. Already, a field of technology providers is coming to the challenge to serve the post-trade/pre-settlement environment. Vendors inching us forward to derivatives automation include Markit Group, T:Zero, Smartstream, Thomson, Misys, Traiana and others.
Since the derivatives market is not standardised, buy-side firms must consider additional technology, staffing and back-office operational processes to cope with derivatives. Many hedge funds, particularly small ones, rely on prime brokers and hedge fund administrators for derivatives support.
However, for those wishing to build an internal technology framework, the core infrastructure for any firm that manages investment assets is a portfolio system. ‘Portfolio system’ is the most general term used for this infrastructure, but this type of technology goes by other names such as a ‘portfolio management and accounting system’ and ‘integrated portfolio suite’. The varying names stem from the technology’s evolution in this business.
Originally, in the mid-1980s, core infrastructure for money management was purely a portfolio accounting system. It acted as the investment managers’ books and records for client accounts. Over time, capabilities expanded to include portfolio management, reporting, performance measurement, portfolio rebalancing, trade compliance, reconciliation, electronic trading, and more. Now, a portfolio system is most typically, and ideally, a single database solution with fully integrated components that serve nearly every functional area of an investment firm.
Today, vendors in this sector offer integrated suites that serve the front-, middle- and back-office needs of asset managers, as shown in the figure below.
The global portfolio systems market, which supports all types of asset management firms, had approximately US$2.32bn in assets as of year-end 2006 and is expected to reach US$2.67bn in by 2010; an annualised growth rate of 2.8%.
True to form and history these systems continue to expand. The latest areas include OTC derivatives processing, advanced risk analysis, and instrument valuation modeling. The vendors supplying this functionality today are crossover vendors from the broker-dealer and banking market.
Crossover vendors dominate the multi-asset portfolio systems segment, and include Calypso, Murex, SunGard Front Arena, FNX Capital Markets Solutions, Imagine Software, OpenLink Financial and Sophis, to name a few. These leading vendors have made a name for themselves handling the over-the-counter derivatives market. Historically, these firms focused on the brokerage, banking and commodities businesses, and today are transitioning into the buy-side area primarily by way of the hedge fund community.
Over time, expect convergence in the marketplace. Portfolio system vendors that serve the traditional market will enhance their solutions with derivative valuation and risk functionality either through development, acquisition or partnership. The competitive landscape is such that everyone must keep up to stay in the game. In order to meet client requirements, vendors must identify and perfect what they do best, and partner where their experience or deadlines do not align with the market’s best practices.
Our globe continues to shrink as connectivity mushrooms. In the world of core investment operations, the increasing market complexity in trading, data and its management, derivatives processing and valuation means systems must be open so clients can extract any data elements and return new inputs. Solutions must be architecturally open and counterparty neutral. Solutions must also be capable of connecting to other services, counterparties, and third-party solutions that a changing market environment requires; all with as much speed, dexterity and accuracy as possible.
Buyers of multi-asset portfolio systems will look for vendors that understand their business and operational workflow. Firms will be loyal to existing vendors and initially patient with work-around. But eventually, the investment demands will dictate action.
Hedge fund firms, like other firms, make trade-offs. Today, comprehensive systems take time to implement and the vendors are newer to providing implementation support. Many large hedge fund firms have had to make their way independently in implementations. This has caused setbacks for vendors who may otherwise have accumulated even larger numbers of new clients.
Additionally, the influx of investment operational outsourcing providers in the form of hedge fund administrators is creating additional options for firms. For others, application service provider (ASP) implementations are providing quick implementations at lower costs.
The evolution of the portfolio systems technology market is a step-by-step approach. Innovations occur in the market – for example, the trade order management system – and after the market settles on standards, portfolio system providers integrate the functionality as a new module. The integration will occur either through acquisition of the innovator or proprietary development. Initially some firms may formally partner to provide a tightly integrated solution. Eventually, OTC derivative handling and advanced risk analytics and valuation will become a mainstream offering.
The arrival of crossover vendors from other sectors and vendors moving across international borders has the potential to change the competitive landscape of leading providers. It also has the potential to further advance solution functionality due to a more diverse client base. As competition takes hold, rivalries may speed development and ultimately benefit clients with a better product. These are the benign or positive aspects.
The portfolio systems market is anything but dull, and the replacement market for portfolio systems will continue to be active. From the challenges perspective, technology vendor consolidations and private equity money (which does not generally represent long-term investors) could have implications for clients. Over the longer term, fewer providers could mean less competitive pricing for clients. Larger firms often have difficulty reinventing themselves or reinvigorating products. And finally, changes in vendor ownership may create disruptions for clients in servicing and solution development prioritisation.