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The New Challenge for Hedge Funds: Operational Excellence

January 28, 2013 by Simon Bartletta, Heather Lord, and Brent Beardsley
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  • Institutional investors are demanding that solid returns be accompanied by a robust operating model and a lower overall risk profile.

  • Having a world class operating model will increasingly become a source of competitive advantage.

  • Hedge funds that are willing to define their vision and cascade that vision into a scalable and flexible operating model will be best equipped to handle changing market and investor dynamics.

 

In early 2012, hedge fund assets under management (AuM) surpassed $2 trillion globally, exceeding for the first time the precrisis peak of $1.9 trillion observed in late 2007. Institutional investors seeking absolute returns have been the primary drivers of this growth. Compound annual growth rates of around 15 percent are expected though 2015, lifting hedge fund AuM to about $3.3 trillion. Moreover, convergence is expected to take hold, putting hedge fund managers and traditional asset managers in competition for the same pool of assets.

The shift of the hedge fund investor base toward institutions, combined with recent regulatory changes, has had some notable consequences: investors are expecting their hedge funds to bring to the table higher levels of transparency, lower levels of operational risk, less complexity, and strong reputations. Operational due diligences are increasingly becoming the norm among institutional investors.

It is against this backdrop that the hedge fund industry has reached an inflection point. Indeed, as the alternative-investments industry matures and becomes more competitive, consistent returns will no longer suffice. Investors are demanding that solid returns be accompanied by a robust operating model and a lower overall risk profile. A world class operating model will become a source of competitive advantage.

Of course, hedge fund managers can pursue this goal in many ways, including investing in world class core infrastructure, adopting solutions based on application service providers, making use of prime-brokerage relationships, and outsourcing aggressively. There is no one-size-fits-all solution for better operational performance and a brighter future. Yet the key challenge that most hedge funds face today is creating an operating model that is aligned with the fund’s strategic vision and flexible enough to enable the front office to evolve along critical dimensions. These dimensions include AuM growth, asset class mix, trading strategy, trading volume, investment vehicles (such as separately managed accounts, or SMAs), products (such as 40-Act and UCITS), and geographic expansion.

Fortunately, there are steps that hedge funds can take to build such an operating model and put themselves on a strong, positive trajectory. But first, it is important to understand how the industry has evolved in recent years.

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