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The Hidden Alpha Hedge Funds are Missing

Optimizing operational efficiency and collateral and cash management can be significant competitive differentiators.

As featured in Institutional Investor

Investors had been demonstrating an increased desire for alternative investments for years prior to the onset of the COVID-19 pandemic, yet the outlook for high-priced hedge funds to deliver serious alpha in the long bull market was not brilliant. However, the seemingly sudden onset of market dislocation, economic crisis, and wild volatility swings brought about by the pandemic created a prime environment for hedge funds to shine. Whether they were ready to seize the moment depended to some degree on their operational efficiency.

“In volatile markets like we had in March, you just didn’t know where liquidity was going or the direction the markets were headed. You weren’t sure how the Fed was going to respond to COVID-19 in terms of some of their fund structures, for example,” says Peter Sanchez, Executive Vice President, Head of Alternative Fund and Omnium Business Services, Northern Trust. “All of that uncertainty led to large trading volumes. Hedge funds that were prepared to handle those volumes in terms of controls, affirmation, collateral and margin, P&L, and exposures and risks had an advantage – they were in a much better position to handle the millions of trades necessary for their clients.”

Winning through Operational Alpha®

The operational efficiency that was a difference maker for some firms, as noted by Sanchez, is rarely a core focus for hedge funds. Core assets and strategy – long/short, bank loans, distressed credit – is the stuff hedge funds zero in on. But there’s an ongoing opportunity for efficient operational processes to enhance performance and the investor experience for any hedge fund, regardless of size. Taken together, the back and middle office processes that can give a fund a competitive edge are referred to by Sanchez as Operational Alpha, and typically best achieved when a fund partners with outsourced service providers and sophisticated client administrators with investment book of record capabilities.

“Operational Alpha is built around two things – incremental potential performance gain for the fund by optimizing its cash or collateral, and transparent data tools that allow improved risk management by making a manager aware it is outside of compliance with their fund documents,” says Sanchez. 

The benefits of Operational Alpha reflected in performance are naturally a bit shinier to hedge funds, but the investor experience is also alpha even if it cannot quite be measured. Optimizing the investor experience, says Sanchez, “means the ability to drill down on the performance of the fund for the investor – maybe that’s giving investors information or reporting on the portfolio. The investor experience is also dramatically improved when they can invest and withdrawal from the fund in a very efficient way, and also when they can interact directly with the administrator. If that experience is robust, automated, and efficient for the investor, it’s another way for hedge funds to differentiate themselves to their existing and potential investors.”

Cash and collateral optimization

Collateral management and cash optimization are two main areas of focus in achieving Operational Alpha. A manager that has hundreds of thousands of trades going through its system and the various systems of its counterparties faces potential pricing differences on all of that collateral, as well as pricing differences on the swap instruments themselves. In addition, managers also need to nail margin calculations, an area rife with the risk of potentially costly mistakes.

“Those pricing differences generate variable margin differences, and you want make sure everyone is in lock step,” says Sanchez. “It’s obviously important to get the fixed margin correct upfront, but equally so to get the variable margin synched at least close enough with your counterparties that you agree on the deficit or the surplus of the margin on a daily basis. Done efficiently and accurately, a manager will almost certainly save operational costs, and potentially save on efficiencies around the amount of collateral they have to pledge greater than what’s being asked for by their counterparty.”

Cash management is another operational facet that can be difficult to squeeze in amidst the bustle of trading distressed bank loans or leveraging relative value strategies, but in a back office run by a service provider partner, the administrator can potentially optimize cash and get a better return –more control over cash, more transparency about balances, and quick investment of the cash.

Northern Trust has built a cash optimization tool for its hedge fund partners, most of which keep their positions and cash with various prime brokers and custodians. “Our tool aggregates all of those positions and calculates all of a manager’s balances, both positive and negative, in all of the relevant currencies,” say Sanchez. “The result is suggested entries to consolidate all your cash in one counterparty; and suggested FX entries to consolidate numerous currency balances into one currency. The third step is to invest it in a money market vehicle so you start to immediately earn a return on that cash.”

The cash and collateral management aspects of Operational Alpha have stood out during the COVID-19 pandemic, particularly in relation to OTC products. “The tools proved incredibly efficient and effective in terms of settlements, margin calls and cash movement, and the amount of volume that supported that collateral management. If you were losing money your margin capacity was strained, and if your house wasn’t in order in terms of collateral management, it could have worsened an already poor performance,” says Sanchez.

Controlling the environment

In many ways, achieving Operational Alpha is about reducing anything that’s inefficient for a manager – what might be called operational drag. By far, the biggest source of operational drag is inefficiencies in data management. One perspective that helps clarify this area for improvement is to consider that data isn’t just numbers. Data tells a story, specifically it tells a hedge fund’s story to its investors. As nearly everyone knows, a story is only as good as its telling.

 “Some of the biggest opportunities to become more effective and efficient at telling an accurate and engaging story are data reconciliation, data presentation, and data intelligence,” says Sanchez. “Mistakes in reporting are very visible to investors, and result in a negative effect on the relationship between the investor and manager. Managers really should view reporting errors as a significant business risk – and most do. To mitigate that risk, managers want to ensure that their processes, controls, and quality assurance are the best so they can trust their control environment. Ultimately, getting the control environment right comes down to technology.”

For example, proper data instruments can provide real-time views of performance, risk exposures, and compliance with fund documents, and help determine whether a fund should change its investment strategy or better align it to fund documents for compliance. There is no better time to take control of the environment than when a new fund structure is being set up, presenting an opportunity to optimize processes, data control, and accuracy by using technology tools to build a strong foundation and manage the related flows.

 “The flows could be fees or expenses, for example, but the architecture and the legal fund structure is set up to minimize potential errors. Setting up the fee structures upfront is a huge benefit in the context of mitigating operational drag,” says Sanchez.  

Transparency and real-time data are also major contributors to reducing operational drag and owning the environment. For funds that partner with Northern Trust, that means interactive dashboards that allow a view of real-time P&L and what is driving it, both intraday and end of the day; a view of their NAV status, and the steps still necessary until final NAV delivery; and a clear picture of all reconciliations, break resolutions, and break exceptions, and the status of trade affirmation and confirmation, and trade processing –  “essentially, the dashboard provides a status update of everything happening in the middle and back office, including immediate oversight and governance,” says Sanchez.

The tools and technologies that drive Operational Alpha are not designed to benefit only the biggest hedge funds. “If you optimize best practices around your operational controls and processes – in other words, if you have a robust and efficient cash management process – you’re going to achieve Operational Alpha,” says Sanchez. “If you automate your collateral management process and find a service provider and partner that knows and manages that process very well, that’s another opportunity for Operational Alpha. These are tools that we provide for clients, regardless of firm size.”  

 “Every investor expects more transparency and flexibility around what is driving hedge fund performance,” Sanchez says. “GPs now have the tool set that allows them to exercise discretion while still allowing greater transparency for LPs – a view of a fully integrated and automated process of presenting data that supports the trades that have been made and the rationale behind them.”

Peter Sanchez portrait

Peter Sanchez

Global Head of Banking and Treasury Services
Peter is an Executive Vice President at the Northern Trust Company and serves as Head of Banking & Treasury Services, a global division which was formed under Peter’s leadership in 2022 to bring together business in Global Banking, Benefit Payments, Treasury Management, Corporate & Institutional Lending as well as Cash Operations to meet the evolving needs across banking, lending, payments and treasury for Northern Trust and its clients.

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