Hedge Funds Could Attract Substantial Inflows Through Automation, Says Whitepaper

New research has highlighted substantial commercial benefits for hedge funds that beef up their organizational due diligence (ODD) through investment in technology.

The whitepaper cites a top performing hedge fund that was consistently prevented from securing new institutional investment because of significant operational flaws that were immediate ‘red flags’ to investors. It was not until these were remedied that the fund was able to attract institutional investments that took it from sub $250million AUM to $1.3billion within 12 months.


In highlighting the commercial benefits of automation in business critical areas such as post trade processing, technology provider Salerio says that along with the estimated 70%+ of new assets under management in hedge funds now secured from institutional investors comes increased scrutiny. “Due diligence assessments play an ever more important role in investors determining who to entrust with their monies – and thus also to fund managers looking to secure a share of it,” it says in its whitepaper.

“With risk in general now such a focus for regulators, market operators and investors alike, the risk (and therefore cost) of potential errors within manual processing is one coming under increasing scrutiny in ODD assessments.”

Expanding on the regulatory impact, Salerio says the organizational requirements part of the AIFMD includes the general principle that Alternative Investment Fund Managers (AIFMs) “require for use, at all times, adequate and appropriate human and technical resources, including administrative and accounting procedures and adequate internal control mechanisms”. Furthermore, a key specified general requirement of AIFMD relates to the effective flow of information between all parties involved.

The whitepaper suggests that while prime brokers have been historically relied upon for middle and back office processing of trades, those managers will be constrained as confidence rises in hedge fund investment strategies and performance in terms of return, volatility and risk due to their operational infrastructure shortcomings. “After all, the prime brokers can only work with the information provided to them. Flawed information into the prime broker through human error – however it arises – means flawed information out from that point forward,” says the whitepaper.

Furthermore, the whitepaper notes that where contractual settlement is applied to a delayed or failed trade the prime broker takes on the additional risk until the trade is settled. The costs resulting from this risk, based on 60% of instructions reportedly needing to be repaired at an average cost of $6 per trade, translates into 10% of confirmations are mismatched, costing $16 per trade, and 15% of all trades are unable to be settled in time, resulting in an average cost of $50 per trade. Even as few as 25 trades a day could result in over £50,000 annually of largely avoidable operating costs in such circumstances,” says the whitepaper.

A further regulatory impact on hedge funds, says Salerio, is the advent of T+2 settlement under CSD-R. The regulation is widely anticipated to increase the number of failed trades for hedge funds who haven’t accurately confirmed trades before sending information to brokers.

The whitepaper suggests that in that case of a time when increased risk assumed by prime brokers becomes no longer acceptable, whatever price the hedge fund pays, these hedge funds should seriously consider the implications if their prime brokers decide the risk of doing business with them is unacceptable.

However, for those existing funds looking to transition to institutional infrastructure, the immediate cost savings may be more oblique, it notes.

The whitepaper concludes that stellar past performance can be insufficient to persuade institutional investors that a fund should be entrusted with their money. It quotes Phillip Chapple of ODD consultants KB Associates, who advises hedge fund managers to undertake ODD evaluations in order to attract institutional investors. He expands on the case at the beginning of the article, saying, the fund’s “innovative strategy and impressive results had attracted a procession of institutional investors to visit them. Yet they were consistently being politely told the investors would monitor their progress, and saw no new funds. Our evaluation identified 360 potential operational issues – including at least 30 that were straight red flags for institutional investors. Meaning that continuing outstanding investment performance wouldn’t be enough to persuade investors to place funds with them.

“Putting the key operational issues right took less than 3 weeks. Within 12 months they had grown from a sub-$250 million fund to $1.3 billion, all the extra funds coming from institutions.”