Alternative Investments: Technology Solutions for Improving Client Experience

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Alternative Investments:

Technology Solutions for Improving

Client Experience

An alternative investment is an investment product other than

traditional investments of stocks, bonds, or cash. Alternative

investments are often used to enhance the overall return on an

investment portfolio, while reducing risks through diversification.

Technology plays a vital role in helping alternative investment

managers not only meet the growing demands of investors but

also overcome challenges posed by increasing regulatory

scrutiny, pricing variations, and a constantly evolving product

environment. To keep pace with the influx of new asset classes

and products, and cater to changing market demands and

demographics, firms engaged in alternative investments will need

to invest in new technology platforms flexible enough to handle

fundamentally varied and continuously evolving asset classes.

Service Oriented Architecture (SOA) offers greater agility to

alternative investment providers by transferring business rules

from legacy applications into a new and more dynamic layer.

Given the tech-savvy nature of current investors, there is now a

greater demand for participation in transactions, transparent fee

structures and better performance reporting. Technology-led

solutions have enabled mobile applications capable of delivering

account information including current and projected cash

balances and security exposure, convenient channels for

24/7 client-advisor collaboration, and social media-based

interaction. In such a technology-oriented climate, successful

firms must identify business challenges and champion

investments in technology initiatives to meet competitive

challenges and stay ahead of the curve.

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About the Author

S. K. Rao

S. K. Rao is a Senior Business Consultant with the Global Consulting Practice of Tata Consultancy Services. Prior to joining TCS,

Rao garnered extensive experience as an investment banker. Rao has been associated with both Indian and international securities markets for more than two decades and has played key roles in implementing business solutions for firms in the securities market space.

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Introduction

Characteristics of Alternative Investments

Range of Alternative Strategies

Alternative investments are ordinarily defined as investment products other than stocks, bonds, and cash–which are considered to be more traditional. Alternative investments include hedge funds, managed futures, real estate, commodities and derivative contracts. Most alternative investment assets are held by institutional investors such as endowments, family offices, pension funds, and high net worth individuals with sufficient time horizons and investment capital. Although all the institutional investors ultimately aim for enhanced returns and diversification, the growth dynamics in investment products play out differently in each segment on account of the unique issues and concerns pertaining to each.

A wide range of alternative strategies are available for implementation across global markets. These strategies can be classified into six basic categories listed below.

Real Estate

Investors can directly invest in property or channel their investments through funds or investment firms that derive returns from the real estate market.

Private Equity/Venture Capital

Private equity investing is when securities are purchased through a private placement rather than a public offering. These investments include the venture capital financing of private companies as well as the buyout of public companies.

Commodities

Commodities are tangible assets such as agricultural products and natural resources. Most direct investing in commodities is executed through the futures market for specific assets. Further, a passive approach to commodity investing is also possible through the purchase of a futures contract on a commodities index. Some of the characteristics of alternative investments are:

Low correlation to traditional financial investments such as stocks and shares Low liquidity

Difficulty in determining market value Limited historical risk and return data

Greater diligence costs due to complex strategies

Inadequate/complicated performance appraisal due to lack of transparency, timeliness of information, and benchmark selection

On account of the complex nature and structure of alternative investments, they usually are not suitable for the average investor. Consequently, many alternative investments are sold as “private placements” to institutions and qualified investors.

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Hedge Funds

Hedge funds are distinct from conventional financial products since they are structured so as not to be subject to the same restrictions that other investment funds require, which, in turn enables them to be relatively less transparent. Hedge funds employ strategies that include the use of derivatives, leverage, and short positions. Each hedge fund executes a tailored investment strategy that focuses on investments appropriate for that specific strategy. Hedge funds are generally available to a limited number of qualified investors who pay performance fees to fund managers.

Managed Futures

Managed futures are a segment of the investment industry where professional managers actively manage client accounts using global futures and other derivatives as the primary instruments. Managed futures accounts can take both long and short positions in futures contracts and options on futures contracts in the global commodity, interest rate, equity, and currency markets.

Distressed Securities

Distressed securities are a type of alternative investment that spans the securities of companies near bankruptcy or under financial duress. Distressed security managers invest in several types of assets

including distressed company debt and equities, bank debt and trade claims, and Lender of Last Resort (LLR) notes. Investments in distressed securities are made through a hedge fund or a closed-end private equity fund with a fixed term.

Based on recent investment trends, it can be argued that alternative investments have ceased to be "alternative". As the traditional asset management industry continues to mature, firms must cope with increasing product commoditization and downward pressures on pricing. Consequently, alternatives have transformed from being a "special case" for many traditional managers to becoming a core-asset class. The increasing acceptance makes the alternative option an integral part of a defensive portfolio that offer diverse benefits in chaotic markets. For example, the long-term nature of private equity and private real estate investments can dampen short-term volatility swings in public securities. Certain kinds of hedge funds are expected to act as diversifiers to equity and credit markets, while commodities and infrastructure may temper inflationary forces. Alternatives enable investors to better tailor investment strategies to address their myriad financial and investment concerns, be it controlling volatility or boosting returns. The share of alternative investments and real estate in the portfolio of high net worth individuals was 24% in 2010 (World Wealth Report 2011, Capgemeni and Merrill Lynch) . Alternative investments will continue to rise at a fast pace, driven by institutional demand, particularly on behalf of pension sponsors.

Alternative and Passive Products vs. Traditional Active Products

According to Boston Consulting Group’s annual study of the global asset-management industry, alternative and passive products are expected to grow faster than traditional active products. Investors reassured by promises of a more stringent risk-management climate and tighter hedge-fund regulations are comfortable considering alternative investments for diversification. The popularity of alternative asset classes, ranging from equity options to currency and gold futures, has been growing for several years putting pressure on

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traditional investments. Further, participation in alternatives among asset managers and retail investors has skyrocketed in recent years as traders have sought to cushion their portfolios against a volatile stock market and persistent fears about the stability of the global economy. According to data from the Options Clearing Corp., which clears trades for all nine U.S. options exchanges, more than 554 million contracts were bought and sold in August 2011, representing a 94 percent increase from the 283 million that were traded during the same period in 2010.

According to Russell Investments' 2010 Global Survey on Alternative Investing, institutional investors have continued to hold on to alternatives and are, in fact, expected to increase their investment allocation to alternatives from 14% to 19% over the next two to three years. The survey has found that real estate, private equity, and hedge funds remain the preferred alternative investment types. Further, on account of inflation-related concerns, there is now increased interest in commodities and infrastructure.

Some of the key drivers of the move towards alternative investments are:

Portfolio diversification (holding assets with different characteristics is an effective way of reducing the risk exposure for the same level of profit potential)

Reduced volatility

Inflation protection to mitigate risks associated with bond portfolios Better risk-adjusted performance

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Figure 1 Projected growth rates of Alternative and Traditional Active Product

Source: BCG analysis.

Note: LDI is liability-driven investment. *Management fees net of distribution costs.

Estimated size, 2010

($trillions; scale = $1 trillion) Traditional active Passive Alternative

Net revenue margine1 (basis points) CAGR, 2010-2014 (%) 150 100 50 0 25 Passive products/ETFs 5 10 15 20 ETFs Passive fixed income Passive equity Alternative products Balanced Fixed income Structured Money market Quantitative Active equity Hedge funds Private equity Infrastructure Absolute return Commodities Real estate (including REITs) LDI

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Alternative Investments: Business Challenges

Need for Next Generation IT Systems

Due to the unique nature of each investor segment, the growth patterns of alternative investments vary significantly. Performance assessment of alternative investment managers are a challenge for several reasons including - a wide range of strategies and asset types, lack of transparency, high due-diligence costs, complex risk characteristics and difficulty in selecting benchmarks. It is also difficult to communicate the results of these multifaceted investments to clients.

Further, the product landscape of alternative investments is complex requiring specific expertise and

resulting in higher diligence costs. Portfolio allocations are objective, measurable realities while institutional investors’ philosophies and strategies, are multi-faceted and not always easy to quantify. Alternative

investments are highly dependent on expertise in specific disciplines that are applied in markets less

efficient than traditional investment markets. In addition, risk characteristics of alternative investments differ from the risks of conventional investments and require preventive measures in addition to the standard protocol. The development of total portfolio asset allocations and total portfolio performance is also

challenging when one or more alternative investment types are considered. The rules for computing returns also vary depending upon the investment type. Alternate investments also require greater risk measures as they are not typically distributed and have the potential for more downside performance than traditional portfolios. Since alternative investments are more complex, firms will need to provide supplemental performance and risk information in addition to the required information. These additional performance measures include the computation of additional return measures, explanation of benchmarks and liquidity information.

Technology has a crucial role to play in meeting the demands of regulators and investors alike in today’s changing market requirements. In a rapidly changing product-centric environment, managers of alternative assets need to support product growth and complexity in a proactive and controlled manner. For example, the alternative funds management environment is highly fluid, gauged from the fact that many hedge funds have expanded into private equity and private equity firms are investing in the credit markets and some traditional asset managers into the alternative asset space. Investment managers require multi-asset coverage, namely, long/short, arbitrage (fixed income, credit, volatility), commodity funds, global macro, structured funds, funds of hedge funds and so on, to meet the diverse needs of wealthy customers. As hedge funds grow, they find that their risk management needs grow exponentially with the complexity and volume of their investments. The risk tools available in Order Management systems may be appropriate for

long/short equity trading, but are often inadequate for credit, OTC derivatives, debt and commodities because they lack robust risk and compliance attribution functionality that is an absolute necessity for these products.

In essence, alternative investments technology must address the following requirements to meet the client and fund managers’ expectations:

Clients need to be able to see, at a glance, the performance of their portfolios in context—that is, compared with the historical performance of alternative products, and also traditional asset classes. n

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Firms must enable what-if projections and analyses to enable cost and performance comparisons, toolkits for customising models, products, workflows, user screens, and Greeks computation and aggregation across any portfolio.

Information must be tailored to the needs and preferences of individual investors, and fund managers should be able to build reports quickly simply by pulling together reliable, accurate information from multiple sources to present a holistic, customized view of the performance of a range of products. Ideally, information must be available in real time—typically over the internet, offering an interactive experience. Also required is the ability to access information through smart-phone networks and mobile devices connected to the internet.

Alternative investment platforms should integrate seamlessly, require minimal daily effort and be able to handle multiple and changing administrators.

Alternative investments platform should have extensive risk management tools (stress tests, hedging scenarios, VaR, limits monitoring).

Analytical systems must be globally integrated, with robust valuation procedures and 24 hour monitoring.

It is clear that many alternative investment managers do not have the technology to support the extensive functionality required for managing alternative and structured investments. Data is often stored in various databases or files and a holistic view of the firm requires extensive manual processes and data manipulation to produce investment history and strategies. This places a heavier workload on operational personnel who would then have to manually duplicate data and/or perform off-line data manipulations to feed data into downstream systems. In addition, commercial and proprietary systems require some degree of custom development to interface with other systems; systems that are designed for different investment needs, that is, hedge funds, fund of funds, and private equity. As technology continues to change, integration with proprietary or closed systems present a formidable challenge to alternative investment entities.

Need for flexible architecture to meet the unique challenges encountered by alternative fund managers.

The need to keep pace with change is forcing alternative investment funds to maintain high standards of adaptability to be able to operate across several markets. For example, in the commodities sector, effective market access is often a question of technology. Alternative investment entities need to ensure, for example, that different market rules and traded products are included in a single portfolio and risk management system. In fact, there are multiple commodities specificities, including perishing or refining, seasonality calendar rules, storage constraints, transportation losses and so on. It is equally important to have flexible portfolio architecture to allow the individual trader to see his/her positions, P&L, limits and risks factors from a variety of different angles and aggregate these factors at different levels. Alternative investment funds need to ensure that technology is both comprehensive and specialized. Not only do alternative funds require a portfolio and risk management system to become commodity, but it should also be cross-asset, as most hedge funds combine commodities with other asset classes.

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Road Ahead: Technology Solutions for Alternative Investments Challenges

Service-Oriented Architecture (SOA)

The rapid ascent of high-frequency and electronic trading, as well as competition to become number one, continues to drive alternative fund managers to identify new, differentiated data sets as core contributing factors in real-time trading models. Integrating real-time event data into trading strategies is the leading ingredient for alternative investment firms when achieving competitive advantage. It is in this context that alternative investment entities will need to embrace open architecture. An open, service-oriented

architecture allows investment firms to freely grow their infrastructure. Open architecture simplifies

integration within the firm’s infrastructure and optimizes straight-through processing; whether data is going in or coming out. The system’s open architecture and standard technology simplifies customization efforts, and allows systems to easily integrate all external processes and inherent functionalities. In SOA, the system is designed to have the main business logic residing in loosely-coupled, interoperable and reusable ‘services’ that are easily consumed by clients. The services in the SOA model are highly re-usable amounts of business logic written in the business domain, not the data domain. Breaking this functionality down into smaller pieces makes sense provided that the piece or building block can be reassembled, rearranged, and reused easily. Adopting this approach exposes processes and behaviours so that they can be consumed by business applications used by alternative investment managers resulting in a higher overall return on investment (ROI).

Automate key aspects of the trade life cycle

Technology can play a crucial role in improving the productivity and efficiency of alternative investment managers. Using technology to automate key aspects of the trade life cycle allows growing hedge funds more time to focus on planning and executing alpha-producing strategies. Take for example the role of automation in improving the efficiencies of private equity. General partners can automate and refine private equity accounting capabilities relating to partner transfers, as well as investment accounting activities like mark-to-market portfolio calculations, unrealized gain/loss calculations for market and FX movements. Similarly, correspondence with private equity investors can be enhanced, giving users complete access to crucial on-demand data round–the-clock with the ability to manage content through an intuitive

administration console. Replacing Excel spread sheet usage, which for many private equity companies continues to be the chief method of data delivery, with a centralized multi-directional hub for reporting related to portfolio company performance, makes it possible for investors to efficiently monitor and manage investment exposures.

Collaborative Messaging, 24/7 Open Channels, Mobile Apps, Social Media

The financial crisis regulatory changes - both existing and anticipated - will only add to the pressure on alternative fund managers to provide increased transparency. In addition, clients are demanding increased disclosure and reporting on their aggregate risk exposures. Generating these reports has meant gathering and authenticating information across dozens and hundreds of spread sheets. Alternative firms need to ensure that report creation and delivery will be addressed by an enterprise solution that provides desktop publishing capabilities with an interface that is not too complicated. The more time that is saved for

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client-facing advisors, the more time they can be in front of clients providing advice and gathering assets. Given the complexities of alternative investments, it is even more important to leverage the latest technologies to allow clients to remain connected wherever they are and quickly retrieve data to make informed decisions. It is in this context that the necessity for a mobile version of the multi-faceted web portal assumes significance, especially when obtaining information from custody or fund administration accounts to mitigate risk and make informed investment decisions. In addition, these mobile applications should be enabled to deliver accounting information, current and projected cash balances, and security exposure information to mobile devices.

Predictive Analytics

Another important tool for alternative investment managers that plays a crucial role in generating alpha is predictive analytics. In the face of increased regulation and complex market environment, alternative asset managers will need superior analytic horsepower to determine the products that deliver the best risk-adjusted return and to master their liquidity positions and risk exposures. Alternative fund managers are greatly hindered by current technology for effective use of enterprise-wide analytics. Indeed, many alternative investment firms remain burdened with a legacy approach to analytics. They need to address:

Siloes of investment using different and incompatible analytical technologies

Inconsistent data with different definitions, taxonomy and levels of granularity and refresh rates An over-reliance on descriptive, rather than predictive analytics.

Predictive analytics makes use of sophisticated algorithms and statistics to manipulate the data into management tools that can help fund managers and financial advisors make more informed, fact-based decisions that deliver better business outcomes.

Cloud-Based Solutions

Alternative investment firms today have new options to meet their IT needs through a suite of applications that are offered through SaaS. Many services such as Fund & Corporate Accounting, Investor Relations, CRM, Web Portal and so on can now be sourced through cloud-based solutions, saving considerable expense in IT infrastructure and support. Since trading is a global business, managers of alternative

investments do not want to be tied into a single exchange. If they have a strategy that is working in, say the United States, they will want to try the same strategy in Europe, in Asia and in emerging markets. In such a situation, using cloud-based services are attractive to hedge funds because connecting to various markets is expensive. Cloud computing brings the ability to share the cost of infrastructure, processing power, hosting and access to the exchanges, only to the extent that one needs it. Speed to market is one benefit that could convince hedge fund managers that cloud computing is the right choice. As demand for ever-growing amounts of information continues to increase, alternative investment funds are seeking simple and direct access to data and applications that cloud computing delivers in a cost-efficient and reliable manner.

Take the case of research for quant trading. Research requires massive amounts of market data — gigabytes and terabytes. One can use cloud computing to solve the problem of obtaining data from an exchange to n

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their workplace. Research tools can be running in a collocated facility and one can use the cloud to access the tools. Then the research part of trading would be sitting in the cloud along with the trading

environment. To give another example, take the case of hedge fund administrators who are responsible for the books and records of their hedge fund clients. They compute a hedge fund's profits and losses and keep track of monthly or quarterly NAV, accounting for investor contributions and withdrawals. Hedge fund administrators can make use of cloud computing to deliver alternative performance tear sheets to hedge fund clients including how well the funds performed relative to benchmarks. Hedge fund managers can offer these alternative tear sheets to their investors as independent, third-party verification of their hedge fund performance. Here a cloud based solutions is used as a step forward in creating more transparency and trust in the hedge fund industry.

The winners will be those alternative investment funds that understand the power of technologies like cloud, analytics and mobility, and can harness that power to transform their businesses. Effective implementation of these emerging technologies will help alternative investment firms redefine and transform their business and operating models, and stay ahead of the competition.

References

The Russell Investments' 2010 Global Survey on Alternative Investing World Wealth Report 2011, Capgemini and Merrill Lynch Wealth Management Boston Consulting Group, Global Asset Management 2011, Building on Success

Wealth Management Business and IT Priorities for 2010: A Global Perspective, Isabella Fonseca, Arin Ray, Celent Consultancy Global Financial Markets: Regional Trends 2010; www.TheCityUK.com

Alternative investment firms seek sell-side technology to support fund growth; hedgeweek 26.06.08; Global Private Equity Report 2010, Bain and Company, Inc.

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Alternative Investments: Technology Solutions for Improving Client Experience