Northern Trust’s new report about transparency in hedge fund holdings reminds me somewhat of the opening narration in the cheesy television show “The Six Million Dollar Man,” which ran on ABC from 1974 to ’78.
The viewer sees an airplane crash and hears a narrative voice describe the pilot, Steve Austin, as “a man barely alive.” But, a character’s voice chimes in here, “We can rebuild him. We have the technology.”
The phrase, “we have the technology” with the slight emphasis on have, has been employed ever since for circumstances in which the barrier to a breakthrough is not technological but is something else. Perhaps the breakthrough requires just the right situation for an application, creating a consensus to get it done, developing economies of scale that will make it fiscally feasible, or the like.
We Can Rebuild Manager-Investor Relations, We Have…
Northern Trust’s Line of Sight report, “The Next Frontier: Overcoming the Challenge of Transparency,” begins by emphasizing that there is as yet no “genuine consensus” covering both managers and investors as to what is to be expected as to position and trade level transparency. Insofar as there was a consensus prior to 2008, it shattered in the crisis and nothing new has replaced it since.
Northern Trust acknowledges that various “creative solutions” have been offered, including the use of risk aggregators that would take in trade-level detail. But, the authors say, such solutions “are realistic only for the largest investors” and have not been generally adopted.
A consensus solution would be one that takes into account four goals, as displayed in the mini-jigsaw graphic from the report, displayed here. Aggregation is one of these goals – and Northern Trust uses the term to capture the usual “Big Data” ideal: hedge fund managers should have available a system that captures data from multiple sources, centralizes it, and provides a presentation/delivery layer. This should be integrated with other systems so it serves as the golden copy for counterparties; normalized for missing values and consistency; and verified via data quality checks, valuation overrides as needed, etc.
The one item on this list of four that isn’t fully on the industry radar yet is integration. Perhaps part of the reason it isn’t is that managers don’t want to sacrifice control over how they use data, and integration may represent some degree of sacrifice. But on the plus side, superior integration will enable them to compete by differentiating their firms “in the eyes of increasingly risk-conscious investors.”
Not an Asset Class
There was a time, not so long ago, when many investors thought of hedge funds as an asset class, and allocated a certain portion of their portfolio to that class, just as another proportion went to bonds or equity. Those days are fading, though, the report says. Instead, investors look at hedge funds for the specific strategies they embody and use them “to complement their allocations in other, more traditional asset classes.”
Managers will want to get into step with this change, and make their pitch not along the lines of “here is why you should invest in our credit fund” but “here is how our credit fund complements the exposures in your fixed-income portfolio.” A fully integrated data management model can assist here, helping investors customize their exposures and strategy.
Other related developments that the report mentions in passing:
- Some managers are looking to their administrators for validation regarding commissions, financing fees, collateral holdings, and valuations;
- A single ‘golden copy’ may streamline many processes that are now quite labor intensive;
- Regulatory reporting has given the process of integration a shove. If reporting has to take place for regulatory purposes, it may not be a great additional shove to adapt it for investors;
- Over time, shadow administration is becoming available to smaller firms.
Creating an industry standard for data integration along the lines discussed in this report remains, Northern Trust says, an ambitious goal. But the $6 million that was sufficient to rebuild Steve Austin is mere piker’s money in this field. And, after all, we have the technology. The barrier is a matter of economy of scale. As the report says, “As more firms adopt these kinds of practices, the costs will come down and make it more accessible.”