White Paper Alterative Ivestmets: Techology Solutios for Improvig Cliet Experiece A alterative ivestmet is a ivestmet product other tha traditioal ivestmets of stocks, bods, or cash. Alterative ivestmets are ofte used to ehace the overall retur o a ivestmet portfolio, while reducig risks through diversificatio. Techology plays a vital role i helpig alterative ivestmet maagers ot oly meet the growig demads of ivestors but also overcome challeges posed by icreasig regulatory scrutiy, pricig variatios, ad a costatly evolvig product eviromet. To keep pace with the iflux of ew asset classes ad products, ad cater to chagig market demads ad demographics, firms egaged i alterative ivestmets will eed to ivest i ew techology platforms flexible eough to hadle fudametally varied ad cotiuously evolvig asset classes. Service Orieted Architecture (SOA) offers greater agility to alterative ivestmet providers by trasferrig busiess rules from legacy applicatios ito a ew ad more dyamic layer. Give the tech-savvy ature of curret ivestors, there is ow a greater demad for participatio i trasactios, trasparet fee structures ad better performace reportig. Techology-led solutios have eabled mobile applicatios capable of deliverig accout iformatio icludig curret ad projected cash balaces ad security exposure, coveiet chaels for 24/7 cliet-advisor collaboratio, ad social media-based iteractio. I such a techology-orieted climate, successful firms must idetify busiess challeges ad champio ivestmets i techology iitiatives to meet competitive challeges ad stay ahead of the curve.
About the Author S. K. Rao S. K. Rao is a Seior Busiess Cosultat with the Global Cosultig Practice of Tata Cosultacy Services. Prior to joiig TCS, Rao garered extesive experiece as a ivestmet baker. Rao has bee associated with both Idia ad iteratioal securities markets for more tha two decades ad has played key roles i implemetig busiess solutios for firms i the securities market space. 2
Table of Cotets Itroductio 4 Characteristics of Alterative Ivestmets 4 Rage of Alterative Strategies 4 Importace of Alterative Ivestmets 5 Alterative Ivestmets: Busiess Challeges 7 Need for Next Geeratio IT Systems 7 Road Ahead: Techology Solutios for Alterative Ivestmets Challeges 9 3
Itroductio Alterative ivestmets are ordiarily defied as ivestmet products other tha stocks, bods, ad cash which are cosidered to be more traditioal. Alterative ivestmets iclude hedge fuds, maaged futures, real estate, commodities ad derivative cotracts. Most alterative ivestmet assets are held by istitutioal ivestors such as edowmets, family offices, pesio fuds, ad high et worth idividuals with sufficiet time horizos ad ivestmet capital. Although all the istitutioal ivestors ultimately aim for ehaced returs ad diversificatio, the growth dyamics i ivestmet products play out differetly i each segmet o accout of the uique issues ad cocers pertaiig to each. Characteristics of Alterative Ivestmets Some of the characteristics of alterative ivestmets are: Low correlatio to traditioal fiacial ivestmets such as stocks ad shares Low liquidity Difficulty i determiig market value Limited historical risk ad retur data Greater diligece costs due to complex strategies Iadequate/complicated performace appraisal due to lack of trasparecy, timeliess of iformatio, ad bechmark selectio O accout of the complex ature ad structure of alterative ivestmets, they usually are ot suitable for the average ivestor. Cosequetly, may alterative ivestmets are sold as private placemets to istitutios ad qualified ivestors. Rage of Alterative Strategies A wide rage of alterative strategies are available for implemetatio across global markets. These strategies ca be classified ito six basic categories listed below. Real Estate Ivestors ca directly ivest i property or chael their ivestmets through fuds or ivestmet firms that derive returs from the real estate market. Private Equity/Veture Capital Private equity ivestig is whe securities are purchased through a private placemet rather tha a public offerig. These ivestmets iclude the veture capital fiacig of private compaies as well as the buyout of public compaies. Commodities Commodities are tagible assets such as agricultural products ad atural resources. Most direct ivestig i commodities is executed through the futures market for specific assets. Further, a passive approach to commodity ivestig is also possible through the purchase of a futures cotract o a commodities idex. 4
Hedge Fuds Hedge fuds are distict from covetioal fiacial products sice they are structured so as ot to be subject to the same restrictios that other ivestmet fuds require, which, i tur eables them to be relatively less trasparet. Hedge fuds employ strategies that iclude the use of derivatives, leverage, ad short positios. Each hedge fud executes a tailored ivestmet strategy that focuses o ivestmets appropriate for that specific strategy. Hedge fuds are geerally available to a limited umber of qualified ivestors who pay performace fees to fud maagers. Maaged Futures Maaged futures are a segmet of the ivestmet idustry where professioal maagers actively maage cliet accouts usig global futures ad other derivatives as the primary istrumets. Maaged futures accouts ca take both log ad short positios i futures cotracts ad optios o futures cotracts i the global commodity, iterest rate, equity, ad currecy markets. Distressed Securities Distressed securities are a type of alterative ivestmet that spas the securities of compaies ear bakruptcy or uder fiacial duress. Distressed security maagers ivest i several types of assets icludig distressed compay debt ad equities, bak debt ad trade claims, ad Leder of Last Resort (LLR) otes. Ivestmets i distressed securities are made through a hedge fud or a closed-ed private equity fud with a fixed term. Importace of Alterative Ivestmets Based o recet ivestmet treds, it ca be argued that alterative ivestmets have ceased to be "alterative". As the traditioal asset maagemet idustry cotiues to mature, firms must cope with icreasig product commoditizatio ad dowward pressures o pricig. Cosequetly, alteratives have trasformed from beig a "special case" for may traditioal maagers to becomig a core-asset class. The icreasig acceptace makes the alterative optio a itegral part of a defesive portfolio that offer diverse beefits i chaotic markets. For example, the log-term ature of private equity ad private real estate ivestmets ca dampe short-term volatility swigs i public securities. Certai kids of hedge fuds are expected to act as diversifiers to equity ad credit markets, while commodities ad ifrastructure may temper iflatioary forces. Alteratives eable ivestors to better tailor ivestmet strategies to address their myriad fiacial ad ivestmet cocers, be it cotrollig volatility or boostig returs. The share of alterative ivestmets ad real estate i the portfolio of high et worth idividuals was 24% i 2010 (World Wealth Report 2011, Capgemei ad Merrill Lych). Alterative ivestmets will cotiue to rise at a fast pace, drive by istitutioal demad, particularly o behalf of pesio sposors. Alterative ad Passive Products vs. Traditioal Active Products Accordig to Bosto Cosultig Group s aual study of the global asset-maagemet idustry, alterative ad passive products are expected to grow faster tha traditioal active products. Ivestors reassured by promises of a more striget risk-maagemet climate ad tighter hedge-fud regulatios are comfortable cosiderig alterative ivestmets for diversificatio. The popularity of alterative asset classes, ragig from equity optios to currecy ad gold futures, has bee growig for several years puttig pressure o 5
traditioal ivestmets. Further, participatio i alteratives amog asset maagers ad retail ivestors has skyrocketed i recet years as traders have sought to cushio their portfolios agaist a volatile stock market ad persistet fears about the stability of the global ecoomy. Accordig to data from the Optios Clearig Corp., which clears trades for all ie U.S. optios exchages, more tha 554 millio cotracts were bought ad sold i August 2011, represetig a 94 percet icrease from the 283 millio that were traded durig the same period i 2010. CAGR, 2010-2014 (%) 25 Passive products/etfs 20 ETFs 15 Alterative products 10 Passive fixed icome Passive equity Balaced Real estate (icludig REITs) Commodities Ifrastructure Absolute retur Hedge fuds 5 LDI Fixed icome Structured Active equity Quatitative Private equity 0 Moey market Estimated size, 2010 ($trillios; scale = $1 trillio) Source: BCG aalysis. Note: LDI is liability-drive ivestmet. *Maagemet fees et of distributio costs. 50 100 150 Net reveue margie1 (basis poits) Traditioal active Passive Alterative Figure 1 Projected growth rates of Alterative ad Traditioal Active Product Accordig to Russell Ivestmets' 2010 Global Survey o Alterative Ivestig, istitutioal ivestors have cotiued to hold o to alteratives ad are, i fact, expected to icrease their ivestmet allocatio to alteratives from 14% to 19% over the ext two to three years. The survey has foud that real estate, private equity, ad hedge fuds remai the preferred alterative ivestmet types. Further, o accout of iflatiorelated cocers, there is ow icreased iterest i commodities ad ifrastructure. Some of the key drivers of the move towards alterative ivestmets are: Portfolio diversificatio (holdig assets with differet characteristics is a effective way of reducig the risk exposure for the same level of profit potetial) Reduced volatility Iflatio protectio to mitigate risks associated with bod portfolios Better risk-adjusted performace 6
Alterative Ivestmets: Busiess Challeges Due to the uique ature of each ivestor segmet, the growth patters of alterative ivestmets vary sigificatly. Performace assessmet of alterative ivestmet maagers are a challege for several reasos icludig - a wide rage of strategies ad asset types, lack of trasparecy, high due-diligece costs, complex risk characteristics ad difficulty i selectig bechmarks. It is also difficult to commuicate the results of these multifaceted ivestmets to cliets. Further, the product ladscape of alterative ivestmets is complex requirig specific expertise ad resultig i higher diligece costs. Portfolio allocatios are objective, measurable realities while istitutioal ivestors philosophies ad strategies, are multi-faceted ad ot always easy to quatify. Alterative ivestmets are highly depedet o expertise i specific disciplies that are applied i markets less efficiet tha traditioal ivestmet markets. I additio, risk characteristics of alterative ivestmets differ from the risks of covetioal ivestmets ad require prevetive measures i additio to the stadard protocol. The developmet of total portfolio asset allocatios ad total portfolio performace is also challegig whe oe or more alterative ivestmet types are cosidered. The rules for computig returs also vary depedig upo the ivestmet type. Alterate ivestmets also require greater risk measures as they are ot typically distributed ad have the potetial for more dowside performace tha traditioal portfolios. Sice alterative ivestmets are more complex, firms will eed to provide supplemetal performace ad risk iformatio i additio to the required iformatio. These additioal performace measures iclude the computatio of additioal retur measures, explaatio of bechmarks ad liquidity iformatio. Need for Next Geeratio IT Systems Techology has a crucial role to play i meetig the demads of regulators ad ivestors alike i today s chagig market requiremets. I a rapidly chagig product-cetric eviromet, maagers of alterative assets eed to support product growth ad complexity i a proactive ad cotrolled maer. For example, the alterative fuds maagemet eviromet is highly fluid, gauged from the fact that may hedge fuds have expaded ito private equity ad private equity firms are ivestig i the credit markets ad some traditioal asset maagers ito the alterative asset space. Ivestmet maagers require multi-asset coverage, amely, log/short, arbitrage (fixed icome, credit, volatility), commodity fuds, global macro, structured fuds, fuds of hedge fuds ad so o, to meet the diverse eeds of wealthy customers. As hedge fuds grow, they fid that their risk maagemet eeds grow expoetially with the complexity ad volume of their ivestmets. The risk tools available i Order Maagemet systems may be appropriate for log/short equity tradig, but are ofte iadequate for credit, OTC derivatives, debt ad commodities because they lack robust risk ad compliace attributio fuctioality that is a absolute ecessity for these products. I essece, alterative ivestmets techology must address the followig requiremets to meet the cliet ad fud maagers expectatios: Cliets eed to be able to see, at a glace, the performace of their portfolios i cotext that is, compared with the historical performace of alterative products, ad also traditioal asset classes. 7
Firms must eable what-if projectios ad aalyses to eable cost ad performace comparisos, toolkits for customisig models, products, workflows, user screes, ad Greeks computatio ad aggregatio across ay portfolio. Iformatio must be tailored to the eeds ad prefereces of idividual ivestors, ad fud maagers should be able to build reports quickly simply by pullig together reliable, accurate iformatio from multiple sources to preset a holistic, customized view of the performace of a rage of products. Ideally, iformatio must be available i real time typically over the iteret, offerig a iteractive experiece. Also required is the ability to access iformatio through smart-phoe etworks ad mobile devices coected to the iteret. Alterative ivestmet platforms should itegrate seamlessly, require miimal daily effort ad be able to hadle multiple ad chagig admiistrators. Alterative ivestmets platform should have extesive risk maagemet tools (stress tests, hedgig scearios, VaR, limits moitorig). Aalytical systems must be globally itegrated, with robust valuatio procedures ad 24 hour moitorig. It is clear that may alterative ivestmet maagers do ot have the techology to support the extesive fuctioality required for maagig alterative ad structured ivestmets. Data is ofte stored i various databases or files ad a holistic view of the firm requires extesive maual processes ad data maipulatio to produce ivestmet history ad strategies. This places a heavier workload o operatioal persoel who would the have to maually duplicate data ad/or perform off-lie data maipulatios to feed data ito dowstream systems. I additio, commercial ad proprietary systems require some degree of custom developmet to iterface with other systems; systems that are desiged for differet ivestmet eeds, that is, hedge fuds, fud of fuds, ad private equity. As techology cotiues to chage, itegratio with proprietary or closed systems preset a formidable challege to alterative ivestmet etities. Need for flexible architecture to meet the uique challeges ecoutered by alterative fud maagers. The eed to keep pace with chage is forcig alterative ivestmet fuds to maitai high stadards of adaptability to be able to operate across several markets. For example, i the commodities sector, effective market access is ofte a questio of techology. Alterative ivestmet etities eed to esure, for example, that differet market rules ad traded products are icluded i a sigle portfolio ad risk maagemet system. I fact, there are multiple commodities specificities, icludig perishig or refiig, seasoality caledar rules, storage costraits, trasportatio losses ad so o. It is equally importat to have flexible portfolio architecture to allow the idividual trader to see his/her positios, P&L, limits ad risks factors from a variety of differet agles ad aggregate these factors at differet levels. Alterative ivestmet fuds eed to esure that techology is both comprehesive ad specialized. Not oly do alterative fuds require a portfolio ad risk maagemet system to become cross-commodity, but it should also be crossasset, as most hedge fuds combie commodities with other asset classes. 8
Road Ahead: Techology Solutios for Alterative Ivestmets Challeges Service-Orieted Architecture (SOA) The rapid ascet of high-frequecy ad electroic tradig, as well as competitio to become umber oe, cotiues to drive alterative fud maagers to idetify ew, differetiated data sets as core cotributig factors i real-time tradig models. Itegratig real-time evet data ito tradig strategies is the leadig igrediet for alterative ivestmet firms whe achievig competitive advatage. It is i this cotext that alterative ivestmet etities will eed to embrace ope architecture. A ope, service-orieted architecture allows ivestmet firms to freely grow their ifrastructure. Ope architecture simplifies itegratio withi the firm s ifrastructure ad optimizes straight-through processig; whether data is goig i or comig out. The system s ope architecture ad stadard techology simplifies customizatio efforts, ad allows systems to easily itegrate all exteral processes ad iheret fuctioalities. I SOA, the system is desiged to have the mai busiess logic residig i loosely-coupled, iteroperable ad reusable services that are easily cosumed by cliets. The services i the SOA model are highly re-usable amouts of busiess logic writte i the busiess domai, ot the data domai. Breakig this fuctioality dow ito smaller pieces makes sese provided that the piece or buildig block ca be reassembled, rearraged, ad reused easily. Adoptig this approach exposes processes ad behaviours so that they ca be cosumed by busiess applicatios used by alterative ivestmet maagers resultig i a higher overall retur o ivestmet (ROI). Automate key aspects of the trade life cycle Techology ca play a crucial role i improvig the productivity ad efficiecy of alterative ivestmet maagers. Usig techology to automate key aspects of the trade life cycle allows growig hedge fuds more time to focus o plaig ad executig alpha-producig strategies. Take for example the role of automatio i improvig the efficiecies of private equity. Geeral parters ca automate ad refie private equity accoutig capabilities relatig to parter trasfers, as well as ivestmet accoutig activities like mark-to-market portfolio calculatios, urealized gai/loss calculatios for market ad FX movemets. Similarly, correspodece with private equity ivestors ca be ehaced, givig users complete access to crucial o-demad data roud the-clock with the ability to maage cotet through a ituitive admiistratio cosole. Replacig Excel spread sheet usage, which for may private equity compaies cotiues to be the chief method of data delivery, with a cetralized multi-directioal hub for reportig related to portfolio compay performace, makes it possible for ivestors to efficietly moitor ad maage ivestmet exposures. Collaborative Messagig, 24/7 Ope Chaels, Mobile Apps, Social Media The fiacial crisis regulatory chages - both existig ad aticipated - will oly add to the pressure o alterative fud maagers to provide icreased trasparecy. I additio, cliets are demadig icreased disclosure ad reportig o their aggregate risk exposures. Geeratig these reports has meat gatherig ad autheticatig iformatio across dozes ad hudreds of spread sheets. Alterative firms eed to esure that report creatio ad delivery will be addressed by a eterprise solutio that provides desktop publishig capabilities with a iterface that is ot too complicated. The more time that is saved for cliet- 9
facig advisors, the more time they ca be i frot of cliets providig advice ad gatherig assets. Give the complexities of alterative ivestmets, it is eve more importat to leverage the latest techologies to allow cliets to remai coected wherever they are ad quickly retrieve data to make iformed decisios. It is i this cotext that the ecessity for a mobile versio of the multi-faceted web portal assumes sigificace, especially whe obtaiig iformatio from custody or fud admiistratio accouts to mitigate risk ad make iformed ivestmet decisios. I additio, these mobile applicatios should be eabled to deliver accoutig iformatio, curret ad projected cash balaces, ad security exposure iformatio to mobile devices. Predictive Aalytics Aother importat tool for alterative ivestmet maagers that plays a crucial role i geeratig alpha is predictive aalytics. I the face of icreased regulatio ad complex market eviromet, alterative asset maagers will eed superior aalytic horsepower to determie the products that deliver the best riskadjusted retur ad to master their liquidity positios ad risk exposures. Alterative fud maagers are greatly hidered by curret techology for effective use of eterprise-wide aalytics. Ideed, may alterative ivestmet firms remai burdeed with a legacy approach to aalytics. They eed to address: Siloes of ivestmet usig differet ad icompatible aalytical techologies Icosistet data with differet defiitios, taxoomy ad levels of graularity ad refresh rates A over-reliace o descriptive, rather tha predictive aalytics. Predictive aalytics makes use of sophisticated algorithms ad statistics to maipulate the data ito maagemet tools that ca help fud maagers ad fiacial advisors make more iformed, fact-based decisios that deliver better busiess outcomes. Cloud-Based Solutios Alterative ivestmet firms today have ew optios to meet their IT eeds through a suite of applicatios that are offered through SaaS. May services such as Fud & Corporate Accoutig, Ivestor Relatios, CRM, Web Portal ad so o ca ow be sourced through cloud-based solutios, savig cosiderable expese i IT ifrastructure ad support. Sice tradig is a global busiess, maagers of alterative ivestmets do ot wat to be tied ito a sigle exchage. If they have a strategy that is workig i, say the Uited States, they will wat to try the same strategy i Europe, i Asia ad i emergig markets. I such a situatio, usig cloud-based services are attractive to hedge fuds because coectig to various markets is expesive. Cloud computig brigs the ability to share the cost of ifrastructure, processig power, hostig ad access to the exchages, oly to the extet that oe eeds it. Speed to market is oe beefit that could covice hedge fud maagers that cloud computig is the right choice. As demad for ever-growig amouts of iformatio cotiues to icrease, alterative ivestmet fuds are seekig simple ad direct access to data ad applicatios that cloud computig delivers i a cost-efficiet ad reliable maer. Take the case of research for quat tradig. Research requires massive amouts of market data gigabytes ad terabytes. Oe ca use cloud computig to solve the problem of obtaiig data from a exchage to 10
their workplace. Research tools ca be ruig i a collocated facility ad oe ca use the cloud to access the tools. The the research part of tradig would be sittig i the cloud alog with the tradig eviromet. To give aother example, take the case of hedge fud admiistrators who are resposible for the books ad records of their hedge fud cliets. They compute a hedge fud's profits ad losses ad keep track of mothly or quarterly NAV, accoutig for ivestor cotributios ad withdrawals. Hedge fud admiistrators ca make use of cloud computig to deliver alterative performace tear sheets to hedge fud cliets icludig how well the fuds performed relative to bechmarks. Hedge fud maagers ca offer these alterative tear sheets to their ivestors as idepedet, third-party verificatio of their hedge fud performace. Here a cloud based solutios is used as a step forward i creatig more trasparecy ad trust i the hedge fud idustry. The wiers will be those alterative ivestmet fuds that uderstad the power of techologies like cloud, aalytics ad mobility, ad ca haress that power to trasform their busiesses. Effective implemetatio of these emergig techologies will help alterative ivestmet firms redefie ad trasform their busiess ad operatig models, ad stay ahead of the competitio. Refereces The Russell Ivestmets' 2010 Global Survey o Alterative Ivestig World Wealth Report 2011, Capgemii ad Merrill Lych Wealth Maagemet Bosto Cosultig Group, Global Asset Maagemet 2011, Buildig o Success Wealth Maagemet Busiess ad IT Priorities for 2010: A Global Perspective, Isabella Foseca, Ari Ray, Celet Cosultacy Global Fiacial Markets: Regioal Treds 2010; www.thecityuk.com Alterative ivestmet firms seek sell-side techology to support fud growth; hedgeweek 26.06.08; www.hedgeweek.com Global Private Equity Report 2010, Bai ad Compay, Ic. 11
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