A hedge fund manager's marketing pitch to potential allocators
normally focuses on investment strategy, performance, risk
management, principals' pedigree, etc. Few managers broach
operational issues in any detail, aside from naming the fund's
administrator, prime broker and legal counsel in passing.
Operational due diligence, nevertheless, forms a key aspect
of an allocator's analysis of a fund, often characterised
as looking under the hood or kicking the tires prior to making
an investment. This process usually has two main goals. The
first is to ensure general standards of management stability
and regularity appropriate to running a viable hedge fund
business. The second element to operational scrutiny typically
entails trying to observe operational checks and balances
that exist to mitigate potential for fraud.
In addition to these, it also behooves allocators to pay
close and careful attention to other specific operational
issues that bear upon a fund's efficiency.
For example, consider two start-up long/short equity funds
with similar short track records trading in the same space
and managed by individuals with commensurate relative credentials.
Fund A employs sophisticated trading technology to achieve
best execution of its trades. Fund B's transaction costs,
execution delays and other sources of slippage compromise
operational efficiency. All other things being equal, one
can fairly assume that Fund A will outperform B over time
and should be preferred to its less efficient peer.
Increasingly, hedge fund managers committed to their craft
seek to deploy the latest state-of the-art trading technology
to improve efficiency and ultimately boost returns. And managers
who pay scant heed to issues of transaction efficiency will
be left behind.
A story in the June 2004 issue of Institutional Investor
outlines industry trends towards more efficient execution,
pointing out that "the majority of institutional trades
today are already executed in so-called low-touch fashion,
either by a fully automated system or by a human trader employing
The Tabb Group, a financial advisory firm, echoes these
conclusions about the burgeoning use of trading technology:
"Buy-side traders now have access to powerful technologies
to better understand, manage and execute trades faster, more
efficiently, less expensively, and more effectively than at
any point in the past
The trader must examine the value
that he or she brings to the table on every order
the trader execute the order better than the market?"
The 2004 Tabb report, titled "Institutional Equity Trading
in America," notes that adoption rates for algorithmic
trading systems far exceeded the authors' expectations.
Algorithmic trading systems model a trader's execution strategy
and use technology to implement defined trades in an automated
fashion to enhance productivity, improve control over intermediaries
and diminish costs. These trading systems are significant
in the quest for best execution and form part of a phenomenon
that has been loosely termed the "electronification"
of markets. The catalyst for this transformation towards low-touch
trading is fragmentation of liquidity and lower commission
prices according to Gavin Little-Gill, senior analyst in investment
management research at TowerGroup. TowerGroup predicts total
algorithmic trading volume to double by 2006.
Systems yielding more technologically savvy trading occupy
a major part of the spectrum of best execution tools that
reduce the variety of explicit and implicit costs associated
with trading. These costs come under the general rubric of
transaction costs and range from brokerage fees to opportunity
costs stemming from poor execution. A strong operational infrastructure
oriented towards best execution cannot be underestimated.
Moreover, soft dollar arrangements that compromise execution
efficiency will be less tolerable as the industry evolves.
In sum, to demonstrate a competitive edge, hedge funds will
increasingly be called upon to show competence in managing
trade executions. To this end, Transaction Cost Analysis (TCA),
whereby managers examine individual trades to redress slippage,
is a facet of trading activity to which few hedge funds can
remain indifferent. The TCA scorecard uses appropriate benchmarks
to assess and improve transaction efficiency.
TCA best execution covers a range of events that stretch
from pre-trade actions to post-trade activities, all of which
relate to efficiency.
As it becomes harder to distinguish between a plethora of
funds seeking capital, one can readily envisage transaction
efficiency becoming a shibboleth for allocators. A hedge fund
that can point to the sophistication of its trading technology
and rigorous controls over execution has qualities that distinguish
it from its peers.
Peter Rajsingh, PhD, is Senior Vice President of Global
Partners Group, a diversified financial services firm with
offices in New York and Fort Lauderdale, Florida.