Hedge funds are investment companies that use a variety of trading strategies to make profits in the markets. The trading strategies include long-short equity, fixed income arbitrage, and global macro. The trading strategies of hedge funds have been changing over the past few years. High-frequency trading (HFT) has become a popular strategy. HFT is characterized by high volume, low latency, and algorithmic trading. It uses electronic execution venues such as exchanges and dark pools to execute trades at very fast speeds and with minimal human input.
We anonymously surveyed hedge funds around the world that manage from 100M in AUM and up, to analyze the current trends in the industry and to discover actions that impacted directly their profit and loss (P&L).
Of 104 hedge funds surveyed, these are the actions and best practices they took to increase their profitability:
1) Adoption of Real-time Risk Management
Risk management is the process of identifying, assessing, and controlling risks to an organization’s capital and earnings. It is a critical component of any electronic trading operation, as it helps to protect against losses that may occur due to market fluctuations or other factors.
If a hedge fund wants to monitor its VaR or PnL in any position, it is time-consuming to collect all of the data by hand. With real-time risk management software, VaR & PnL updates are made continuously as new data streams in.
Another advantage of using real-time Risk Management techniques is that they can help detect changes in option pricing. You can spot where the change happened, and then take that information to aggregate sensitivities, which should allow you to interpret what happened.
2) Improved Execution quality
To reduce the market impact on trading operations and achieve the best execution quality, hedge funds opted to implement their own “Smart Order Routers” (SOR) to use with their trading algorithms.
Computer models send large orders to the market and the SOR module should be smart enough to decide the best execution path. For example, it could chop a big order into small lots over a period of time, following a schedule that is designed to minimize the impact on the price of the security.
For example, applying commonly known algos:
- VWAP (Volume Weighted Average Price)
- TWAP (Time Weighted Average Price)
- POV (Percentage of Volume)
Additionally, a key factor in execution quality is speed.
For this purpose, they use direct market access (DMA) and co-location services, which allow their computer servers to be placed in the same data center as the exchange’s servers.
This way, they can send their orders directly to the exchange without having to go through an intermediary, which would introduce latency.
3) Valuing illiquid securities and portfolios
The difficulty of identifying the fair value of an infrequently traded, custom-built OTC derivative or complex loan product is well-known.
In addition, because illiquid securities aren’t actively priced as often as liquid ones like stocks, the valuations are not as accurate and could end up smoothing reported returns. This could result in an overestimation of volatility and risk levels.
Hedge funds have traditionally relied on the sell-side counterparty that produces the instrument to provide valuations for them. But this practice has raised some concerns over conflicts of interest, transparency, and valuation subjectivity. These issues are important to consider if you are thinking of investing in a hedge fund.
Due to the increased pressure on independent valuation, it is becoming more important for fund managers to have impartial and expert valuations. These should be performed either by a process in-house or with a specialized provider rather than be done by fund managers themselves.
4) Multi-asset class coverage
Managers are continuously searching for alpha in different asset classes and markets. Unfortunately, they might not be able to easily accommodate new instruments with their current infrastructure.
The foundation of a firm’s risk management profile should be a platform that can support complex financial instruments and provide you with up-to-date tracking and reporting. This will allow you to keep track of your risks without any miscalculations.
The platform you choose needs to be able to determine the risks your portfolio is taking on by looking at things like the style of your investments, the sector they are in, their interest rates and other factors.
These capabilities will allow the fund to run timely, comprehensive stress tests for its entire portfolio, as well as individual products, to get a quick, accurate picture of the firm-wide risk position.
The system should also be easily extensible to allow for the addition of new instruments as they become available.
5) Enterprise-wide data mining
Hedge funds often hold and store their data in a fragmented, inconsistent way, taking it from multiple sources. This gives rise to a profusion of data that is difficult to use and format in every company.
While this may provide adequate individual funds or asset class reporting, it can aggravate firm-wide exposure or valuation risks.
To compete effectively in today’s trading environments, hedge funds need data that is cleaned and consolidated in a consistent manner to produce an enterprise-wide view of risk in real time.
From this survey, we read that across the industry, and for the best performer funds, there has been a top concern: Risk Management Systems and Technology tools
Hedge funds are in a dangerous game, but they’re implementing effective risk management measures to make sure they’re on solid ground.
Yet, as the last financial crisis and more recently the pandemic illustrate, events can get out of control quickly. In the face of faster trading speeds, increased volume, growing instrument complexity, and globalization, hedge funds must manage a wider array of risks today than even five years ago.
Meeting these challenges starts with a risk assessment that identifies what risks the company could face and how they deal with them. It’s important to review your systems and processes to make sure they are able to take care of your company’s needs.
A best-practice infrastructure at your company will require a sophisticated IT platform that can report on your global position by counterparty and provide timely valuations. It should also provide an overview of the funds at multiple levels you have in store.
The right technology solution would allow for real-time, actionable financial data at any time, making it easier to avoid risks with high automation for operating the business.
Technology is constantly changing to best serve the needs of the industry with controls that regulate company data and human judgment to create a risk management framework. This framework will help your business compete in a new environment.
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