Pricing of complex over-the counter derivatives is at the top of the list of operational issues facing the buy-side, fund management officials say. At the International Securities & Association for Institutional Trade Communication Europe’s annual conference last November, fund managers voted pricing as the single biggest operational issue they face when processing alternatives such as OTC derivatives. The use of OTC derivatives is common among the hedge fund industry. But recently, traditional long-only funds have been utilizing more of these instruments and the complexity and unfamiliarity of the instruments presents a challenge for the managers.
To support the growing demand for pricing services, administrators are gearing up operational capabilities to offer an expanded service, said David Aldrich, head of Securities Banking, Europe at the Bank of New York. “The utilization of these instruments is widespread within the hedge fund industry and is becoming more common within the traditional long-only funds,” he said. “The move from niche to mainstream use has created a real challenge to managers of these funds. Service providers such as BNY have responded by expanding their service offering to include the automated utilization of third party valuation agents.” JPMorgan and HSBC Alternative Fund Services also offer valuation service and rely on in-house expertise and third-party products. Some of the independent pricing providers include SunGard Reech and Lombard Risk.
“Fund managers want more data,” said one operations executive at a global fund management group. “We want to move to the Holy Grail--where gross net assets and values are provided daily by administrators so we can avoid dual processing and get better data.” Pricing is a key operational issue because it affects other areas of operations directly, so tackling this function can dramatically improve efficiency. Research conducted by buy-side consultancy, Investit, highlighted problems with many operational areas when processing derivatives and pricing was a key hardship for fund managers. “Looking at the other business areas that operations feed, the difficulty in getting timely and accurate data has a much wider impact,” said Joanne Getty, consultant at Investit. This stretches from the fund manager’s modeling tools requiring accurate values and exposures, through to client valuation reporting, risk analysis and compliance reporting.
With daily data, fund managers can avoid dual processing and improve the accuracy of the data, which would benefit other areas of processing, such as net asset value calculations and reconciliation processing, said an official at a fund management group. Today, for example, a fund manager may get the data from the administrator on a weekly or even monthly basis, which means the fund manager must duplicate the data in-house in its own accounting system for its own use. If the valuation was provided daily the fund manager would not have to do the position keeping internally at all, the official said.
To improve operational efficiency for pricing and other functions, fund managers also need to increase their knowledge of products because a lack of understanding of unfamiliar products can often result in operations problems downstream. “There needs to be a greater understanding of the various impacts that these instruments have on a portfolio for each different business area, and relevant data can then be identified to be supplied to the appropriate platforms,” said Getty. “The technical platforms, operations process and community knowledge base all need to be brought up to standard to achieve efficient and accurate processing.” For some managers, the increasing complexity of instruments within managed funds is changing perceptions of outsourcing, said Aldrich. “No longer is outsourcing a last resort, it is increasingly a necessary tool of managers who are focusing on their core competencies, especially the creation of alpha, and taking advantage of the extremely sophisticated solutions available for non-core, but essential, functions such as operations.”