12
I
Citi Prime Finance’s 2011 IT Trends & Benchmarks Survey
IT Investments Follow a Cycle that Results in
Commoditization Over Time
As discussed, the wave begins when there is divergence between
the hedge fund’s needs and the existing system offerings
available in the market. This prompts market leaders to invest
in customized IT solutions. From there, the hedge fund is able
to realize unique capabilities as their differentiated platforms
come on line. Because these offerings are highly specialized,
there is potential over time to commercialize the IT spend
invested by the hedge fund and seek alternate uses or users of
their platform. It is at this point that the “differentiation” phase
of the wave peaks.
The window during which a hedge fund can commercialize their
IT platform is usually short. Market dynamics tend to shift over
time and this works to limit interest in new platforms. There
is nearly always a “frst-mover advantage” in terms of which
frms can successfully syndicate their capabilities or platforms.
Those looking to take this track too late in the cycle fnd that
there is only limited, if any, interest in their offerings. This was a
fact that many hedge funds that sought to commercialize their
trading and portfolio management platforms post-2008 came
to realize.
As more and more hedge funds seek the same differentiation
that earlier managers achieved through customization, new
service providers emerge that are better suited from a scale and
cost perspective to offer a solution. Finally, the consultants who
worked on customizations within the original hedge funds either
create their own offerings or go to work with the underlying
vendor to enhance the standard market platforms.
In this way, core functions become commoditized, allowing
newer hedge funds to easily achieve specialization that earlier
hedge funds had to pay dearly to create.
Timing of Commoditization Waves Vary
The period of time it takes for a wave to crest and recede varies
based on many underlying conditions. As a general rule of
thumb, commoditization will occur much more quickly when
the industry is in a growth phase. Between 2000 and 2007, the
size of hedge fund industry assets increased 4x. According to
HFR, AUM rose from $490 billion to $1.9 trillion in this period.
The number of funds increased from 3,873 to 10,096. This rapid
expansion created an ideal backdrop of new buyers coming to
market seeking the capabilities that earlier funds custom built.
This encouraged commoditization to occur quickly, and Wave 1
to pretty much conclude by 2007.
Aswill soon be discussed, we are currently inWave 2which began
back in 2004. The slowdown in industry growth has dampened
hedge fund IT spend and this is allowing the cycle to draw out
longer than Wave 1. Regulatory pressures are helping to drive
Wave 3. Having specifc dates that the industry must meet for
providing certain information may cause certain capabilities
created in this phase (i.e., compliance) to commoditize more
quickly, whereas other facets of the current spend (i.e., research
management) may remain a differentiator far longer for funds
making investments at present.
It is useful to understand this overview of hedge fund IT
investment evolution before delving further into the drivers,
impact, commercialization and commoditization involved in
each of the three waves of hedge fund technology investment
we’ve identifed.
Wave 1 Customizations Drive Trading & Portfolio
Management Enhancements
Wave 1 is the only full cycle the hedge fund industry has
fnished to date. Each of the stages of this evolution—from the
differentiation early hedge funds sought to be better able to
handle complex portfolios, to the resulting ability to capture
operational alpha through to the emergence of broadly available
middle offce outsourcing services and multi-asset trading and
portfolio management platforms—is highlighted in Chart 8.
To recap, the absence of multi-asset and derivative platforms
was the driver that kicked off Wave 1 IT investments. Pioneering
hedge funds opted to develop their own portfolio management
and trading platforms as existing offerings were seen as overly
geared to long-only managers. Given the lack of sophisticated
vendor systems, funds that invested in these core areas
at the outset of Wave 1 were able to realize a truly differentiated
platform.
At a time when competitors were relying solely on
service-provider reports and trading tools, those hedge funds
that had created customized platforms were able to create their
own view of their portfolio holdings. This allowed for several
benefts. Maintaining reconciled books internally, and being
able to trade both simple and complex instruments based off
of up-to-the-moment positions allowed these cutting edge
funds to realize effciencies and controls beyond those found
at competitors.
“Software has come down-market in the last few years.
Pre-2008, 90% of our deals were with funds managing $1
billion USD+; now, 40%of our deals are with funds managing
under $1 billion USD.”
– General Manager & SVP of Sales and Marketing for a
leading fnancial software vendor