Thought Magazine

The Case for Operational Alpha in the Alternatives Space

Countering a perfect storm

As regulatory reporting requirements ramp up, the alternatives funds industry considers multiple new protocols. Confronting this "perfect storm" of complexity, fund managers are employing new operational models to help them better strategize to capture alpha. But some things are simply beyond your control— and that's where the trouble can start.

Let's say you are a large global alternatives manager with multiple fund vehicles and products, running the gamut from traditional equities to complex structured products. Of course, you transact with multiple counterparties and therefore maintain multiple accounts with them. In essence, you have exposure to those counterparties on both an intra-day and an ongoing basis.

Unfortunately, if any of your counterparties go the way of Peregrine Financial, MF Global, Lehman Brothers or any other now-bankrupt entity, you will be exposed to a process you no longer fully control. This can ultimately lead to significant losses for both you and your investors—to include both absolute losses, opportunity costs and losses incurred due simply to the time value of money.

Confronting a perfect storm

Trading with counterparties that suddenly declare bankruptcy is only one of many pitfalls that worry today's alternatives managers as they seek to manage systemic risks beyond the more obvious cases of fraud or gross negligence. Add to this the risks associated with the current politicallycharged environment reproving Wall Street for "corporate greed" and "undeserved bailouts"—and it is no wonder that alternatives managers have the sense that they are confronting a potential perfect storm.

On closer examination, it's clear that the elements of this perfect storm are focused on data and information as everyone wants greater transparency. Today, alternatives managers are the targets of frequent demands from investors and regulators—as well as other industry participants intent on "getting a leg-up" in setting new reporting and communication protocols.

Protocols abound

Sadly, while we may be awash in innovative technology such as iPhone, Blu-Ray technology, Twitter and Facebook, the search for a common protocol—a unified alternatives reporting framework for the industry —has proven elusive.

While several new protocols exist, the industry has not yet settled on the winner—nor has it agreed upon harmonized disparate reporting structures or even streamlined reporting processes.

A closer look at the essentials (see figure 1) of the five most frequentlydiscussed protocols out there today illustrates the rising tide of complexity that fund managers face. In addition, guidelines and protocols overlap— both of the governmental and nongovernmental variety.

To begin to find the right solution for their fund, alternatives managers must consider all of these protocols, listen to their investors and then think carefully about their own particular structure and resources.

Since this will require substantial investments in both managerial time and focus, alternative managers may want to consult with a fund administration provider who can help them parse through all of this complexity.

Figure 1: Five Most Important Protocols

Strategic models support operational controls

Industry-wide, alternatives managers faced with these new reporting standards, requirements and protocols are seeking a solution in a strategic framework to help them control operational variables, due in part to the very success of the alternatives industry. This is because the industry's move to more transparency has largely been fueled by increased governmental scrutiny and institutional allocations to alternatives. Allocations are a natural evolution of the institutional investor space, given the significant risk/reward and diversification benefit to investing in alternatives.

Consider Altegris's "The Case for Liquid Alternative Investments,"1 which notes that from January 1997 through March 2012, a traditional portfolio with 60 percent U.S. stocks and 40 percent bonds underperformed the same portfolio that injected 30 percent into alternatives strategies— by a noteworthy 25 percent.

Furthermore, the analysis showed that this traditional portfolio had an annualized standard deviation of 10 percent and a maximum drawdown of -31 percent, whereas the portfolio with alternatives had an annualized standard deviation of 7 percent and a maximum drawdown of -22 percent for the same period.

Which portfolio to invest in may seem like an obvious choice, but experienced allocators know that this decision really depends on a whole host of other variables that allow for the above risk return profile to actually materialize.

Fortunately, one of the most critical variables that alternatives managers can control is operational process and soundness. Once this is understood, the question then becomes how to manage and enhance this critical variable, while allowing for alpha generation in today's hyper-transparencyfocused environment.

It may help to stand back and consider which general, strategic models your fund should adopt for managing your operations (see figure 2), based on some key factors such as fund size and complexity:

1. Insource with Service Provider Oversight Model—Very large funds with US$5 billion plus in assets oftentimes adopt a model where it insources —with provider oversight. Because it has the resources to support a large back and middle office with significant technology outlays, complexity is less of a driver of the decision. As it gets more complex, a third-party fund administrator can provide more value because it can help the business scale.

2. Insource/Outsource Model—The middle group uses its own systems but leans on service providers for key capabilities. This can be true for funds across asset sizes and complexity levels. For example, a $500 million fund may not be able to fund all the systems it needs plus a data warehouse, but it can run an operationally savvy business nonetheless by using a fund administrator to help in mirroring books and records. Of course, as a fund's complexity increases, it will show more interest in outsourcing— and the provider's brand becomes more important.

3. Outsource Model—Finally, if your fund doesn't have an end-to-end operational platform, you need to pick a robust service provider partner. In this third model, regardless of size of the fund, your administrator's brand and strong capital base is most important because of the reassuring signals it sends to your investors.

Figure 2: Three Strategic Models

What works for your fund

Of course, even a cursory glance at these models will show that there is no perfect way to run your alternatives operations. Furthermore, these models by no means represent the only way to think about your operations strategy; they are merely illustrative of some possible scenarios, costs and benefits. What actually works best for your fund will depend on your unique position in the market, among other factors.

What is very clear, however, is that in order to take advantage of current institutional inflows into the space, it behooves alternatives managers to consider such emerging models as a critical step toward providing consistent and accurate reporting across their organizations. To do this well against a landscape of increasing regulatory demands and competing protocols requires a great deal— knowledge of the rules applicable to different markets, understanding about how to harmonize information and the ability to draw that information from one central source.

And, as institutions continue to invest in alternatives, fund managers may want to consider teaming up with a reputable service provider, who can grow and scale with their business.


1 June 2012, www.altegris.comWeblinking practices

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