Middle offices are the lifeline of any successful hedge fund, and in today’s constantly shifting landscape, hedge fund managers need their middle office functions to be scalable and efficient to succeed. After a decade filled with industry tailwinds, macro winds have shifted in favor of hedge funds, and middle office technologies have advanced to evolve along with new market demands.
We spoke with Nadia Cobalovic, Co-Chief Operating Officer, Northern Trust Hedge Fund Services and Devashish Kanoria, Head of Operations, Northern Trust Hedge Fund Services, India, to understand the growing importance of technology in the hedge fund industry and what role it will play in the overall efficiency and performance of the middle office to support portfolios into the future.
Institutional Investor: What are some key components of the hedge fund middle office and how has that evolved over the years?
Nadia Cobalovic: Middle office can mean different things depending on who you ask. In the industry, it seems like many players view the middle office as a set of component services that can be any combination of real-time trade affirmation, lifecycle event management and processing, street-side reconciliations, valuation, cash management, treasury, risk management and P&L. At Northern Trust, it’s anything post-trade execution, so everything that I mentioned. We step in post-execution on behalf of our clients and carry it all the way through to reporting to their investors.
The industry has evolved considerably from some years ago when fund managers performed those functions in-house. There has been a shift away from the in-house model and there are a couple of reasons for this. First, the capabilities and technology of service providers have evolved considerably. Second, these services are not set-it and forget-it. And finally, middle office technology and operations are expensive to stand up and maintain and require scale to provide efficiently.
To best support middle office processes, there needs to be constant investment in people, technology, and the other capabilities that help bring efficiency. Fund managers recognize that service providers have the tools and expertise to make that happen. By outsourcing middle office operations, managers can move this function to a variable cost model and free up capital to invest in their core business functions – raising assets and managing investments.
What are some biggest challenges the industry has faced recently, and how does that impact middle office servicing?
Nadia Cobalovic: Certainly, market change, such as T+1, and the evolving regulatory environment, such as the SEC private funds rule, continues to be a main area of focus.
We have also seen a trend of large managers growing, multi-manager platforms proliferating, and fund launches becoming more infrequent. The focus of these large managers is on managing their portfolios and with that can come increased complexity. For example, a manager may want to expand into digital assets or other esoteric instruments. That can be really challenging from a middle office perspective when a manager increases volumes or expands the types of assets that they manage, and they must have flexible middle office support.
We also see expense pressures. Investors are expecting certain levels of return, and expense control figures into this very acutely. It’s all about how you’re managing your limited resources, whether that’s financial capital or human capital, and how you’re operating your business. Managing expenses as it relates to operating a fund becomes a very big concern and that is where an efficient middle office is most important.
And finally, the need for exceptional talent is very real. That talent needs to have subject matter expertise in the products being traded – with that comes not only an understanding of how to settle the trades but how the product is traded and subsequent life cycle events.
For many hedge fund managers that you see and interact with, where are their middle office capabilities most acutely falling short? What are the specific areas where they’re really struggling?
Devashish Kanoria: For anyone still managing their middle office internally it comes down to constant systems management and investment. We’ve met with managers who built in-house systems over the past decade which were fit for purpose then but now require too much ongoing maintenance, so they are looking for a better path forward.
Another of the biggest struggles we see with our clients is their ability to maintain efficient global operations. If you are a global hedge fund managing your operations in-house, how do you make your operating model scalable? You don’t want to have redundancies. If you have global trading desks across many regions, that’s where the service provider can be a true partner who has a global presence with deep subject matter expertise and can provide support across multiple time zones.
Nadia Cobalovic: While there are still managers who manage some of these processes in house, we have also met with others who may have partnered with a provider early on who now may not be best positioned to support the manager’s changing business. That is usually related to some of the things that Devashish mentioned, like footprint, but can also be tied to capabilities. A provider who was fit for purpose when the manager was starting their business may not be best positioned to support their growth or other changes.
We hear all the time that investors need to keep their technology architecture, data systems, automated workflows scalable and easily adaptable to new technologies if they want to remain competitive. Hedge fund managers are also getting these messages all the time - why is it specifically critical for hedge fund managers to have middle office functions that are scalable and efficient?
Nadia Cobalovic: Without a focus on efficiency and scalability a fund can find itself in a position where it cannot execute its strategy. Over the course of my career, I have seen technology change how we work, and it has been a game changer in how we have been able to improve our processes and help our clients be more efficient. The middle office forms the backbone of an accurate trading book and, ultimately, accurate NAV and investor reporting. We simply can’t get it wrong.
Devashish Kanoria: Change happens, and it always will be that way. Things like margin pressures, cost pressures, etc., will continue to impact the way we work, the way we operate. Some of those changes will also be driven by the regulators. If we talk about T+1 settlement and other market changes, you will need to scale, you will need to be efficient in the way you process or there can be very real negative implications for your business.
Among the various components of middle office services, which are most integral to focus on to significantly increase scalability?
Nadia Cobalovic: I would say the answer to that can be different for each organization. I think some are strong on the trade management side of things, and to Devashish’s point that can make T+1 a non-event. Maybe some are not as strong in treasury, for example, and they’re doing things where they’re logging into multiple websites to manage their cash balances and wires. The answer really depends on the type of organization that you’re talking about and the infrastructure that they’ve implemented.
Ultimately, I think that a high level of scalability and efficiency is important across all those components. As I look at it, whether it’s risk management, treasury management, collateral, all those things, I couldn’t say that one is more important than the other. They all are really critical to ensuring portfolio accuracy.
How is Northern Trust’s solution better positioned compared to other choices in the market to accommodate a hedge fund’s growth?
Nadia Cobalovic: The reality is that we have been doing this for as long as our business has existed. To our advantage, most of our systems are proprietary and we have an in-house technology team. This is not a new service or service offering, which gives us an incredibly strong position in the market. We’re not trying to play catch up and I’m really proud that we have built a business that is market-leading in terms of depth of knowledge and breadth of capabilities. Our ethos is one of partnership with our clients and prospective clients.
One primary factor that differentiates our middle office services is our single platform. Omnium is a robust platform, where trades are modeled to ensure accurate trade capture which then drives accuracy in downstream processes – like settlement, treasury management, reconciliation, and valuation as examples. This allows us to provide our clients with a normalized view of their portfolios across all different market structures. There is no need for cross system data batching and internal system-to-system reconciliations.
Our system can support both public and private assets on a single platform - everything from listed equities and bank debt to OTC derivatives and private credit in one place. This means that as a manager grows and diversifies, we can grow with them. We are also able to manage a high level of complexity, both in terms of fund structures and in terms of products that are traded. Our sweet spot is not only limited to products – we’re also supporting incredible trade volumes on the platform – on average processing millions of transactions on a daily basis.
Today there is growing demand for multi-manager portfolios which means that the ability to slice and dice a portfolio on a consolidated or individual basis is important. Our platform allows for seamless tagging of trades and other activity to allow our clients to view their portfolios in a similar manner to how they view their trading business.
Finally, it’s safe to say that everyone has data, but having one normalized golden source, and being able to distill data into actionable insights, makes a difference and allows managers to scale information, research and the investment process.
Devashish Kanoria: One of our greatest differentiators is our global model which we had well before it became a trend, and this has always been how we have operated. We have a robust follow the sun model that provides staffing scale and efficiency while also offering local support. As normal courses of business, our teams pass the book across the globe to provide our clients with around-the-clock support. This has allowed us to develop a deep bench of expertise in understanding complex, global products, which has helped us to more quickly process solutions and support new products.
After all, service, expertise, and integrity are our enduring pillars – that’s how we’ve built this business, and these are the principles by which we approach our day to day.
What are the specific opportunities and hurdles for hedge fund middle office services that you see coming in the next five years?
Devashish Kanoria: With everything we’ve talked about, we need both technology and people. One is not effective without the other. And I think that competition for talent will continue to be a challenge. With all the buzz about technology and automation, we can often forget that it’s critical to have the best of the best overseeing these processes. For us, investment in technology is crucial, but also investment in the people who can make the difference between success and failure.
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