The cost of oblivion

That sweet reverie popped like a soap bubble as managers at small start-up funds realised that today's hedge funds need more than the spreadsheet that came installed on their PC to manage risk.

Microsoft Excel continues to amaze us and the fact that the latest version now supports one million cells says quite a lot about today's market. Whether you find the idea of those millions of cells impressive or frightening may be the personality test one should take when starting a fund.

These are scary times for hedge fund managers. Although there is plenty of money out there, the risk of failure has never been higher. Add in the cost of managing that risk and one has to wonder if anyone is in their right mind to open up a fund in this climate.

Let us look at a few numbers. As reported in the Financial News, the costs of starting up a hedge fund from scratch have tripled thanks to meeting the needs of regulatory compliance and managing risk.

Today's hedge fund manager has more challenges on his or her plate than raising capital and delivering profits to their clients. Now, they must have a strong grasp of technology to keep ahead of a global market and to keep regulators informed and unsuspicious.

At a recent Merrill Lynch conference on hedge funds, managers with less than $200 million in assets under management would have a hard time meeting operational costs thanks to compliance requirements and the efforts to manage the firm's risk. One hedge fund official estimated recently that the cost of a compliance officer has shot up nearly 40% since 2005. And even as firms are pushing back on regulations, they expect further grips from regulators in the near future.

Care for some more bleak news? Last year, an estimated 83 hedge funds closed for business in the US. Although everyone recalls the biggest flameout – the $9.1 billion Amaranth Advisors – the challenges of the smaller funds tell a truer tale. Hedge funds fail for a variety of reasons but the main culprit is a failure to manage and analyse risk. The managers of the dead funds failed to take risk seriously and they should have employed solutions to better manage their risk.

So says Samil Pai, managing member and chief investment officer of ST Capital, a hedge fund based in New York. He says that experienced hedge fund managers who once worked at larger, more established firms often make the same mistakes as the managers who did not.

"Even when managers move from a big institution to a small one, sometimes they lose sight of the fact that there was the big infrastructure around them," he says. "The technology and resources you lose when you go from a big shop to a small one is a very important issue they face when they leave."

In some instances, new and inexperienced fund managers are oblivious to the existence of the risk management tools to help them, according to Pai.

"Probably 30-50% of hedge funds manage their risk on Excel spreadsheets, according to one study. There are a host of tools out there that are for Monte Carlo simulations and so on, that provide risk management support. The prices range from the thousands to the hundreds of thousands of dollars," he says.

Add in the cost of operating in a global marketplace and the regulatory requirement to archive email and instant messages for nearly a decade, and the technology woes and bills quickly start to pile up.

In some cases, a chief executive of a hedge fund is also its acting chief risk officer and its chief technology officer. Multi-tasking may be a hallmark of today's hectic lifestyle but it can be a nightmare for an ambitious hedge fund.

The hedge funds of tomorrow will still have phones and PCs, but there will be a vast array of technology to keep them afloat – all at a cost, though. That is no dream. >