Building a hedge fund to challenge legacy players

Ross Newell, business development manager at CMC Institutional, discusses some of the challenges faced by those looking to formalise their independent FX trading activities into a structured fund, and why the demands of the investors should never be underestimated.

The path to establishing a boutique hedge fund and beyond is one that requires careful navigation. While this may initially seem an insurmountable challenge to many, it should be considered in the context of the constraints now being faced by bigger hedge funds. With growing frequency, these legacy firms are finding themselves operating in an environment that can make the pursuit of alpha more challenging than it historically has been. That, in turn, creates an opportunity for successful traders to break into this market; and – with the best managed currency funds offering historical returns that far outstrip those seen in other asset classes – if anything, there remains a yawning deficit of investment opportunities in this space.

 

What has driven opportunity in the hedge fund industry?

Ross Newell: There has been a long phase of consolidation in the hedge fund industry, with a pattern now showing that the vast majority of money is being directed towards the larger, more established managers. However, in many instances these legacy players are now struggling to outperform the market and maintain a good rapport with investors when there’s a need to deviate from strategy. This is making for a somewhat tougher outlook. 

Emerging data underlines how smaller, more nimble hedge funds can outperform legacy competitors, and so arguably deserve to be given a chance. The ability to be more reactive in the pursuit of alpha without upsetting investors should be recognised, although the challenge is that getting such a fund off the ground in the first place is no mean feat. 

Investors are often reluctant to leap into the unknown, but these funds were never designed to be low risk. Anecdotal evidence also shows that nascent funds are willing to offer investors far better terms – and thus the potential for more impressive returns – than their established counterparts. 

 

Why are FX funds underrepresented?

Ross Newell: As a multi-asset provider of liquidity, CMC Institutional engages with funds across the spectrum. There does, however, appear to be a perception that the asset class comes with a higher level of risk and this unknown may be suppressing investor demand, but FX fund managers can placate investor concern by applying very defined risk metrics through a number of well-known principles. These include dictating target Sharpe ratios and constraining leverage, while the most efficient returns can also be seen at lower levels of drawdown compared to alternative classes. The potential alpha offered in debt or equity portfolios can be impressive, but the opportunity posed by FX is in another league. On this basis, diversification is an incredibly valuable tool – even in higher-risk strategies, there should still be plenty of demand for funds in this asset class. 

 

What challenges are fund managers left facing?

Ross Newell: There are two key issues nascent fund managers need to address concurrently. First is the reality that they are likely using a range of platforms and accounts with multiple brokers to have come this far, making the leap to formalise their trading into a fund. Second, there’s the need to attract money. As previously noted – with investors leaning towards bigger, more established funds – the ability to show that internal structures are robust is incredibly important. The pursuit of capital also means that savvy investors are having the foresight to drive good deals with this type of fund, suppressing the fees they are willing to pay, with managers left to accept this as part of the cost of business. 

But, beyond that, the transition from simple trading to formally running funds for others also means being prepared for a degree of due diligence to be performed on the fund at any time. The idea that a trader may access multiple trading relationships is unlikely to instil confidence in investors, both from a core risk perspective and also on the basis that intraday or even end-of-day reporting could be cumbersome to deliver quickly and accurately. 

 

How can fund managers overcome these challenges?

Ross Newell: Getting the sales pitch right to harness the funds relies on having the correct combination of credentials, track record and pitch to pique the interest of investors. Internal processes will need to be sufficiently robust to stand up to scrutiny from financiers – then there’s also the challenge of where to get liquidity from. Disjointed systems with a string of poorly regulated brokers held together on a series of spreadsheets is unlikely to make the right impression, and for a fund of this size to get the attention and support of a legacy prime broker is also highly unlikely. This market has changed, pushing expected minimum order sizes well out of reach as a result. 

However, there’s a small group of institutions such as CMC Markets that are very well placed to provide assistance on both these fronts. Experience of multiple technologies, track records of serving many different client types and the availability of robust, institutional quality dealing platforms means the necessary support can be made available, while their own tier one liquidity relationships can be leveraged to deliver high-quality market access. Projecting the image that you are working with a long-established, stock-exchange-listed and well-regulated entity should instil confidence in prospective investors. What’s more, large global institutions by their nature come complete with 24/7 infrastructure support – and that’s before you get to the issue of liquidity.

 

What’s the problem with liquidity?

Ross Newell: Running comparatively small positions as an independent is likely fine even in relatively fast-moving markets but, once order sizes are scaled up, the risk of split fills or slippage can prove problematic. There is also a challenge with ensuring the market isn’t getting advance notice of the pending trade when a quote is being generated, so having access to properly customised pools of liquidity can be critical in creating trade certainty for the fund and/or securing even better prices on a trade. This in turn could be all it takes to ensure a fund’s ultimate success. 

The reality is that evolution in the liquidity market means only the largest of funds will tap prime brokers for market access. With that in mind, finding a solution that allows consolidation of existing broker relationships, along with a pathway that ensures better and more reliable pricing as the weight of money increases, should be instrumental in impressing investors. This again is where working with a long-established and well-capitalised counterparty can prove invaluable. If investors are set on driving a hard bargain when it comes to fees, funds need to do everything in their power to paint a picture of high-quality relationships across all their professional services providers, and be backed off by a downward trajectory on costs – especially beyond the short term. 

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