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2009

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Inside This Issue
Overview: The Changing Hedge Fund Landscape Shapes Demand For Technology From CRM To Compliance: The Madoff Effect Drives Demand For A Data Trail Risk Management: The Pros And Cons Of Building Your Own System FINalternatives Survey: High-Frequency Trading Has a Bright Future Need For Speed Drives Technology Q&A: PerTrac Execs Say Hedge Funds Need to Step Up Transparency, Risk Management To Lure Investors Hedge Funds Slash Overhead, Vendors Reap The Rewards Hedge Fund Software & Technology Providers 2

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Hedge Fund Technology & Trading 2009

The Changing Hedge Fund Landscape Shapes Demand For Technology
By Deirdre Brennan Last year’s major shakeout in the hedge fund industry—with roughly 20% of all funds closing up shop—has radically altered its technology and risk management landscape. Those funds that did survive and the new ones just entering the market are scrambling to equip their operations with the best platforms to appease both their investors and the regulators tightening the screws on them. But after the recent market bloodbath, and the attendant disastrous returns and huge redemptions, building operations inhouse, or even supporting existing technology, is sometimes no longer financially feasible. Outsourcing, once taboo in hedge fund circles, has become a viable option for funds looking to scale down their in-house operations, while at the same time improving risk management and transparency—the new buzz words in the hedge fund industry. But the question of whether or not to outsource certain middle- and back-office functions is a big one, and there is no blanket answer. Matt Simon, an analyst at independent research firm Tabb Group, explains that a fund’s size, strategy and philosophy all contribute to whether or not a firm decides to utilize third-party vendors. “One thing that hedge funds have learned over the years is that building technology can be time-consuming and is not their core business. They are there to manage money, not to build technology,” he says. “But, for some of these high-frequency/stat-arbtype players, the building of technology is
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their core bread and butter. So, for those guys, the building of technology is something that they are going to continue to do.”

Hedgies Split On Strategy

In fact, Simon, who has been studying the industry in preparation for a report due out in September, says that the hedge fund universe is increasingly breaking into two camps—the “Warren Buffet-style, buyand-hold” camp, where managers study balance sheets and read sell-side reports, and the “trading” camp, where sophisticated proprietary traders try to capture small profits from large volumes of trading. “The traders don’t really care what the underlying names are; they are more interested in being able to capture spreads and be able to profit from short-term blips in the market trading patters,” Simon says. Addison Tsai, managing director at Old Greenwich, Conn.-based hedge fund shop SDS Capital Group, is seeing tremendous growth in this area first-hand. “A lot of trading strategies are converging to higher frequencies,” says Tsai. And while the number of money management firms utilizing so-called highfrequency trading strategies is miniscule compared to the overall universe of asset managers, according to Simon, those traders are responsible for 73% of the equities trading volume on U.S. exchanges, and he expects them to consume an even bigger piece of the pie in the future. ►
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In Shift, Investors Hold The Cards
Once upon a time, an investor counted himself lucky to be able to gain access to a top-tier hedge fund. Managers such as SAC Capital Advisors’ Steve Cohen and Renaissance Technologies’ Jim Simmons could write the rules, imposing hefty minimum investment requirements, long lockup periods and high performance fees, with smaller, less pedigreed managers following suit. Investors smiled and handed over their money, satisfied that they were getting the best possible returns on their investments. Then, in 2008, the sky fell. Lehman Brothers collapsed, Bear Stearns went the way of the dodo, liquidity and credit dried up, arch-fraudsters Bernard Madoff and Marc Dreier revealed that supposedly sophisticated hedge funds and funds-ofhedge-funds were some of their biggest patsies, and hedge fund managers lost the biggest bargaining chip they had over their investors—solid returns. “This fall was a key pivot point in the industry, where for a long time investors didn’t have a lot of power—hedge funds did things their way,” says Chris Momsen, senior vice president and general manager of global accounts at Advent, a financial software firm that specializes in portfolio management and accounting platforms for asset managers. “I think hedge funds had inappropriately structured their fees in regards to their investment strategy.” He explains that managers who were investing in illiquid securities that became even more illiquid were facing off against investors who wanted to redeem. “Managers had to give them their money within 30 days or put up gates, which caused problems,” he says. “So what I
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think you are going to see going forward is a better alignment between the time horizon of investors and the management style of the hedge fund.” And how will this be achieved? Transparency. “Some of that will be solved by lookthrough reporting, so the fund investors will see their underlying investments in the fund,” he says. Transparency rules the roost in 2009. According to Tabb’s Simon, “transparency of positions, transparency of balances, transparency of pricing—anything to do with transparency,” is foremost on both investors’ and managers’ minds. One firm that has always insisted on full transparency is New York-based hedge fund incubator SkyBridge Capital. Co-founder and managing partner Anthony Scaramucci explains that all of the funds that his firm seeds must be completely transparent. “We want to have an interface with a fund manager’s prime broker. It’s like a Reagan ‘trust but verify’ relationship,” he says. “What we do is have a feed from one of the software providers where everything gets uploaded into that system, and we have a global macro portfolio report that gets generated by that software.” The data feed not only provides SkyBridge with piece of mind that everything is on the up and up and the trades are being cleared and reconciled correctly, but it also serves as a risk management tool. The system SkyBridge utilizes, GlobeOp Risk Services’ GoRisk, can be used for back testing and stress testing strategies, and also to independently confirm to investors that agreed investment style, risk profiles and limits are being adhered to. ►
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“It has proven to be a good way to sell these managers because when we go out to market them to institutions and high networth individuals, us being able to say that we have transparency and that we have a great, solid risk management team working alongside the manager adds credibility to the manager,” he says.

Transparency Is Key, But Accuracy Is King

stress tests to properly inform the portfolio manager’s macroeconomic views takes time and must be customized. It’s not the complexity of the technological screens that will impact an investor portfolio. It’s the hedge fund manager’s proper interpretation of the information that far surmounts the aesthetics. All said, consistency and content outweigh all else.”

While transparency is important, accuracy is critical. If managers don’t have proper data, all the analysis and transparency in the world won’t help them make good investment decisions. “The Advent view of the world is that everything is based on accurate accounting information,” Momsen says. “If people have data in spreadsheets, and the information in someone’s hand is not accurate, then the firm can make erroneous decisions, and that can allow them to be undermargined or overmargined; it can cause trading errors.” Rachel Minard, president of San Francisco-based hedge fund Cogo Wolf Asset Management, agrees that the most important thing for her is to get accurate data so that her fund managers can make informed decisions. “New technologies and the costs associated [with them] are not the biggest challenge, but rather procuring the relevant information to inform the investment team’s top-down views,” says Minard, whose firm employs a combination of both in-house and outsourced technology and software. “Almost all hedge fund data is historical. Constructing the appropriate optimization model and programming the relevant
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The Prime Focus

In the past year, the wisdom of the proverb warning not to keep one’s eggs in just one basket proved true once again. When Lehman’s basket had the table knocked out from under it, the hedge funds that used its prime brokerage services were left with egg on their face. The result? Hedge funds are now using more than one prime broker. This, of course, comes with its own set of operational issues. “Most systems out there were either built by broker-dealers or bought by broker-dealers. As a result, there was a lack of willingness to work with other brokerdealers,” says Bo Vastine, director of sales at Advanced Financial Applications, a technology company that provides a platform to help traders manage their workflow in a multi-prime environment. “When you began to see not just the large hedge funds, but the medium and small hedge funds moving toward a multi-prime scenario, the system that they may have been using for their single prime could no longer facilitate the workflow for their second prime. That meant a lot of manual processing, even cutting and pasting.” Vastine says that what hedge funds are looking for is a system to tie these multiple primes together, with some important ►
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considerations to take into account, such as ease of use, ease of integration and connectivity. “A system like ours that is agnostic allows them to generate those end-of-day files to multiple prime brokers and custodians,” he says. Advanced Financial Applications currently works with 23 different prime brokers, and its open architecture allows it to be fully customized to the users’ needs.

Picking Your Providers

While there are a multitude of factors for hedge funds to consider when selecting service providers, one long-time industry expert says that hedge funds aren’t, in fact, actively selecting their service providers, which can be a costly mistake. “The due diligence that hedge funds do when picking their service providers is horrible,” says Jeffrey Rathgeber, co-founder of hedge fund consultancy Pelorus Advisors. “If you go to those meetings where hedge funds are picking a fund administrator or a prime broker, the [fund managers] let the prime broker run the show.” He also says that hedge fund firms often let pre-existing relationships influence which providers they use, even if that provider is not the best one for the given task. He points to a case where one of his former hedge fund clients traded bonds through Goldman Sachs and traded equities through Lehman Brothers. “The managing partners had their minds set on it because those were their existing relationships,” adding that at the time, “Goldman was the king of equities and Lehman was the king of fixed-income. They had it backwards.”
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Rathgeber says that no matter what the software or type of technology a fund is thinking of using, the managers should make a list of exactly what they want or need from a system, and then give that list to the service provider well in advance of the presentation. That way, the service provider will have time to put together a presentation to show the manager exactly how the system or software can perform those stated tasks. “If you look at a hedge fund, the amount of operational effort that is spent recreating the world that they wanted all along but never really communicated effectively is staggering,” he says.

The Road Ahead Could Be Rosy
While some hedge fund investors may use the tough economic environment as an excuse to sit on the sidelines, some see a reason for optimism. In fact, according to one investor and manager, there may never be a better time to make money. “In an environment like this there has never been greater opportunity,” says Scaramucci, who will be rolling out the third SkyBridge fund of hedge funds later this summer. “First, there is a tremendous amount of talent still looking for homes in the musical chairs of Wall Street and hedge funds. Second, there is a shortage of capital. People are fearful to put money out. And third, you add to that distressed prices, and that sets up pretty well for good investment opportunities.” But to profit from those opportunities, hedge fund managers need to adapt to the changing needs and requirements of investors and regulators, as well as those of a changing marketplace.
Hedge Fund Technology & Trading 2009

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© 2009 PerTrac Financial Solutions. All rights reserved.

From CRM To Compliance: The Madoff Effect Drives Demand For A Data Trail
By Hung Tran & Jonathan Shazar Bernard Madoff has gone up the river, unlikely to ever return. But the specter of his $65 billion Ponzi scheme continues to hang over the alternative investments industry. For many investors, especially those of the all-important institutional variety, the only way to combat Madoff’s dark cloud is to shine a bright light on what have long been the more secretive corners of the industry. Onepage monthly statements from hedge fund managers are no longer enough; their clients are demanding transparency, due diligence and risk management previously anathema to many in the industry. They want detailed reports on everything from how managers are selected and who their prime brokers are to how those managers reconcile their trades and balance their books. “Since the Madoff scandal, we’ve been dealing with multi-billion dollar endowments and pension funds that are looking to automate and create an [audit trail] around their research and diligence process,” says Jeremy Bacon, a Goldman Sachs veteran and founder of Backstop Solutions, which offers customer relationship management, sales, marketing and accounting services. Chicagobased Backstop has a total of 185 customers on its platform, 105 of them being hedge funds. Bacon says the firm has continued to grow, despite the recent trials and travails of the alternative investment industry. “We’ve obviously had clients fold, but we’ve continued to add more clients than we’ve lost,” he says.
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Erol Dusi of Imagineer Technology, which provides software and tools to help hedge funds and other investors run their businesses more efficiently, has also seen his firm benefit from growing demand for transparency. He says hedge funds that previously did not report their numbers to databases are now rushing to get their information out. “We’re seeing a tremendous [movement] in that direction, and it’s all a result of what has happened within the last six months,” he says. Baseball fans spend countless hours debating a player’s “intangibles,” the things that don’t show up in box scores or statistics but that can be the difference between winning and losing. There is a similar focus today from investors—spooked, no doubt, by the shadiness of Madoff’s operations— on the things that don’t have a metric represented by a letter of the Greek alphabet. “The fact is, you’re investing in the managers’ ability to manage during tough markets, and you’re investing in his integrity and personality,” Dusi says. “Those things are not going to be captured in returns. Rather, they are going to be calculated from your meetings with them and data from background checks.” In fact, it is those intangible details that are often the deciding factor in whether a fund manager wins a mandate, according to one consultant from Cambridge Associates, who asked not to be named. ►
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“I take detailed notes on every manager I meet, from whether they seem fidgety to what they order at lunch,” said the consultant. “If the guy I’m meeting with has whisky on his breath and bags under his eyes, you can bet that I’m not going to recommend him to my client, even if his numbers are out of the park.”

Specter Of Regulation Looms Large

Fear of being taken in by the next Bernard Madoff is not the only factor driving the demand for a paper trail. New regulation of the alternative investment industry looming both in the U.S. and in Europe has managers rushing to anticipate what will be required of them by authorities. While it’s still unclear what form new regulations will take—that there will be new regulations is a certainty. It seems equally clear that new regulations will, at a minimum, force hedge fund and private equity managers to offer greater transparency and impose stricter compliance requirements. Research and advisory firm Celent expects that global information technology spending associated with governance, operational risk and compliance activities will increase from $1.4 billion in 2008 to $1.7 billion in 2011. “There is now a ‘get big or get out’ theme at play,” says Cubillas Ding, a senior analyst at Celent. “Firms and vendors need to position themselves accordingly in terms of purchasing or developing solutions. Significant investments are required in an end-user market which is increasingly sophisticated in its demands.” Ding’s colleague, Isabel Schauerte, concurs.
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“Regulation is sure to place greater burdens on the middle- and back-office functions of hedge funds,” says Schauerte, a capital markets analyst at Celent. “Here, the last years have seen great progress in terms of technological sophistication. In many cases, funds have grown to a size and scope that forces managers to run their business more formally. This has spurred technology adoption rates.” Schauerte also credits the increase in institutional investors’ allocations to hedge funds for the push to adopt better technology. “The growth in assets from this breed of investors comes with requirements on operations and risk management that have forced hedge funds to embrace IT to a greater extent,” says Schauerte. “Going forward, regulatory compliance is also going to be a greater issue for hedge fund administrators.” But despite the inevitability of stricter regulation, many firms have not accorded improved compliance systems the priority they deserve, according to Bill Mulligan of New York-based HedgeOp Compliance, which provides compliance, operational and due diligence reporting to the alternative investment industry. “When we get involved, we make sure that there are not other priorities that are going to push compliance issues to the back of the line,” he says. And according to Backstop Solutions’ Bacon, the time to prepare for the looming regulations is now. “Each vendor out there has had to make sure that their systems can help to buoy the compliance and regulatory requirements as related to the products that they’re offering,” he says.
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Risk Management: The Pros And Cons Of Building Your Own System
By Aleksey Matiychenko, Risk-AI, and Alexander Makeyenkov, DataArt Risk Management is in vogue these days. The crisis of 2007-2008 has in many ways been blamed on the failure of risk managers to predict the stress that we have all now lived through. With global markets rebounding and hedge funds posting positive results, the discussions about improving risk management policies and systems are taking place at many hedge funds. Effective risk management requires that the firms establish culture, policies and procedures that are specific to their operating model. However, at its core risk management is a quantitative discipline that requires significant investment in data, systems and people. In this article we discuss what it takes to develop internal risk management architecture.

Necessary Tools

Since risk management is a quantitative discipline, the first step in developing risk management infrastructure is the development of a repository to house four types of data: 1. Holding and trade level data 2. Historical pricing data for securities traded by the fund 3. Historical data for risk factors used in various analyses 4. Results of risk management analyses It’s been a long term practice in the financial services to use Microsoft Excel as a tool for both storing data and performing analysis. The growing complexity of financial products and the need to have robust systems make Excel spreadsheets a less than ideal environment to store data. To be truly reliable, the data used in risk management analysis should be housed in a relational database such as a MS SQL Server or Oracle. Once the data repository is built, tools to analyze the data need to be put in place.
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The exact set of tools depends on a hedge fund’s strategy, range of securities traded, liquidity and other factors. There are, however, some tools that are likely to be used across all hedge funds. ● Value at Risk (VaR) – Perhaps no other tool received as much criticism and blame for the current crisis as VaR. While VaR has many well documented shortcomings, it’s likely to remain an important part of a risk manager’s toolbox. VaR provides risk managers (and their bosses) with a quick read of the hedge fund’s risks. ● Stress Tests – Scenario analysis based on either historical stress events or theoretical scenarios can be used to complement VaR analysis. ● Greeks – Various sensitivity measures such as Option Delta, Gamma and others provide important information about the fund’s exposure to different market factors. ● Factor Analysis – Factor analysis can be used to uncover potential hidden tilts in the fund’s portfolio. ►
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Risk management systems should be able to perform the above analysis and provide clear and consistent reporting mechanisms so the output of the analysis can be used by risk managers, traders and a fund’s investors.

Build vs. Buy

Whenever new systems need to be put in place, the usual question of build versus buy arises. There may be many factors that affect the ultimate decision to build or buy a system. Though price is often an important criterion, it should not be the deciding factor. There are many instances when a hedge fund should opt for a buy decision and avoid spending time and resources on internal development. The buy decision is usually justified when implementing systems that aren’t specific or critical to the hedge fund’s core strategy. Such systems usually include: contact management, accounting, trade capture and others. The decision to buy or build a risk management system depends on the complexity of the hedge fund’s strategy and the variety of products traded. Most commercially available systems may be sufficient to analyze a certain range of products. Few systems are able to produce meaningful analysis of a diversified and complex portfolio. Even fewer do it well. If anything can be learned from the current crisis it is that risk management needs to be part of a core strategy of any investment firm. What this means is that risk management systems need to be part of the core strength of any hedge fund that wants to stand out. For such hedge funds, buying an off-the-shelf product may be a first step in
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developing risk management architecture, but it shouldn’t be the only step. Ultimately, all commercial packages are made to be able to satisfy the largest number of customers. Some packages can be customized to each client’s needs, but the customization effort may be complex, limited in scope and expensive. We have seen such implementation at a number of hedge funds. The usual architecture involves a vendor risk management package such as Risk Metrics, MeasureRisk or others. Any risk management system (vendor or inhouse) needs to be integrated with trade capture, portfolio management, and back office systems. Depending on the complexity of the fund’s portfolio, the vendor system may not be capable of handling certain instruments. In such situations, the solution may involve either building an internal system to handle these instruments or purchasing an additional vendor system(s). We, in fact, have seen multi-strategy hedge funds purchase one system to handle equity products, a second system to handle fixed income, and a third system to handle exotic products. Ultimately, all these systems need to work together. While ensuring seamless dataflow and building custom reporting that integrates all the systems is a big task in itself, there is an even a bigger issue. At the end of the day, a risk manager needs to have a complete picture of portfolio exposures. Such a picture needs to incorporate correlations among various products that exist in disparate systems. Building a tool to bring all these exposures together is akin to developing a complete risk system from ► scratch.
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A typical risk management infrastructure at a multi-strategy hedge fund
Trade Capture Market Data Portfolio Management Fixed Income Risk System

Central Data Repository

Equity Risk System Other Risk System

Integration System
Custom Reporting Risk Aggregation Straight Through Process

Equity Risk Reports

FI Risk Reports

Other Risk Reports

Portfolio Level Reports

For a fund that has decided to dedicate time and resources to develop its own risk management system, the decision of whether to hire full-time personnel or to outsource the development needs to be made. Developing a risk management system is not a trivial process and is likely to take significant time and money. Human resources required to implement such a project typically require at least two, and likely more, highly-skilled professionals with graduate or post-graduate degrees and extensive software skills. Even in the stressed employment markets that we are experiencing right now, such individuals carry an expensive price tag. Hiring several such individuals may not justify the value added by the development. AddiFINalternatives 12

tionally, a proper enterprise-level development effort will require investment into project management, quality assurance and maintenance practices, all of which will call for extra hires. The solution to this may lie in outsourcing a significant part of such development to a firm specializing in such projects. The in-house vs. outsource decision does not need to (and perhaps shouldn’t) be mutually exclusive. In order to extract the full benefit from the custom developed system, the fund should employ at least one of those highly-skilled risk professionals capable of modifying and maintaining the system. Having an outside vendor perform most of the development would ensure faster implementation. ►
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Cost Comparison

It’s impossible to estimate costs of implementing a robust risk management system without detailed analysis of the fund’s strategy and operations. However, some basic indications may be provided.

Vendor Package
Vendor System Integration & Maintenance (2-4 developers) Total

From

Cost

To

Time To Implement
3-6 Month 3-6 Month 6-12 Month

Total Cost of Ownership (5 Years)
$1,000,000 $1,000,000 $2,000,000

80,000 250,000 200,000 400,000 200,000 400,000

Custom In House
Development & Ongoing Maintenance

From

Cost

To

Time To Implement
9-12 Month

Total Cost of Ownership (5 Years)
$3,000,000

400,000 600,000

Custom Outsourced
Development Annual Maintenance

From

Cost

To

Time To Implement
6-9 Month

Total Cost of Ownership (5 Years)
$1,000,000

400,000 600,000 50,000 150,000

Developing a custom risk management system is a perilous undertaking indeed. A lot of things can go wrong in such a complex project. If done right, though, it provides important the benefit of a custom-tailored solution at a price level comparable to, and often better, than many commercial products. Aleksey Matiychenko is a Senior Partner and Chief Executive Officer at Risk-AI, LLC Alexander Makeyenkov is a Senior Vice President of Capital Markets at DataArt

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The Great Investor’s Mentality Quiz do you have it?
Take the quiz and remember that great investing is a mindset, not a skill-set. Unfortunately, mindsets are harder to change than skill-sets. But just like other great investors, you can put systems and discipline in place to help foster a culture with the “great investor” mentality. 1. a blackjack player has 19, takes a hit and gets a 2 for 21. Was the decsion to take a hit a: a. Good decision b. Bad decision 2. a $20 stock has $15 in net cash and a volatility of 50%. the risk of this stock should be measured by: a. Downside potential - $15 net cash b. Volatility - $10 (based on 50% volatility on $20 stock price) 3. Letting “winners run” should enhance portfolio returns: a. True b. False 4. you buy a house for $1 million that subsequently declines in value to $500,000. someone offers you $800,000 for the house. do you: a. Take the deal b. Pass 5. human instincts are well-designed for portfolio management: a. True b. False 6. risk-adjusted return should be the highest weighted factor in determining position size: a. True b. False 7. the best time to buy is when: a. Fear in the market is low b. Fear in the market is high 8. economic forecasts are an easy way to improve an investment thesis: a. True b. False 9. two stocks trading at $20 have the same potential upside to $40 and downside to $10. you have greater confidence in the upside being achieved for stock one. assuming all else equal you would: a. Have a greater exposure to Stock 1 b. Have equal exposure to both assets 10. Modern portfolio theory is the optimal method to manage a portfolio: a. True b. False
To find these answers visit Alpha Theory’s website at: www.AlphaTheory.com/quiz. ALPHA THEORY (212) 461-4757 | info@AlphaTheory.com | www.AlphaTheory.com

IneffIcIent posItIon sIzIng Is the bIggest rIsk funds take toda . y
Alpha Theory fixes the problem and provides true risk management for fundamental investors.

FINalternatives Survey: High-Frequency Trading Has a Bright Future
By Irene Aldridge High-frequency trading has grown exponentially in the past several years, and, according to the FINalternatives 2009 Technology and High-Frequency Trading Survey, that growth is here to stay. A whopping 90% of respondents think that HFT has a bright future. In comparison, only half believe that the investment management industry has favorable prospects, and only 42% have a positive outlook when it comes to the U.S. economy. Given that dose of pessimism, it should be noted that HFT tends to work particularly well in volatile range-bound markets like the current economic environment. The optimism for HFT—which research firm Tabb Group estimates accounts for 73% of equities trading volume on U.S. exchanges—is bound to bring additional skill and capital to the high-frequency arena. At present, many financial industry participants understand the business of HFT, yet few understand the details and implementation involved. Some 39% of hedge fund managers, investment advisers, executing brokers and proprietary traders have just “a little” understanding of the high-frequency business, according to the FINalternatives survey, with 52% reporting a solid understanding. By contrast, only 40% of the respondents report that they had a solid grip on the implementation of HFT, with 19% reporting no understanding of implementation tactics whatsoever. The outlook for HFT is largely driven by the high profitability potential of well implemented HFT systems. While traditional buy-side trading strategies hold positions for weeks or even months, HFT is ►

Need For Speed Drives Interest In Technology

There’s a major technology shift happening in the financial markets, one that isn’t going unnoticed by the alternative investment industry. New exchanges and electronic communication networks have come online, fragmenting the market and increasing the potential number of trades. All of these innovations require efficient data transmission: messaging involved in order transmission, confirmation of order placement and the like. Technology has enabled these changes, especially the efficiency and speed of execution, most notably, increasing the number of daily trades while simultaneously decreasing the average trade size. Given the changes, it’s no surprise that over 60% of the respondents to the FINalternatives 2009 Technology and High-Frequency Trading Survey said their ability to execute electronic trades is “extremely important.” ►

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characterized by fast turnover of capital. Instead of capturing large price changes over extended periods of time, HFT aims to book multiple small gains over short pe-

riods of time. An overwhelming 86% believe that the term “high-frequency trading” referred strictly to holding periods of only one day or less. ►

Distribution of responses to the question “What position holding time qualifies as HFT?”
70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% < 1 second 1 second 10 minutes 1 hour 4 hours 4 hours 1 day 1 day 5 days 5 days 1 month 1 month 3 month Over 3 month 10 minutes 1 hour 0.0%
Source: July 2009 FINalternatives Hedge Fund Technology & Trading Survey

According to Jim Wang of the Stevens Institute of Technology, the six global equity top exchanges combined send and receive 200,000 messages each second during trading hours, with an average message taking just 0.115 seconds to reach its destination. Robust technology enables this kind of information throughput. One way to speed up the transmission of messages between exchanges and their clients is locating order-sending servers in close proximity to the exchange, a practice known as co-location. Co-location reduces the distance the trading message needs to travel to and from the exchange. Still, only 15% of the survey respondents rated colocation as an “extremely important” capability, with 60% of the survey respondents rating co-location as “not important.” Despite its perceived lack of importance, most respondents (58%) also outsource at least part of their co-location capabilities. Among other highly outsourced technological capabilities were Internet-wide information gathering (57% outsource this capability) and trading software (outsourced by 64% of the respondents). ►

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Intra-day position management is important for two reasons: savings from the overnight position carry costs and elimination of the overnight risk. The carry is the cost of holding a margined position through the night; it is usually computed on the margin portion of account holdings after the close of the North American trading sessions. Overnight carry charges can substantially cut into the trading bottom line in periods of tight lending or high interest rates. Second, closing down positions at the end of each trading day also reduces the risk exposure from the passive overnight positions. Smaller risk exposure again results in considerable risk-adjusted savings. In addition to high capital turnover and intraday entry and exit of positions, the FINalternatives survey respondents further identified the following key distinctions of HFT: Trading decisions made upon tick-bytick data analyses and Algorithmic trading. Tick-by-tick data processing and high capital turnover do indeed define much of HFT. Identifying small changes in the quote stream sends rapid fire signals to open and close positions. The term “high-frequency”

itself refers to fast entry and exit of trading positions, the process best executed by algorithms and dedicated computer programs employing artificial intelligence. Only 51% of the respondents report using HFT at present, but 60% of the respondents indicate that they intend to use HFT in the future. The FINalternatives survey garnered 202 responses, of which half worked for a hedge fund, 26% for an investment advisory or consulting firm, 12% for a fund of hedge funds, and smaller numbers for executing brokers, proprietary traders, mutual funds, research providers, technology firms and family offices. Some 59% said that portfolio management is their primary responsibility. Irene Aldridge is an expert in algorithmic and high-frequency trading. Ms. Aldridge’s new book “High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems” (Wiley Trading, ISBN: 9780470563762) is available for pre-order on Amazon.com. Ms. Aldridge can be reached at ialdridge@ablealpha.com.

The two least-outsourced areas proved to be computer-aided number-crunching and computerized generation of trading signals: 62% and 58% of the survey participants, respectively, indicated that they prefer to perform these functions internally in their entirety. Other functions for which the participants showed strong preference to develop and run in-house were backtest engines and investment allocation modeling software. Still, survey participants reported interest in buying selected off-the-shelf software. In particular, 55% of the respondents reported having bought electronic execution software and trading software; 50% noted buying Internet-wide information gathering software and real-time third-party research. It seems that trading technology still has long ways to go to meet the rising interest and demand.

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Q&A: PerTrac Execs Say Hedge Funds Need To Step Up Transparency, Risk Management To Lure Investors
When it comes to analytic and workflow solutions for investment professionals, PerTrac is the undisputed 800-pound gorilla of the asset management industry. The firm boasts more than 2,000 clients in 50 countries, including institutional investors, family offices, private banks, service providers and money managers. While the firm is best known in the hedge fund industry for its PerTrac Analytical software, which tackles the quantitative side of investment management by helping money managers track and analyze investments, that is only one spoke in the wheel. Two other software systems complete the firm’s PerTrac suite: PerTrac CMS—which helps managers keep track of communications with their investors and service providers—and PerTrac Portfolio Manager, which helps funds of funds and institutional investors manage information relevant to their portfolios. And while growth in the money management industry has slowed, PerTrac has continued to roll out innovate new products, such the snappy sounding P-Card, which promises to help smooth communications between managers and investors. FINalternatives recently sat down with PerTrac’s president and CEO, Gerald Mintz, and his colleague, managing director Meredith Jones, to discuss how the hedge fund industry is changing, and more specifically, how new pressures on the industry are forcing managers to increase transparency, strengthen due diligence and invest in technology.
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►
Hedge Fund Technology & Trading 2009

How did last year’s tough market conditions and high-profile scandals affect the alternative investment industry?

‘Don’t redeem; hold on.’ So, I think all of those shifts are going to cause people to want to track each of those things more carefully going forward.

Mintz: The industry has really gone through a severe shock—some people have fallen What changes are happening in the indusout and other people will likely still fall out. I try now, and how are they driving demand would say that all of the trends in the indus- for technology? try argue toward people having more automated, third-party systems. There’s less Jones: I’ve been in the industry since beconfidence in a marketing report that is fore Long-Term Capital Management blew produced by a manager’s own Excel tem- up, and I’ve watched the progression of how plate and own calculations than one pro- the industry has matured following each criduced by something like PerTrac that has sis. After LTCM, after the tech wreck, and a known name. There is a strong desire for now, clearly, after the market meltdown people to have tools to track and document and Bernie Madoff, there’s been a period of due diligence. Also, traditionally managers were reluctant to share informa“You can’t see a survey these days where tion with investors, but they don’t rank transparency and investors are now demanding that they get risk-management right behind performance.” more information about the underlying risk. Investors want things like sector exposure or strategy exposure or re- rapid maturation in the markets and in the gional exposure, and they want to be able alternatives space. What we’re beginning to aggregate that information and make to see right now is an accelerated process focusing on transparency. You can’t see a decisions. Liquidity mismatches are also a big survey these days where they don’t rank deal for people—making sure that the transparency and risk-management right promised liquidity of, say, a fund-of-funds behind performance, whereas before, perproduct actually matches the liquidity of formance was far and away the most imthe underlying investments. For example, portant thing that investors were looking for. if an institutional investor is co-mingled in a fund with high net-worth investors, that How is the looming potential for increased may not be such a great thing. Some of regulation affecting funds? the high net-worth investors may want to cash out and that would force redemp- Jones: In terms of internal systems, certions, while the institutions might say, tainly regulation could have a large ►
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impact on that as well. What’s required by various governments will drive to a large extent how the industry has to evolve with respect to technology. The way they do business, who they talk to, who they don’t talk to; all of those kinds of things. A lot of things are up in the air right now. Clearly, with the whole regulation issue, there have been some proposals on the table, but nothing concrete. I think all of those things are going to push toward transparency as well. We’re moving further down the transparency line and we’re also moving toward daily and weekly estimates so that people have a better view as to what’s going on in their portfolio. Are you seeing any new hedge fund launches? Jones: I did a prime broker event and, of the 25 groups that were there, four of them were new funds that were just starting out. But they’re taking a more cautious approach, and they’re also taking the time to get some systems in place. It’s not just two guys in a townhouse running a fund anymore. We’re probably looking toward the late third or fourth quarter for the number of new funds to starting ramping up again. Mintz: I think what Meredith said that is a really important point to emphasize is that barriers to entry are higher because inves-

tors are looking for proper risk systems and transparency, at least in terms of where the assets are, and making sure you’re not dependent on one prime broker. The Lehman situation certainly scared a lot of people with the assets kind of held in limbo. And then on the fund of funds side, people are looking to see what’s your value-add. If it’s due diligence, prove to me that you have a really rigorous due diligence process and systems around that. If it’s portfolio construction, show me that you’ve got a good handle on risk and you can give me a portfolio that’s going to perform well and not give me as much kind of a dispersion that I might get if I just picked a set of funds. So, in each case, managers are going to have to put in systems and procedures to show investors that it’s worth investing in them. That, of course, will raise the cost of a launch. So, it argues that funds have to be a little bit larger to be able to afford those kinds of systems. I think the bar has been raised for what you need to run a fund. What is the future of the industry? Mintz: I think you’ll see more outside administration, and I think more focus on custody of the assets. We may see more in managed accounts, which is one way to address some of the custody and liquidity issues.

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When every millisecond counts, you can count on this book.

Written by industry expert Irene Aldridge, HighFrequency Trading offers innovative insights into this dynamic discipline. Covering all aspects of highfrequency trading—from the formulation of ideas and the development of trading systems to application of capital and subsequent performance evaluation— this reliable resource will put you in a better position to excel in today’s turbulent markets.

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Hedge Funds Slash Overhead, Vendors Reap The Rewards
By Hung Tran As assets under management dwindle and performance fees fall, hedge funds are increasingly looking for ways to cut costs. But choosing whether or not to outsource certain operations—especially those that have traditionally been done in-house, such as risk management—is a big decision. Managers must not only look at the potential cost savings, but must also consider the quality, reliability and security of their vendors. Despite the caveats, hedge funds are increasingly taking the leap. “It used to be a black mark to have outside risk managers,” says Kenneth Grant, who has served as head of risk management for some of the world’s most prominent hedge funds, including SAC Capital Advisors, Tudor Investment Corp. and Cheyne Capital. In 2005, Grant set up his own shop, but he didn’t go the hedge fund route. Instead, he opted to focus on what he knows best—creating customized risk management reports for hedge funds. His firm, Risk Resources, employs 20 people and works 24 hours a day analyzing everything from volatility and portfolio exposures to value at risk and scenario analysis. While Grant says there are many firms that provide some sort of risk management services software, it is the qualitative side of the analysis that is often lacking. “Managers need someone to interpret all the data that they are given and tell them what it means,” he says. “It isn’t enough to just crunch the numbers.”
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Jayesh Punater, founder of New Yorkbased Gravitas Technology, which specializes in providing technology and software integration services to the alternative investment community, says he is seeing a surge in hedge fund firms choosing to outsource in order to save money and streamline operations. “This is the era of hedge fund 3.0,” Punater says. “These hedge funds are smarter, rather than larger. They’re reducing overhead by using outsourced data centers and their focus has shifted from investing to running a real business.” Punater says that pressure from investors and regulators is forcing hedge funds to expand their definition of risk, and hence, to find ways to manage it. “No longer are firms just focused on P&L and trading risks; now they’re focusing on regulatory risks and the needs of investors,” he says. “What we’re seeing is increased demand for customized risk dashboards.”

Outsourcing the IT Guy

Another way hedge funds are reducing costs is by cutting personnel. Whereas funds once flush with cash could afford a full-time information technology staff, tough times call for tougher decisions. “We recently saw a fund that was $6 billion before 2008,” says Alexander Kouperman, president of InfoHedge, a four-yearold technology firm. “We met with ►
Hedge Fund Technology & Trading 2009

the CFO and the chief technology officer, A managed service provider also has the and the CFO pointed a finger at the CTO knowledge of the technology options and and said, ‘This guy is my old friend and our possibilities since they provide support to wives are friends, but I have to fire him now multiple businesses and are able to bring because we don’t have the money to pay this value to the fund.” his salary.’” Kouperman says his InfoHedge, which Protecting The Secret Sauce counts more than 90 hedge funds among But not all hedge fund executives are sold its clients, is seeing a boom in demand, es- on the prospects of outsourcing everypecially from firms that are being forced to thing but the trading to vendors. Brian Kim, downsize their operations due to decreas- founder of New York-based hedge fund ing assets under management. Liquid Capital Management, says outside “The outsourcing space is definitely in technology is a double-edged sword. good shape, given what is currently hap“If everybody was buying the same pening in the market,” he says. risk management platform, frankly, I don’t Warren Finkel, president of Network feel like it could be any good,” he says. Doctor, which specializes in providing IT services to the financial “These hedge funds are smarter, community, says he, too, is seeing an inrather than larger. They’re reducing crease in business from overhead by using outsourced data the hedge fund sector. “We are seeing a centers and their focus has shifted from strong move towards investing to running a real business.” complete managed service offerings where IT consultants are being hired to handle all technology and not just “If [third-party vendors] were so good at relying on break/fix work,” Finkel says. “This managing risk, then they should be doing allows the hedge fund owners to plan their my job.” spending and also allows them to focus Dmitri Sogoloff, founder of New Yorktheir efforts on managing funds rather than based Horton Point, a quantitative hedge worrying about day-to-day IT problems.” fund, echoes Kim’s sentiments. Sogoloff, He adds that another advantage of us- whose firm uses InfoHedge’s technology, ing an outside IT provider is that “a man- says while he’s satisfied with the vendor’s aged service provider can offer 24/7 sup- capabilities, there are just some functions port, monitoring and maintenance and that hedge funds should not outsource. provide technicians who are certified “We’re a technology-heavy shop and and proficient in each technology includ- we have a lot of stuff that we develop in► ing networking, phones and computers. house,” he said.
FINalternatives 24 Hedge Fund Technology & Trading 2009

Indeed, despite the growing clamor for outsourcing solutions, Kim says vendors have more work to do. He has been searching for a way to ease the burden of labor-intensive back-office functions, but has found the solutions available wanting. “Back-office and mid-office support is something I feel is a little lacking in the industry,” he said. “Everybody wants to sell you the latest trade management and execution platforms, but if I could get some more help in the back office, that would alleviate my burden from an administrative standpoint.”

The Nuts & Bolts: Servers, Hardware, Telephones & IT Experts

While some hedge funds—especially those dealing in high-frequency trading strategies like Horton Point—may be loath to use outside risk management systems, many of those same hedge funds prefer to employ third-party hardware vendors to manage servers, telephones, data recovery systems and the like. In fact, Horton’s Point’s Sogoloff says he is comfortable with outsourcing the

generic infrastructure that every hedge fund firm must have, such as computer hardware and backup services that provide business continuity in case of a disaster. “We don’t need to spend the time or the money internally to do this,” he says. New York-based technology provider Richard Fleischman Associates is benefiting from clients like Sogoloff—who in essence use a combination of in-house and outsourced technology. The firm boasts more than 400 hedge funds, private equity firms and broker/dealers as clients and is growing at a rapid clip. “We probably do about 100 startups a year, and one of the things we’ve seen, post-Madoff, is a spread of outsource and in-source solutions, whether it’s with equipment offsite or with in-house facilities,” firm founder and namesake Richard Fleischman said. “For folks starting new businesses, there is a lot of trepidation about building new offices, and they come to us for hosted solutions where they can get off the ground pretty quickly with minimum out-of-pocket expense.”

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Fast access to real-time accurate research is crucial to making timely and informed investment decisions. Tamale RMS® brings together all of your research on a central platform configured to support your unique investment process. Tamale pioneered the field of Research Management Solutions with a simple-touse software application that helps investment professionals manage and process the firehose of research information, more effectively. Tamale RMS makes it easy to capture, store, find and share your research. Nearly 2,000 front office professionals rely on Tamale RMS® to manage their research workflow. Now you can manage more ideas and make better investment decisions.

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Hedge Fund Software & Technology Providers
Premium Service Providers
®

Advent For 25 years, Advent has been providing portfolio management and accounting, straight through processing and trade order management software, services and data to the world’s leading financial professionals. Advent is the industry standard investment management software for asset managers, hedge funds, fund administrators, prime brokers, family offices and wealth managers and private client service providers. Phone: (800) 685-7688 Web: www.advent.com Alpha Theory Alpha Theory, the investment industry’s leading Fundamental Portfolio Optimization tool, is the premier solution used by hedge and mutual fund portfolio managers to develop an efficient portfolio using the concept of risk-adjusted return. Alpha Theory leverages research and instinct to build a repeatable system for optimally sizing positions. Phone: (212) 461-4757 Web: www.alphatheory.com BackStop Solutions Group Backstop Solutions Group, LLC is a Chicago-based provider of award-winning software services to alternative asset managers, including funds of funds, hedge funds, family offices, pension funds and endowments of all sizes. BSG’s core platform includes tools for client relationship management, investor accounting, partnership allocation, web reporting, and funds of funds research & portfolio management software. Phone: (312) 277-7700 Web: www.backstopsolutions.com InfoReach InfoReach is an innovative company focused on providing leading software solutions for the trading of financial securities. INFOREACH TMS combines order entry, rule-based portfolio trading, order management and FIX connectivity in a single broker-neutral trading platform. Product features include global assets traded either manually or algorithmically, high-frequency, analytics, charting, etc. Phone: (212) 269-2722 Web: www.inforeachinc.com

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Hedge Fund Technology & Trading 2009

Meridian Equity Partners Meridian Equity Partners is an independently owned Wall Street broker dealer with a global reach and a local feel. We provide customized, best-of-breed strategic solutions to the investment management community. Products include: equities, options, futures, fixed income and forex. Member NYSE, FINRA, NFA & SIPC. Phone: (212) 500-6650 Web: www.meptraders.com PerTrac Financial Solutions PerTrac Financial Solutions was founded in 1996 with the goal of creating a comprehensive suite of software solutions for investment professionals. Now an industry standard, PerTrac software is used by more than 2,000 clients in 50 countries, including banks, brokerage firms, consultants, plan sponsors, family offices, investment managers and funds of funds. The company’s foundation product, the PerTrac Analytical Platform, is now the world’s leading asset allocation and investment analysis software. Phone: (212) 661-6050 Web: www.pertrac.com

Client Relationship Management
Actuate Advent Software Backstop Solutions Code Red Digiterre EZ Data Fidelity National Info. Services FundCount Imagineer Technology Group Netage Solutions PerTrac ProTrak International RiskMetrics Group Satuit Technologies UNAPEN Viveo
FINalternatives 28

www.actuate.com www.advent.com www.backstopsolutions.com www.coderedinc.com www.digiterre.com www.ezdata.com www.fidelityinfoservices.com www.fundcount.com www.itgny.com www.netagesolutions.com www.pertrac.com www.protrak.com www.riskmetrics.com www.satuit.com www.unapen.com www.viveo.com
Hedge Fund Technology & Trading 2009

Compliance Software
Global Relay Communications HedgeOp Compliance MyComplianceOffice Smarsh www.globalrelay.com www.hedgeop.com www.mycomplianceoffice.com www.smarsh.com

Electronic Trading / Trade Execution
Aegisoft Baxter Financial Chi-Tech Fidessa First Advantage First Derivatives Flextrade Inforeach Investment Technology Group Lightspeed Trading Market Technologies Marketcetera Meridian Equity Partners Omego OptionsHouse Orc Trading smartTrade Streambase Thesys Technologies thinkorswim Traderserve Trading Metrics XELink www.aegisoft.com www.baxter-fx.com www.chi-tech.com www.fidessa.com www.fadv.com www.firstderivatives.com www.flextrade.com www.in4reach.com www.itg.com www.lightspeed.com www.tradertech.com www.marketcetera.com www.meptraders.com www.omgeo.com www.optionshouse.com www.orcsoftware.com www.smart-trade.net www.streambase.com www.thesystechnologies.com www.thinkorswim.com www.traderserve.com www.tradingmetrics.com www.xelink.net

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Hardware & IT
Alden Technology Partners Eze Castle Integration Generic Network Systems Gravitas Technology Indus Valley Partners MTM Technologies Network Doctor Vichara Technologies www.aldentech.com www.eci.com www.gnetsys.net www.gravitastechnology.com www.indusvalleypartners.com www.mtm.com www.networkdr.net www.vichara.com

Investment Technology Partners www.investtechpartners.com

Portfolio Analytics, Accounting & Risk Management
Advent Algorithmics Alpha Theory AlternativeSoft Appian Analytics APT Archway Technology Axioma Bravura Solutions Calypso Charles River Development Cogency Software Cognizant DataArt DST Global Solutions Eagle Investment Systems Fermat Fidessa FinAnalytica FinLab Fiserv
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www.advent.com www.algorithmics.com www.alphatheory.com www.alternativesoft.com www.appiananalytics.com www.apt.com www.archwaytechnology.net www.axiomainc.com www.bravurasolutions.com.au www.calypso.com www.crd.com www.cogencysoft.com www.cognizant.com www.dataart.com www.dstglobalsolutions.com www.eagleinvsys.com www.fermat.fr www.fidessa.com www.finanalytica.com www.finlab.com www.fiserv.com
Hedge Fund Technology & Trading 2009

Fi-Tek FundCount GlobeOp Financial Services Horizon Software Imagine Software Imagineer Technology Group Isis Financial Systems Linedata Services Murex Nirvana Solutions Northfield Information Services Odyssey Financial Technologies Omego OpenLink Paladyne PartnersAdmin Patni Penny IT Works PerTrac PNC Global Investment Servicing Richard Fleischman & Associates Risk-AI Riskdata RiskMetrics SimCorp SmartStream Sophis SS&C Technologies Sungard Sybase RAP TKS Solutions Twenty-First Century
Note: This list is not all inclusive. Large banks, hedge fund administrators and prime brokers also offer many of these services.

www.fi-tek.com www.fundcount.com www.globeop.com www.hsoftware.com www.derivatives.com www.itgny.com www.isisfs.com www.ldsam.com www.murex.com www.nirvanasolutions.com www.northinfo.com www.odyssey-group.com www.omgeo.com www.olf.com www.paladynesys.com www.partnersadmin.com www.patni.com www.pennyitworks.com www.pertrac.com www.pncgis.com www.rfa.com www.risk-ai.com www.riskdata.com www.riskmetrics.com www.simcorp.com www.smartstream-stp.com www.sophis.net www.ssctech.com www.sungard.com www.sybase.com www.pennyitworks.com www.21stcenturycompany.com www.viteos.com www.xenomorph.com
31 Hedge Fund Technology & Trading 2009

Viteos Xenomorph

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Description: In this special FINalternatives issue, Hedge Fund Technology & Trading, we look at the demands investors are placing on hedge funds, and how buy-side firms can utilize software and technology to address these demands, while keeping operational costs under control. Visit www.finalternatives.com for daily hedge fund news.