Bridgewater Associates, one of the largest hedge funds in the world with $120 billion in assets, will soon use Northern Trust to shadow the fund administration work it outsourced to BNY Mellon in 2011.
For asset managers, outsourcing middle and back office work to custodians is nothing new; it has been going on for years as the big custodians like JPMorgan, Citi, BNY Mellon, Brown Brothers Harriman and Northern Trust use their skills, plus massive deployments of technology, in the high-volume, low-margin business of fund administration.
The first big fund to outsource was PIMCO back around 2000, said Pete Cherecwich, head of global fund services business unit at Northern Trust. As in-house systems age, funds facing the decision to invest in new technology have often decided to to outsource instead. The big custodians can provide depth of expertise, the latest technology, a large staff of technology experts and career paths for technologists that they wouldn’t find in a bank.
For hedge funds, using outside administrators is a relatively recent development.
Historically a lot of hedge funds did their own fund administration, said Cherecwich.
Spurred by the Madoff scandal, many institutional investors began to insist on third party fund administration. Citadel, the Chicago-based hedge fund, sold its sophisticated fund management system, Omnium, to Northern Trust in 2011 and became a client.
For hedge funds, an outside administrator doesn’t satisfy all their concerns. With fairly complex portfolios, large hedge funds were not entirely comfortable with a third party administrator, he added. Many reserve the right to set the value on positions regardless of what the fund administrator says.
“They said that from a quality perspective, while it was nice to have an independent administrator, they knew their own portfolios really well so they wanted to make sure the valuations were right. So they ended up shadowing the administrator, keeping a set of records on the fund’s own systems and engaging in discussions with the administrators before regular reports were released.”
Bridgewater has taken the outsourcing concept to a whole new level, he explained, by outsourcing their shadowing. By using Northern Trust to shadow BNY Mellon, it can achieve a formalized way to compare valuations. In addition, with two outside custodians holding Bridgewater records, the fund achieves full redundancy; if something happens to either primary administrator, the fund can move over to the shadow organization to produce its reports. Presumably that would also make it easier for a fund to fire one administrator, knowing it has a second to fall back on.
Although using two administrators increases Bridgewater’s costs, investors strongly approve of the arrangement, Cherecwich said, because they have top quality accounting, full independence, and complete backup of Bridgewater records from the middle office to the back.
Valuations can differ even in something as apparently straightforward as an IBM stock transaction -- a late trade could the value slightly. But it’s in more complex instruments that shadowing shows its greatest value. In pricing fixed income or derivatives, different models and different assumptions can lead to different valuations.
“Derivatives can have a big swing because of leverage. Quality control doesn’t focus so much on calculation of the price but ensuring the terms and conditions are the same. An individual [OTC] contract has lots of places for errors.”
In the price-sensitive world of fund administration, the goal is to automate as much as possible, including quality controls and determining and reconciling differences in results between the main fund administrator and the shadowing firm.
“One of the things we are building is the ability to re-calculate a value,” said Cherecwich. “We don’t want to value a derivative ourselves; we use reputable firms like Markit, Numerix or SuperDerivatives.
Valuations can also be thrown off by input errors, such as buying a U.S. stock on a Canadian exchange and pricing the results in USD rather than Canadian dollars. If a mismatch shows up in the results, the fund administrator and the shadow should be able to find and correct the discrepancy.
Northern Trust has no figures on how many discrepancies may occur; it won’t go live with Bridgewater until the beginning of next year.
Cherecwich sees great potential in the shadowing role. Using reconciliation software from a commercial vendor, it is building a comparison engine to run its quality control business.
“I am happy being the shadow. We are building the comparison engine, so the quality control will happen on our side, and we will have something unique in the industry. Bridgewater is on the cutting edge -- this is a brand new approach.”
It also promises to be an easier sell to funds than the usual outsourcing task of replacing existing systems.
“Nobody likes conversions because they are really hard. With shadowing, I can go to all the people who are doing their administration in-house and I can save them money.”
