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April 21, 2005

High Tech at the Hedgies

By Peter Chapman

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Hedge funds are technologically savvy do-it-yourselfers, according to a new report by the Tabb Group. In a comprehensive study, the research and consultancy surveyed dozens of hedge funds on direct market access, algorithms and order management systems. But while the report awarded the hedge funds high marks on technology, it also contradicted a popular perception that all hedge funds are sharp shooting stat arb shops. Hedge funds' investment styles, for instance, aren't too different from those of the traditional managers, Tabb noted. Most hedge funds, like most traditional money managers, use fundamental, not quantitative, research.

The major difference between the two groups is this: Hedge funds, unlike the traditional players, can short stock. But Tabb also reported another difference between long-only desks and hedge funds. The latter are more likely use direct market access and algorithmic tools.

Algorithms are in the spotlight for four reasons. First, hedge funds' execution strategies are more quantitative. Second, they have smaller staffs, which necessitates more automation. Third, hedgies manage costs better. Finally, they are more concerned with maintaining anonymity and keeping their strategies secret.

Tabb interviewed execs at 63 funds. They manage some $110 billion in total assets. That's about 12 percent of the $930 billion hedge fund industry. The industry has some 8,600 firms, Tabb estimated. Of the 63 funds, 18 were categorized as large, managing over $1 billion. Another 30 were categorized as small, managing less than $250 million. The rest were mid-sized, managing between $250 million and $1 billion.

Tabb's findings show significant differences in the management of large and smaller funds. The biggest difference is in their reliance on prime brokers. Big funds are less beholden than smaller funds to their prime brokers, according to Tabb. In fact, small funds appear to be almost captive.

Other studies of the hedge fund industry have noted that the vast majority of funds are small. Van Hedge Fund Advisors International, for instance, noted that, at the end of 2002, over three quarters of the industry managed assets of less than $100 million. Only four percent managed assets greater than $500 million.

Josh Galper, the author of the new study, joined Tabb Group 12 months ago. The consultant previously spent 18 months at Sanford C. Bernstein & Co. and before that, was at Merrill Lynch for two years.

At Merrill, he was involved with business development. That took in trading-related mergers and acquisitions and a focus on algorithmic, electronic and automated trading. He worked first in the equities division. After that, he worked for a short-lived group at Merrill called securities services that had responsibilities in prime brokerage and other areas. At Bernstein, Galper was a consultant, focusing on electronic trading. He ended up running its portfolio and automated trading desk.

Traders Magazine technology editor Peter Chapman interviewed Galper on his survey's technology findings.

Traders: Contrary to popular perception, hedge funds are not all sharp-shooting stat arb types.

Galper: No. They are mostly fundamental asset managers working in a hedge fund model.

Traders: Hedge funds have been very profitable for the prime brokers. Yet, your report says there is a movement afoot among hedge funds to seek out lower cost providers. That we could see an exodus of large firms from their prime brokers. What's happening?