Bring Open Source into Hedge Funds

The hedge fund industry is hurting. Perhaps more collaboration among funds will help

I read closely's recent special section for CEOs about open-source software, and I wanted to offer some modest suggestions about what open source might do for the hedge fund industry. I run a San Francisco-based hedge fund called Algert Coldiron Investors.

Our industry is in a lot of hurt right now, and I want to see some open-source love, too.

The financial-services implosion was like an atomic bomb hitting our industry. It nuked profitability. Experts predict anywhere from 30 percent to 70 percent of hedge funds will disappear in 2009, and the survivors will see assets under management (AUM) fall by as much as 50 percent. And this is an industry where AUM had ballooned to well over $1 trillion in 2008.

Not only is the asset base declining, but managers like us are under tremendous fee pressure from clients. You can be sure the days of 2 and 20 (2 percent annual management fees and 20 percent performance fees) have largely vaporized. That double whammy is forcing almost every firm to go through life-saving triage exercises in cost reduction. We slashed our own noncompensation budget by 40 percent for 2009.

The Trouble With Platforms

After headcount, a typical hedge fund's largest expense item is technology. Much of that expense goes to the trading systems that we use. Let me tell you a secret: Our "secret sauce" is our trading strategies—it's not our systems for trading. These platforms can cost even a smaller fund like mine hundreds of thousands or even millions of dollars a year. Look, I just need a trading platform that executes our strategies. The software needs to connect to other systems that our different brokers and exchanges use and complete the trades driven by our increasingly automated strategies. This trading platform market is probably a $1 billion annual industry today.

Our problem is that the trading platform vendors in our industry and the exchanges where we trade all want to make us use their proprietary systems. In return, they want to charge us a lot of money, especially if we need to connect to another broker or exchange or, worse, need to make some quick change. We get charged for one-time engineering, annual license fees, a share of our trading action—and sometimes all three.

Think of these proprietary systems that connect to one another and allow trades to happen as extremely expensive electrical cords. What if every appliance had a proprietary cord? What if you had to pay people to plug in these cords for you? How'd you like to pay $100 and up for every cord for every different appliance, plus engineering fees, plus a percent of the cost of the electricity? That's a good business for cord companies, but lousy for consumers.

Open source is already pervasive in our industry—at the technology infrastructure layer. Linux on commodity processor hardware systems swept through Wall Street earlier this decade, sucking out billions of dollars of annual operating costs wasted before on proprietary products. (Sun Microsystems [JAVA] used to power Wall Street; today's it's Red Hat [RHT] Linux on Intel [INTC]-based servers.) Other pieces of open-source software are the hidden engines beneath new applications, software such as the MySQL database, the Tomcat application server, and more. How about some open source at the application level? Maybe an automated trading platform that lets me focus on my trading competencies?

No Green Eyeshades

I wish my own industry had a better history of collaboration. So take the Eclipse Foundation as a better example. This group, originating at IBM (IBM) in the late 1990s, re-formed as an open-source nonprofit in 2004 to bring industry vendors together to collaborate on Java developer tools. Within a year, more than half of all Java developers were using these tools. What had been a half-billion-dollar integrated developer environment (IDE) market today is no longer even tracked by analyst firms, and Eclipse boasts almost 200 member companies.

Alas, my own industry is too focused on trading and making money to get organized to collaborate on any solution. We're hard-wired in our genetic code for alpha and profit, not to don green eyeshades and collaborate to cut costs.

I'd like to see Tom L. Wood return. Tom ran a firm called TLW Securities that developed a pioneering broker-neutral trading platform in the 1990s that offered almost everything I would like to have today. Ironically, Tom's trading platform was developed in an open-source language called Tcl (pronounced tickle). At one point, TLW Securities, which specialized in hedge fund trading, handled more than 20 percent of the trading volume on the New York Stock Exchange.

It was too good to last. Tom sold out in 1999 to a trading firm on Wall Street. And the next year that firm was absorbed into Goldman Sachs (GS).

Nine years later, we could really use another Tom Wood in this industry.