 Tony Freeman
Director of Industry Relations, EMEA
The “hedgification” of the traditional long-only fund management segments is gathering pace. Changes to UCITS3 and the increasing warmth of plan sponsors to techniques previously reserved for the hedge-fund sector have introduced leverage, shorting and routine usage of derivatives. The result is so-called “130-30” funds, fund managers’ latest big idea that appears at least to instill investor confidence by bridging the gap between long and short strategies.
However, it is a mistake to think in binary terms – there are many shades of grey in this area. Recent research commissioned by Omgeo from the consultants Detica indicated six distinct types of buy-side firm: at the least adventurous end of the scale is a pure-beta chaser. At the other end of the scale is the audacious alpha fund, and in between there are four other segments; “relaxed-long”, “broad”, “market-neutral”, and “multi-strategy”.
Categorising buy-side behaviour as either hedge or traditional is therefore a misleading over-simplification. However one trend is very clear: the traditional buy-side firms at the beta-chaser and relaxed-long end of the spectrum do not have the IT applications they need to manage 130-30 funds. Their systems architecture is based around a large number of relatively static holdings in a narrow range of asset classes. The advanced alpha funds have no such restrictions: for example, there is a reputedly a hedge-fund administrator in Dublin whose client not only invests heavily in catastrophe derivatives that are a play on the level of rainfall in Argentina, but as a hedge have bought a mountain and installed meteorological equipment to accurately monitor the situation. The catastrophe derivatives and the mountain are both assets of the fund and have to be held on the position keeping and valuation systems. Such asset-diversity would be a major problem for a firm whose expertise is in equities, AAA rated bonds and exchange traded derivatives. There has also been huge growth recently in the climate and energy derivatives area and most legacy fund-accounting packages aren’t able to deal with these asset classes.
What’s the impact of this sea-change in approach? Tales are emerging of prime brokers being swamped with RFPs from buy-side firms they have never previously dealt with. Why is this? Put simply, prime-brokers can reach the parts that custodians can’t. Many big custodians will wax lyrical about their ability to service hedge-fund structures, but it seems they aren’t convincing everyone. It is very clear that the biggest prime-brokers (Goldman Sachs, Bear Stearns, Merrill Lynch, Morgan Stanley etc) don’t do custody. What they do have is skills in pricing, performance attribution etc that cover all the traditional asset classes and styles, as well as the more exotic segments and styles.
A couple of examples will be illustrative: there are still major custodians whose primary fund-accounting platforms do not allow a negative position. They were constructed on the basis that clients (mostly pension funds) were not permitted to short-sell. The only way to process a short-position is to have a permanently failed trade! Another example is fund-of-funds: custodians have been taken aback by the growth of this style. Performing attribution and performance analysis, risk profiling etc on fund of fund structures is very difficult for custodian systems built around equities, bonds and cash.
By contrast, prime-brokers do have these capabilities. The logical outcome for a buy-side firm launching a 130-30 fund is to ask the prime broker community to pitch for the asset-servicing business in competition with the custodians.
The other, probably unforeseen aspect of this new era is the re-emergence of bundled product capabilities and, more controversially, bundled pricing. Buy-side RFPs are making it clear that they are open to using the prime brokers’ IT capabilities rather than develop them in-house. Often the usage cost will be blended with other fees. Maybe this is purely a time-to-market factor, but it is probably a more fundamental change. Conventional wisdom is clear unbundled pricing is what the buy-side needs, and yet 130/30 funds are actually promoting bundled pricing.
Whilst institutional interest in hedge fund type strategies remains strong, prime brokers will be in a strong position to offer the most flexible infrastructures. Going forward, the pressure will be on custodians to evolve their services to support the search for alpha and to remain competitive. Attitudes to risk vary so much across buy-side firms, it’s no longer a case of black or white, long or short. Service providers will have to think in glorious technicolour to keep in the game.
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