Convergence of Trading Strategies Is Breaking Down Service Barriers
September 8, 2008
As hedge funds and traditional long-only asset managers borrow strategies from one another, the lines of demarcation between the prime brokerage and custodian bank communities are blurring, which is spurring both cooperation and competition.
Many long-only managers are expanding their reach into over-the-counter derivatives, while others are adopting hedge fund--like long-short strategies such as so-called short-extension and absolute return. And with wider acceptance of their investment strategies, some hedge funds are blossoming into larger institutions and, in some cases, adopting long-only techniques to complement their more innovative activities.
"Long-only managers are increasingly looking to leverage their scale into higher-margin products in alignment with shifting investor demands for alternative funds," says Andrew Wilson, managing director of global market financing services for Merrill Lynch & Co. "Hedge funds, in turn, have been successful in delivering alternative strategies and are now looking to broaden their product base, diversify their investors and increase assets further. In effect, we are seeing the convergence of asset management beginning to occur."
One of the key factors driving the phenomenon is the third version of the European Union's Undertakings for Collective Investment in Transferable Securities (UCITS) directive, which became fully effective February 2007. UCITS III allows investment funds domiciled in Europe to trade OTC derivatives, which can be used to create short positions or increase leverage.
Customer demand is also playing a role in traditional funds' desire to enter new asset classes, as is the emergence of a generation of traders and portfolio managers who are more familiar with exotic contracts, according to industry observers.
The end result: Financial intermediaries are being forced to reevaluate how they deal with two sets of clients, and service barriers are being broken down. "As hedge funds grow larger and become more mature they take on the trading and operational characteristics of long-only funds, which is requiring custodian banks to evolve or adapt," says Steve Crosby, New York-based senior managing director of PricewaterhouseCoopers' investment management and real estate advisory group.
At some banks, custody divisions established to service traditional asset managers can offer useful services to hedge funds. "We have been working with the global prime finance unit more closely over the past few years because, from the subcustodian and trustee side, we are able to provide special-purpose offshore vehicles for hedge funds entering domestic emerging markets," says Michael Gedigk, managing director of sales and client relations for Deutsche Bank's domestic custody services unit. "As margins within the hedge fund industry become tighter and funds are trying to find the next new opportunity, they need local expertise to figure out how to best enter a market."
Gedigk cites India as a country that recently allowed hedge funds in--with sufficient documentation and under strict guidelines. "Our aim was to understand the multitude of rules--presented in piecemeal form--and how to implement them on behalf of our hedge fund clients," he says.
Nick Thomas, global head of structured fund products for HSBC Securities Services (HSS) in London, also points to increased interest from hedge fund clients in accessing emerging markets. "Overall activity has historically been quite small," he notes, "but the amount of capital investment has increased over time so hedge funds have been coming to HSS and HSBC's Global Banking directly for core custody and emerging-market equity execution."
