While the bulk of a traditional hedge fund manager’s investment thesis is implemented through equity and/or fixed income transactions, cost pressures are forcing prime brokers to diversify towards servicing strategies that utilise instruments other than cash equities and bonds, such as listed derivatives clearing, synthetic and FX prime brokerage. Top-line revenue for prime brokers has been compressed due to increased central bank intervention in global markets, as well as low market volatility. This has resulted in a decrease in their clients’ leverage, a fall in trading volumes across all instruments and the emergence of the inconsistent ‘risk-on/risk-off’ approach.
From a bottom-line perspective, the challenges are the same for prime brokers and their clients. With so much legislation impacting the industry, the cost of doing business is increasing for all participants but the smallest fund managers are being hit the hardest.
From an investor’s perspective the last five years have been characterised by poor returns and asset erosion, but the quest for alpha remains. Herd mentality may have resulted in assets flowing predominately to the largest hedge fund managers, but this will likely result in a homogenisation of returns as deployment of capital becomes more onerous and managers chase the same trades.
Consequently, a return to prominence of emerging managers is observed, many of which are prop desk spin-outs. Investors are being persuaded by the increased agility of these funds with more attractive risk/return characteristics and employing fee structures more closely aligned with investor interests.
Furthermore, the investor community is ascribing more importance to liquidity and transparency on the back of several prominent fraud cases. One direct trend resulting from this is the emergence of separately managed accounts. This represents a significant opportunity for those prime brokers that are able to deliver an increased understanding of the asset owner, the trading counterparty and the credit risks involved.
Additionally, servicing managed accounts can be a counterintuitive concept for a prime broker to amalgamate into their strategy, as it typically requires an operational acceptance of multiple smaller accounts being traded by the same manager, each for a different investor and with lower trading levels.
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