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It said that “as Europe’s fixed-income dealers devote more resources and attention to hedge fund clients, traditional long-only fund managers risk losing out on research, liquidity and other valuable sell-side services”.
It added: “Many of the institutions participating in Greenwich Associates’ 2006 research expressed uneasiness about what they perceive to be a troubling situation. European institutions are under considerable pressure to generate robust investment returns to keep pace with mounting pension liabilities or other business demands.
“However, mark-to-market accounting rules and other regulatory issues are providing new incentives for institutions to maintain relatively high allocations to fixed income, as opposed to higher yielding but more volatile equities. At the same time, the flat yield curve and the relatively low interest-rate environment have made it tough to make money in fixed income.”
Institutions were being prompted to move into structured fixed-income products, high yield, emerging markets or other asset classes that promise greater returns, and of course, greater risks.
The firm said: “In particular, the institutions interviewed by Greenwich Associates this year voiced concerns about credit risk, the potential for credit defaults and the delivery, settlement and other risks associated with the booming credit derivatives business.
Greenwich consultant Frank Feenstra said: “When and if their concerns about risk are borne out, investors will be relying on the strength of their dealer relationships for the liquidity, coverage and support needed to withstand a downturn.
“Unfortunately, it is precisely these sell-side resources that are becoming more difficult for some traditional long-only fund managers to secure as hedge funds expand their reach.”
The study noted that hedge funds are less price sensitive than fund managers - many of which feel a fiduciary responsibility to rigorously enforce best execution rules.
“Despite some suggestions, regulators must ensure that they do not draw too narrowly the definition of what constitutes best execution in fixed income,” said Greenwich consultant Peter D’Amario. “In light of this ambiguity, we advise European institutions not to hamstring themselves by adopting and enforcing an overly narrow definition of best execution. In fixed income and equities as well, best execution encompasses much more than price.”
Overall European fixed-income trading volume — including cash bonds and derivatives — increased approximately 8% from 2005 to 2006.
Almost all the growth came from “dramatic increases” in trading volume in credit derivatives and a 40% jump in agency security trading volumes.