Asian Hedge Fund News

I received an alert from Albourne Village about small hedge funds in Asia.  They were having trouble competing with large hedge funds, as measured by assets under management (AUM), for investors.  Institutional investors want a fund to have at least $100 million USD AUM.  Most funds (67%) in Asia have less than $50 USD AUM.  There are increasing operational, compliance and risk management costs for the small funds.  Finally, there is doubt that the manager can continue the fund's performance if AUM increase.  The article can be accessed here.

US Insider Trading Investigation - Latest Events

The fifth consultant working for Primary Global Research, an expert network firm, was arrested yesterday.  Winifred Jiau was accused of leaking insider information about two technology companies:  Marvell Technology and Nvidia Corporation to two unnamed hedge funds.  As noted before, expert network firms are much like corporate access departments at investment banks.  They match experts in a company, sector or industry with investors whereas corporate access matches company officers with investors.  Unfortunately, the experts are not as well-trained as the company officers in what they are allowed to say.  Most companies have investor relations departments that coach the officers.  There is nothing like that for experts.  The latest articles are from
Bloomberg and Reuters.

Mutual Fund Categories

We have spent a lot of time on hedge funds.  Let's spend a little time on mutual funds.  Mutual funds, through their investment policy, define their investment universe.  This may be the type of security:  equities or fixed income.  Equities are divided by the size of the companies such as micro, small, mid or large capitalization stocks.  It can be the type of stock:  growth or value.  Fixed income can include different classes of bonds:  high yield, corporate, convertibles, US Treasuries or municipal.  Both equities and fixed income can be split into sector/industry and country/region of the company.

The basic sectors are:

• Basic Materials
• Conglomerates
• Consumer Goods
• Financial
• Healthcare
• Industrial Goods
• Technology
• Utilities

Regions can be classified as:

• US/Canada
• Latin America
• Western Europe
• Emerging Europe, Middle East and Africa
• Japan
• Australia/New Zealand
• Asia ex-Japan

Based on the investment universe, most mutual funds limit themselves to an asset box such as small cap growth stocks or high yield bonds of US companies.  An exception would be Ken Heebner at Capital Growth Management.  Mutual funds are usually constrained by what they can invest in.  Hedge funds are defined by how they trade.

Where Are the Investment Ideas?

Most of the investment strategies that have been described have a common theme:  the manager is seeking to profit by finding undervalued or overvalued securities.  Where do they find them?  Is it in widely followed large capitalization companies in the US?  Not likely.  It's hard to see mispriced stocks when there are twenty sell-side analysts ferreting out information on the same investment.  It's better to go where there is little research coverage.  In the US, Western Europe and Japan, this would be in micro, small and mid-sized companies.  It may be an industry or company in the developing (such as China, India or Brazil) or frontier countries (such as Nigeria).  A manager may decide to invest in esoteric securities such as Credit Default Swaps and OTC (Over the Counter) Derivatives.

Of course, there are exceptions:  David Einhorn and his very public bet against Lehman in 2008.  For those interested, his detailed analysis has been posted here (starting on page 4) by Whitney Tilson at seekingalpha.com.  George Soros and the British Pound;  Jim Chanos and Enron.

Investing Across Many Funds

The last strategy that we will talk about is investing across multiple strategies.  There are two methods:  through a third party called a fund of funds or within a multi-strategy hedge fund.  Both are similar investments that create market forecasts.  They are used to allocate capital to the funds and strategies that will outperform.  If there is a lot of merger and acquisition activity, they may invest in a merger arbitrage fund.

For the fund of fund strategy, the advantages are:

• Diversification among hedge fund strategies
• Ability to invest in different hedge fund managers
• Another layer of monitoring and due diligence

The disadvantage is that the fund of fund manager charges an additional layer of fees.  This is known in the hedge fund world as the "2 and 20" (2% of assets under management and 20% of profits).  Because of this additional layer, the fund of funds would need to have a higher return than the multi-strategy fund to give the investor the same return.

The advantages of a multi-strategy manager are longer lockup periods and flexibility to invest in different strategies.  Investors cannot withdraw their capital during the lockup period.  This allows managers to expand their investing universe to less liquid assets.

The disadvantages of a multi-strategy fund manager are:

• Manager may not have the expertise to manage different strategies
• The investor is not diversified in manager selection

Global Macro: Go Anywhere, Do Anything

Many investors view global macro as the Wild West of strategies.  Managers following this strategy can invest in any country, market or security.  Macro is short for macroeconomics.  By studying these statistics such as interest and foreign exchange rates, commodity demand and political conditions, managers identify price movements and invest to exploit them.

They can be split into two types:  discretionary and systematic.  Discretionary managers invest by forming a thesis and creating trades to profit from their thesis.  They may understand the emotional intelligence of investors and identify irrational and/or inefficient market conditions.  They can analyze data at the microeconomic level that has not percolated up to the macroeconomic level.  Systematic managers use trading rules to follow trends as their thesis.  Oftentimes, these trades are triggered by quantitative models monitored by computer software.  This is sometimes be called the "black box" as the rules are proprietary to the manager.  These rules may exploit differences in interest rates (carry and yield curve trades), currencies (purchasing power parity), stocks and volatility (option pricing models).  Some funds use a combination of both types.

Global macro funds' flexibility allows them to invest in any category but may produce funds that do not have an investment specialty.  Since many institutions invest using an asset allocation model, it is difficult to monitor them.  They can invest in anything and may break the allocation rules of the investor.

The most famous manager using this strategy is probably George Soros and his most famous trade "broke the Bank of England" in 1992.  A recent manager, who emerged from the housing crisis, is John Paulson.  You can read more about him in Greg Zuckerman's The Greatest Trade Ever.  For additional information about the crisis, Michael Lewis' The Big Short is great reading.  For more information - including references to other books and white papers, please go to this article.

Equity Market Neutral Strategy

Like many other hedge fund strategies, equity market neutral (EMN) managers establish long and short positions in undervalued and overvalued securities.  Unlike long/short managers, EMN positions are balanced along  sector, currency and country lines.  For example, the manager may go long Intel by buying $1 million and go short by selling $1 million of Advanced Micro Devices.  Since both companies are in the same sector, the fund has a neutral position.  This is a simple example.  The manager may choose to create a neutral position by using derivative securities.  For example, a long position in British stocks would be hedged by a futures position in the British Pound.  Any fluctuation in the US Dollar to British Pound exchange rate would not affect the portfolio.  The goal is to have no net exposure to market, industry or foreign exchange risk.  The only source of return is picking the right securities.  This is called the rule of one alpha (Bruce Jacobs and Kenneth Levy, "The Law of One Alpha", The Journal of Portfolio Management, Summer 1995).

To create these portfolios, the manager usually follows these steps:

1. Establish a universe of stocks
2. Generate a forecast
3. Build the portfolio

For more details on these steps, consult with this AIMA Canada paper or Mark Anson's Handbook of Alternative Assets.

Since the portfolio is constantly being hedged due to changing market conditions, it is important to own securities that are liquid.  A position in a stock that is thinly traded will not give the manager the flexibility to dynamically hedge against market events.

Non-Mainstream Hedge Fund Strategies

A couple of not so well-known strategies in the relative value universe are stub trading and volatility arbitrage.  In stub trading, the fund manager is identifying price discrepancies among stocks that own a large stake in another company.  This is based on the principle that the market does not recognize the additional value of the secondary company to the owning company's business.  When the market eventually sees this and prices the security accordingly, the manager can sell out the position.

Volatility arbitrage uses the same philosophy as other strategies - buy the undervalued and sell short the overvalued securities and profit when they converge.  Here the securities are options and warrants on an asset.  Using various mathematical models, the manager calculates the implied volatility of an asset.  The undervalued option can be identified using the Mean Reversion (compares implied and historical volatility of a security) or Generalized Autoregressive Conditional Heteroskedasticity (compares implied and forecasted volatility of a security) model.

Convertible Bond Arbitrage Strategy

The convertible bond arbitrage manager can create a portfolio that acts like a normal bond.  They establish a long position in convertible bonds and a short position in the equity of the bond issuer.  A convertible bond is a bond that has an option for the owner to exchange the bond for stock from the issuer.  The short equity position should be equal to the long convertible position.  The long position is equal to the amount of stock converted multiplied by a factor - called delta or hedge ratio.  This factor changes constantly and causes the fund manager to adjust their equity position frequently.

The fund has several sources of return:

• Change in convertible bond price - If the bond's price rises, then the return increases
• Change in stock price - If the stock's price falls, then the return increases
• Convertible bond's coupon - Interest paid from the bond increases the return
• Short rebate - Interest earned on capital from short stock position increases the return
• Interest paid on borrowed capital - Fund manager pays interest on borrowed funds, reducing the return

Additional Developments on Insider Trading Probe

I came across two articles from yesterday regarding the FBI's insider trading probe.

The first article, by Bloomberg News, recites the recent history of Taiwan and its place in the information chain for technology companies.  Taiwanese chipmaking foundries such as Taiwan Semiconductor and United Microelectronics manufacture chips for Apple, Dell, etc. and have proprietary insights in their businesses.  Since 2004, there have been cases of analysts (sell side and expert network)  disseminating insider information according to US standards.  However, in Taiwan, this is tolerated since information swapping is expected.

The second article, by Reuters, reiterates previous news regarding information gathering in the hedge fund world.  It relates how a well known mutual fund firm (in this case Wellington Management) also runs hedge funds and the conflicts that may occur between the fund types.

Gold - The Next Bubble?

I was led to this Bloomberg article by Cam Simpson about gold through an alert from Albourne Village.  It details the creation of gold as a liquid security:  an exchange traded fund (ETF) called StreetTracks Gold Trust (ticker:  GLD).  This was later named to SPDR Gold Trust.  Since its inception in 2004, the ETF has expanded beyond the NYSE and is traded in Japan, Hong Kong, Singapore and Mexico.  Previously, gold was bought and sold as bullion, coins or part of jewelry.

With all the crises in the past decade (technology bubble, real estate bubble, bailout of financial firms and "Flash Crash"), confidence in stocks is low.  Fixed income yields are low due to the Federal Reserve's policies.  Investors are turning to buying gold as a refuge.

Last year, John Paulsen of Paulsen & Company launched a gold fund last November.  In 2010, it is up 33.6% according to this article at www.businessinsider.com.  For a more information about his gold fund, please go to this link.  As a side note, there is a quick article about the fund's performance in January (It was down 14%.).  This is just a quick comment on the short term attitude on Wall Street and volatility of any concentrated investment.

The author, Cam Simpson, writes that George Soros thinks gold is a bubble but still holds SPDR Gold as the largest position as of September 30, 2010, according to the SEC.  Gold may be a bubble but when do you get out of your position?

Fixed Income Arbitrage Strategy

The next group of hedge fund strategies are convergence trading or arbitrage strategies.  Fixed income arbitrage strategies is much like equity long/short.  The manager identifies cheap (undervalued) and expensive (overvalued) bonds and establishes long and short positions.  Returns are generated when they converge, the cheap position increases or the expensive position decreases.  Managers may use bonds such as US Treasuries, corporate, municipal and high yield bonds and mortgage backed securities.  Positions may be established at different maturity levels in the same bonds (yield curve arbitrage) or in different bonds that are similar.

Unlike equity long/short, the individual positions produce small returns.  Hedge funds that use this strategy use leverage to enhance returns.  This can be done by direct borrowing from their prime broker or using derivatives like swaps.

Most famous fund is Long Term Capital Management.  You can read a complete and concise account of the firm in When Genius Failed:  The Rise and Fall of Long-Term Capital Management by Roger Lowenstein.

Hedge Fund Strategy: Regulation D

Regulation D (Reg D) securities are sold by companies that are raising capital through a private offering without having to register with the SEC.  Reg D contains a list of rules allowing companies to be exempt from filing.  There are three main rules 504, 505 and 506.

As part of an investment strategy, hedge funds are mainly interested in micro and small capitalization companies.  There are two reasons for participating in the offering:

• The offering price is at a discount to the current market price
• Since there is a price discrepancy in publicly traded and Reg D stocks, the manager can establish a simple arbitrage position of shorting the public stock and going long on the Reg D stock.

The advantage to the issuer company is the ability to raise cash quickly.

Distressed Securities Investing

Hedge funds using the distressed securities strategy invest in companies that are being reorganized, going thorough bankruptcy proceedings or going through some poor performance.  These companies have the lowest credit ratings from such companies as Moody's and Standard & Poor's.  The notes below are a summary of the article "Hedge Fund Investing in Distressed Securities" by T.Casa, M. Rechsteiner and A. Lehmann that was part of CAIA's curriculum.

There are five main sub-strategies:

1. Short
2. Long/short
3. Capital structure arbitrage
4. Value
5. Rescue financing

For stocks, the first has been tackled in a prior article.  A manager can be short by buying the derivative instrument credit default swap (CDS).  To sum up, the manager is obligated to pay a counterparty a fixed amount on the bonds of the distressed company.  In return, if the company has something known as a credit event, the counterparty pays the manager a fixed amount.  The details of the fixed amounts and credit events are listed in the CDS contract.  As the company's situation worsens, the CDS appreciates in price or the hedge fund receives the payment.

Long/short using bonds instead of equities but the premise is still the same.  The manager will establish a position in undervalued bonds and be short in overvalued bonds.

Capital structure arbitrage is similar to long/short except that positions are taken within the same company's securities.  The manager takes a long position in the senior securities such as senior bonds and a short position in junior securities such as stocks.  In the bankruptcy process, senior securities are favored if any assets are recovered.  In theory, the net value of the long and short positions should be positive i.e. the short position should decrease more than the long position.

Value managers take a long position in the company before it announces a reorganization plan to court.  They hope to profit from the rise in prices after the plan is approved by the company's creditors.  They can also take a long position after the plan is approved as other investors will not take the risk at this stage.

In rescue financing, the hedge fund lends money to distressed companies right to prevent bankruptcy filings or establishes a long stock position.

The above five substrategies differ in their approach and timing.  There are five stages in the lifecycle of a distressed company and each substrategy (in parentheses) invests during a certain stage:

1. Pre-default:  the company is restructuring  (rescue financing)
2. Early bankruptcy:  the company tries to restructure its finances;  usually by giving creditors an equity stake for debt reduction or extension  (short, long/short, capital structure arbitrage)
3. Mid-bankruptcy:  balance sheet is stabilized  (short, long/short, capital structure arbitrage)
4. Late bankruptcy:  company is almost recovered  (value)
5. Emergence:  company is recovered  (value)

In 2007, there were $105 billion in estimated assets in distressed securities; up from $30 billion in 2002.  With the market turmoil in 2008, this strategy will grow as there will be more distressed situations to invest in.

Maybe we can examine the bankruptcy process later.  There were many interesting articles in the Wall Street Journal about it during the General Motors and Chrysler crises in 2009.

The Current State of Small Introducing Prime Brokers

In an earlier post, I directed to you to an article about the bulge bracket prime brokers.  I came upon this at the site:  www.finalternatives.com.  The author, Michael DeJarnette of ConvergEx's Northpoint Trading Partners, writes about the smaller prime brokers.  Many of these firms have merged or been acquired by larger financial or technology firms.  The merged firms have become a new category called "mid prime", "integrated prime" or "independent prime".  The link to this article is here.

Beneficiaries of the FBI's Insider Trading Investigation

I have been following the investigation by the FBI about the possible use of insider information from expert networks.  As with everything else, someone's misfortunes may be another firm's gain.  I came across this article on Fortune's site.  Several types of hedge funds are positioning themselves to take advantage.  Hedge funds that use a quantitative method of picking stocks do not use fundamental research and have no need of an "edge".  Their strength lies in the accuracy of their algorithm.  Large firms and fund of funds with good compliance departments that safeguard their investors will also be less hurt by the probe.

Event Driven Strategy - Merger Arbitrage and More

The event driven strategy invests in a wider range of situations than merger arbitrage.  Merger arbitrage managers are concentrated on mergers and acquisitions.  Event driven managers may invest in firms that are:

• In the middle of a reorganization
• Spinning off a division
• In bankruptcy
• Starting a share buyback program
• Distributing a special dividend
• Specific news announcements such as earnings restatements
• Significant market events

Again, the manager is trying to exploit mispricings of the company's securities due to these one-time events.  Another term for this strategy is special situations.  Some sources state that merger arbitrage is a substrategy of event driven.  I can see the logic behind this.  However, for these articles, I am using the definition promulgated by the Chartered Alternative Investment Analyst program (at www.caia.org) and has these as separate strategies.

Merger Arbitrage Strategy - Investing in Deals

The next group of hedge fund investment strategies that we will take a brief look is corporate restructuring.  The most well known is merger arbitrage.  In this strategy, sharp-eyed managers identify mergers that are happening or that will happen to profit on a paired trade.  The stock of the target firm will be bought and the stock of the acquiring firm will be sold.  When a merger is announced, the buyout price is usually at a premium to the current price of the stock.  The normal market action is for the price to rise in reaction (or anticipation) to the announcement.  Meanwhile, the price of the buying firm declines as the market anticipates a short term correction because the firm will need to use resources, cash and time to integrate the target firm.

In a cash acquisition, the manager would buy the target firm at a price lower than the bid.  When the transaction is closed, the profit would be the spread between prices.  In a stock for stock merger, the manager takes the positions described above:  short the buying firm and long the target firm.  When the transaction is closed, the target firms' stock is converted and used to close out the short position.  The profit is the spread between both positions.  The hedge fund also receives the short interest rebate.

To identify the best trades, managers will use a variety of information sources such as the financial statements, SEC filings, company and sector knowledge.  They will be well informed in regulatory and anti-trust issues.  They will need to know when and at what price to trade into the positions.  Depending on their investment thesis, rumored deals may be included in the portfolio.  Obviously, this is much riskier as trading desk rumors are rampant.

There are several reasons the deal may not be completed.  The merger may not be approved by all of the regulatory agencies.  Another firm may try to buy the target or acquirer.  The target may try to acquire another firm as a takeover defense strategy.  The shareholders may not approve the deal.  This is the risk.

In bad markets, there may be very little merger activity.  In times like these, the fund will invest in low risk fixed income vehicles until activity increases or may shut down the fund and return money to the investors.

A Quick Note about Sovereign Wealth Funds

Sovereign Wealth Funds (SWFs) are one of the less well-known types of institutional clients.  They are mainly in commodity rich states, such as Abu Dhabi Investment Authority or Norway's Government Pension Fund or may be located in various countries - predominantly in Asia, such as the Government of Singapore Investment Corporation or Temasek Holdings.  There is a recent article at Zawya.com that can be accessed here.  It states that SWFs are increasing their holdings in hedge funds and other alternative assets as well as corporations.  An example of the latter is China Investment Corporation's investment in Morgan Stanley.

I was alerted to this news article by Albourne Village, a site for alternative investing.  Other good websites that I subscribe to are FINalternatives, Hedgeworld News and HedgeFundBlogger.com.  They are all free and deliver news to your email.

Hedge Fund Strategy - Emerging Markets

A hedge fund manager investing in emerging markets concentrates on securities from markets that are moving from a centralized, government controlled economy to a western-based capitalistic system.  The manager may be using any of the normal investment strategies such as long/short or global macro (according to Richard Wilson at HedgeFundBlogger.com in his article at this link).  Because of the risks involved, the volatility of the returns is high.  Some of them include:

1. Government intervention
2. Political instability
3. Lack of liquidity
4. No accounting standards for financial statements
5. Currency risk
6. No regulatory oversight organizations such as the SEC or FSA
7. Inability to hedge because shorting securities is prohibited

Now, you may be asking why a manager would invest in such a minefield instead of investing in the US, Japan or Western Europe.  It is because emerging markets are inefficient and the smart manager has more opportunities to uncover under or over-valued securities.  For example, Altria (ticker: MO) is covered by an army of research analysts.  They are experts on every aspect of that company.  The idea that a manager will uncover a bit of news that is unknown to them is not probable.  However, emerging markets are covered by few analysts.  The same logic applies to mid-cap, small cap and micro cap companies.

One last note - emerging markets may be subdivided into frontier markets.  Frontier markets include western Africa, sub-Saharan Africa, Central America and parts of the Europe, Middle East and Asia (such as Croatia, Pakistan and Vietnam).

The Activist Hedge Fund Strategy - Improving a Company from Within

Compared to the long/short strategy, there are few hedge funds using the activist strategy.  This involves building a large position in the company and then, using that ownership weight, to improve corporate governance of the company.  This will make the company more attractive and raise the share price.  These funds will hold only 5 to 15 companies at one time.  The portfolio is very concentrated and may experience high volatility - although you could say that about any investment.

Activist managers may try to change corporate officers through a proxy battle, change the amount of equity or debt assumed by the company, cut costs, initiate a share buyback plan or special dividend to shareholders.  They can liquidate assets (such as real estate), spin-off non-performing divisions, sell divisions unrelated to the company's core business, etc.  Unlike other hedge fund strategies that are secretive in nature, the plans of activist managers are in the public domain.  This information is available in the Schedule 13D filing with the SEC.  There are seven sections in the 13D.  The most important are the Purpose of the Transaction and Materials to Be Filed as Exhibits.  The first section states why the fund is buying the position.  The materials section adds the details behind the goal of the fund and has any communications to the senior management of the company.  13D's must be filed when the hedge fund has taken a 5% position (called a beneficial ownership).  This must be done within ten days.

The methods are quite similar to private equity or Warren Buffett except they do not buy the whole company.  An example of an activist hedge fund manager is Bill Ackman of Pershing Square Capital Management.

Insider Trading Investigation - Latest Events

There have been much news recently about the FBI's insider trading investigation.  Several hedge funds' offices were searched earlier this week, other hedge and mutual funds have been issued subpoenas and an executive at a expert network firm was arrested.  Expert network firms give access to industry and company experts to fund managers and analysts.  This is similar to the corporate access sponsored by investment banks at conferences and roadshows.  Unlike the sponsored events, these experts are not company officers.  Corporations usually have investor relations representatives who coach the executives on what to say and what not to say.  Below are a set of informative articles regarding the latest updates in the insider trading investigation:

• Insider Trading Probe and Expert Networks
• Insider Trading Probe Leads to Charges
• Expert Network Executive is Arrested

Short Strategy

Short selling has accumulated a lot of bad press during the financial crisis of 2008.  In this posting, we will look at the strategy of short hedge funds.  The strategy is simple.  The fund manager shorts stocks of companies that they believe will go down in value.  Any unused capital is usually invested in a safe security such as Treasuries. The value of the short positions is greater than the long positions unlike the long/short strategy.  They are the opposite.  They are net long.

According to Filippo Stefanini (Investment Strategies of Hedge Funds, 2006), a company that is a candidate for shorting would have management that lies to investors, insider trading, destruction of value, deteriorating fundamentals or changes in the equity structure.

Jim Chanos of Kynikos Associates Ltd is a prominent short seller. He is one of the managers who exposed Enron Corporation.

Introduction to Equity Long/Short Strategy

When the words hedge fund are used, most people associate it with the long/short equity strategy.  The fund manager constructs a portfolio of stocks in two components:  long positions in attractive/undervalued stocks and short positions in unattractive/overvalued stocks.  Additionally, there can be positions in derivatives such as stock options, index options or index futures.

Managers specialize in three distinct areas:  concentration, market capitalization and geography.  Concentration relates to the sector of the stocks.  Market capitalization is the size of the company and geography is the region/country of the company.  A manager can specialize in one sector, market cap or region/country or across multiple sectors, market caps or regions/countries.

Managers may use fundamental or quantitative stock picking strategies.  The traditional fundamental strategy involves knowing a company inside and out when making an investment decision.  This includes financial statement analysis, talking to company officers (such as the CFO), learning about the company's industry, gathering intelligence on the company from conferences and meeting with the company's day-to-day points of contact (such as their clients, vendors, supply providers, competitors, etc.).  The analyst or manager collects this data and forms an opinion of the company's prospects based on the mosaic theory.  Hedge funds mainly concentrate on mid and small cap stocks because they have limited coverage from the sell side.  A large cap company such as Coca-Cola has many analysts covering it and lots of public information available compared to a mid or small cap company.  In the latter case, there is a better opportunity to spot an undervalued and underappreciated stock price.  The sell side institutions base their business model on this strategy.  Many hedge funds and a majority of mutual funds use it.

Another fundamental strategy is known as the top-down approach.  Here managers study the economic drivers to forecast the prospects for different sectors of the economy.  From here, they would predict how individual companies would fare.  They would look at statistics such as Gross National Product, inflation, interest rates, import/export figures, etc.

The quantitative approach uses factors as a way to screen out unsuitable stocks for investment.  Some examples of factors are P/E ratio, price to sales ratio, price to book value ratio, etc.

Technical analysis can be used for the price momentum strategy.  Managers may use price charts to find stocks that are outperforming or underperforming the market and establish long or short positions.

Those are the mainstream long/short strategies.

Prime Brokers and the Hedge Funds They Serve

I have found a very thoughtful blogger who had researched the relationships between prime brokers and their hedge fund clients.  He had discovered that certain investment banks specialize in serving different investment strategies i.e. Barclays cover many funds using Fixed Income Arbitrage.  The article is here.  He has written other posts which, I will admit, are more advanced that what we have covered so far.  If you want to look at hedge funds from an investor point of view, they are all good reading.

PS  There is also a good comment attached to the article

Hedge Fund Strategies

Most of the time, hedge funds are lumped together under one umbrella.  While the aims of fund managers are basically the same, the methods can be very different.  By methods, I mean investment strategies.  There are four main categories of strategies:  market directional, event driven, arbitrage and opportunistic.

Market directional strategies are affected by the securities markets.  When the term hedge fund is mentioned, the investing public immediately thinks of two of them - equity long/short and short.  The former allows the portfolio manager to have both long and short positions within the fund while the latter has short positions.  The other two are less popular - activist and emerging markets.  The activist hedge fund tries to improve the management of its positions and profit from the subsequent rise in stock price.  The emerging market fund invests in its namesake.

Corporate restructuring (aka risk arbitrage) funds invest in companies undergoing a current or possible transaction.  The most well known strategy is merger arbitrage which is based on a merger between two companies and whether or not it will be completed.  The distressed securities strategy invests in companies that are being re-organized or are in bankruptcy proceedings.  Event driven funds invest in companies that are going through mergers, bankruptcy, spinoffs, re-organization, special dividends or stock buybacks.  Regulation D invest in securities issued through private placements such as through rule 144A.

Arbitrage funds identify two similar securities with different prices will converge to the same price.  The main strategies are fixed income arbitrage, convertible bond arbitrage, equity market neutral and relative value arbitrage. The first two capture price discrepancies between buying a security (bond or convertible) and hedging that position by shorting a similar security.  Equity market neutral combine long and short positions in a portfolio to eliminate market risk.  Relative value arbitrage strategies find a relationship between the prices of two securities.  When there is a discrepancy to the historical pricing, the funds seeks to take advantage of it and profit when the relationship returns to the norm.

Opportunistic strategies are global macro and fund of funds.  Global macros managers take a top-down investment approach.  They look at macroeconomic factors and invest accordingly.  Funds of funds invest in other hedge funds.  Depending on market conditions, they are able to re-allocate capital to generate superior returns.

We will take a closer look at these strategies in later entries.  There are other strategies that are not as  common and we may review them too.

Hedge Funds and their 13F filing data

A number of articles have focused on investment banks and how their prime brokerage divisions service hedge funds.  I came across this article a couple of weeks ago regarding 13F filings by hedge funds.  Hedge funds report their holdings to the SEC on a quarterly basis.  Christopher Holt of the website AllAboutAlpha.com has an interesting article regarding the trading volume and performance of securities on funds' reports after publication of the filing information.  You can access the article here.

A Little Trader Talk

I wanted to make a quick point on a post based on a conversation I had with a colleague.  We sat on the trading floor near one of the sales trading desks and they were, as usual, shouting out orders the entire day such as 1,000 shares of Microsoft.  My colleague remarked, "They don't seem to be trading much money.  1,000 shares times $47 is $47,000."

When traders yell out orders on the floor, the share amounts are in thousands.  So, 1,000 shares is actually 1,000,000 shares.  If the number of shares are less than 1,000, they are called little shares.  A 500 share trade would be 500 little shares of Microsoft.

Private Placements under Rule 144A

Investment banks may sell restricted securities to large investors with over $100 million in assets (called Qualified Institutional Buyers or QIBs) based on Rule 144A.  This is a private, low-key transaction that is not advertised like an IPO.  There is no management roadshow to promote the issuer.  Most of the times, they are done within a short timeframe.  When these transactions occur, the sellside firm first must affirm that the buyers are QIBs.

These securities are not registered with the SEC and do not have to provide a full prospectus to the buyers.  Instead, an offering memorandum is prepared.  This document has a description of the issuer's business, financial statements and management's analysis of the most recent results.

A large number of these transactions are done for preferred convertible bonds and for ADRs (American Depository Receipts) or GDRs (Global Depository Receipts).  This is an method for non-US companies to access US capital markets without having to submit to US disclosure laws.

Is There Any Way to Attribute Revenues for Corporate Access?

One of the items valued by the buyside is access to corporate management.  As was stated before, this could be a meeting or presentation at a conference or non-deal roadshow.  After either event, how can the sponsoring investment bank confirm that the buyside client is doing more business i.e. trading commissions?  The bank can check the before and after revenue levels in regards to the trading activity for the issuer.  There are certain caveats that must be taken into account.

• If the security is lightly traded, then the fund manager may execute trades in a more heavily traded stock to pay for the meeting.
• If the meeting merely caused the fund manager to keep the current holding, then the manager may execute trades in another security to pay for the meeting.
• If the trading desk for the sponsoring bank does not give "best execution" for the security, the manager may execute trades in another security to pay for the meeting.
• A better metric may be to calculate the trading market share of a security.

Studies in Client Profitability

We have reviewed the broker vote and the main factors that contribute to it.  The next logical step is to analyze them and determine if the investment bank is receiving a good return on its allocation in resources.  It's a simple revenues versus expenses calculation.  The art is in determining what the expenses are and how to weight them.  What services are the most important and bring the most value to the buy side?  How much does each service cost?

Within the financial services industry, the most expensive costs are people's time.  For the main roles that interact with the buy side, banks would measure:

Research Analyst - 1x1 meetings, group meetings, field trips, projects/special reports, 1x1 calls, conference calls, entertainment
Research Sales - calls/time spent on client, entertainment
Salestrader - calls/time spent on client, entertainment

For Corporate Access, the statistics would include 1x1 meetings, 2x1/3x1 meetings, group meetings, field trips, presentations, conference calls, special events and entertainment.

In addition to the basic profit/loss analysis, there are scenarios run to estimate revenues if the resource allocation changes.  If a fund is given more meetings, what is the upside in revenue?  What is the downside in revenue if resources are cut?  How should we approach a client who is not giving the firm enough revenues to merit the resources that are given to them?  Here is where senior management needs to make hard decisions.  This is usually the province of a relationship manager for large accounts and sales management for others.  We will discuss the role of the relationship manager at a later time.

How Technology Can Serve Hedge Funds

A prime broker is able to offer hedge funds its technology resources to facilitate its daily operations.  The fund managers are allowed to concentrate on running their funds by outsourcing them.  Here are some functions that the prime broker offers funds.

Reporting

Prime brokers offer bespoke reporting with the ability to analyze the fund's whole portfolio.  The reports can measure the performance of the fund, calculate the Net Asset Value (NAV) and provide risk management reports in real-time.  They can run performance reports comparing the cost of a trade against an industry benchmark (i.e. VWAP or TWAP).  Being able to calculate the value across all positions allows for accurate portfolio margining.

Trading

Prime brokers can give hedge funds access to their electronic trading platforms.  These include direct market access (DMA), algorithmic trading and program trading.  The best platforms allow fund managers to execute their trades anonymously and without affecting the market.  Credit Suisse's Advanced Execution Services and Goldman Sachs' REDIPlus are the best that are out there.  The field is very competitive and every firm is constantly improving their services.  Speaking of anonymity, there are a number of dark pools run by investment banks such as Credit Suisse's Crossfinder and Goldman Sachs' SIGMA X.

Research

Prime brokers offer access to research created by their equity, fixed income and derivatives analysts.  This can be distributed through the banks' proprietary web portals.

Custody and Trade Settlements

One of the basic functions that a prime broker performs for a hedge fund is to act as a custodian for its assets and to settle its trades.  The custodian holds the fund's stocks, bonds, commodities, etc. in a separate account.   As a result of the Lehman bankruptcy, there have been discussions of how to safeguard these assets better.  Some funds were unable to retrieve the assets that were embroiled in the bankruptcy procedure.  Because of this risk, managers are having 3 or more prime brokers handle their funds.

The prime broker processes and settles the fund's trades with different counterparties.  Since the broker clears all the trades, it is able to give the fund manager centralized reporting.  The global brokers will be able to handle trades across different countries and products (such as equities, fixed income, commodities, foreign exchange, futures, options, warrants, credit default swaps, equity swaps and other over-the-counter derivatives).  It also handles corporate actions on securities.  These actions include:

• Mergers and spin-offs
• Tender offers
• Dividends and interest payments
• Calls on bonds
• Stock splits
• Annual meetings and proxy communications
• Accounting i.e. calculation of Net Asset Value (NAV)

Collateral Management for Hedge Funds

Let's return to the world of prime brokerage and hedge funds.  One of the advantages that hedge funds have is the ability to use leverage to enhance their returns.  Prime brokers are the main source of financing.  Hedge funds may finance trades on margin.  In securities trading, margin is the amount of money borrowed from the broker to buy the position using another position as collateral.  The hedge fund finances the remaining through the margin deposit.  The deposit is compared against the maintenance margin requirement constantly.  If it is below the requirement level, then a margin call to collect the difference is issued by the broker.  At this time the broker does not care how the call is collected.  It can ask for cash or may sell the fund's other holdings.  Here, it is important for the hedge fund to have a good relationship with the broker.  The broker will have more patience on margin calls in this case.

For commodity futures, the idea is the same except the margin rate is much lower.  The initial futures margin is around 5 - 15% of the value of the contact.  This is compared against the margin maintenance.  If it is below the maintenance level, then a call will be made to bring the balance to the initial margin.  The maintenance margin is usually lower than the initial margin to allow for some price fluctuation.

Another method of financing is the repurchase agreement (repo).  This is merely selling the security while agreeing to buy it back at a future date and price.  The difference in prices (called the spread) is the interest rate.  Hedge funds will take the borrowed cash and invest it.  Hopefully, they will earn returns higher than the interest paid.

Both repos and margining will be under the collateral management desk of the prime broker.

Hedge funds have multiple holdings in their portfolios.  Prime brokers calculate how much leverage to give them by using proprietary formulas based on the riskiness of the portfolio.  The methodologies include running it through stress tests, scenario analysis and mapping it against various risk factors.  The large prime brokers are able to do this across securities, derivatives, commodities, etc.  This takes a sophisticated and powerful technology system that consolidates data and gives funds one-stop shopping for reporting.  This is called portfolio margining.

Active Extension Funds: Mutual Funds with Leverage

One of the main types of institutional investors is the mutual fund.  In the last five years, a new type of fund has been created called 130/30 active extension.  A mutual fund (a.k.a. long only) can only buy securities.  The 130/30 fund can short securities in the same manner as a hedge fund.  However, leverage is restricted to 30% of the portfolio value.  There are other funds that have more or less leverage and are known as 150/50, 140/40 or 120/20 funds.

The proceeds from the short sales can be re-invested as additional investments.  The fund still has overall 100% exposure to the markets.  This allows investment management firms to capitalize on all their research.  If a firm's analysts and portfolio managers cover a stock and determine that it's price will go down, then it can act on that knowledge by shorting the stock.  In a mutual fund, they would sell the position or not buy it.

130/30 were created by mutual fund complexes as a reaction to the growth of hedge funds after the technology bubble.  At that time, absolute return vehicles were growing rapidly and mutual funds had lost the trust of the investors.  Hedge funds were increasingly taking away the best talent from mutual funds and this was seen as another way to combat the brain drain.  130/30 funds would command higher fees than long only funds and contribute to their bottom line.

An issue would be the availability of stocks to short.  Do the mutual fund managers know how to short stocks from an operational point of view?  Do they have the relationships with Prime Brokers' stock loan desks that hedge fund managers do?  One does not call a stock loan representative out of the blue and ask to borrow securities.

Later on, we will compare the strategies and results of mutual funds, 130/30 funds, long/short hedge funds and equity market neutral hedge funds.

Types of Buy-Side Firms

In many posts I have used the term buy-side.  It is composed of institutions that pool money from investors, either many or few, and use that capital to invest in securities, real estate, commodities and other assets.  The buy-side includes banks, insurance companies, pension funds, endowment funds for universities, hedge funds, mutual funds and sovereign wealth funds.  Not included in this list are retail investors such as high net worth individuals and family offices.

Most of the types of investment vehicles are self-explanatory.  Hedge funds are limited to being investors that are accredited i.e. someone with a net worth of more than $1 million or annual income of $200,000 or more for the past 2 years and the current year.  For a married couple, the minimum annual income level is $300,000.  On the institutional side, the firm (known as a qualified purchaser) must have a net worth of $5 million.  A hedge fund may have up to 100 investors or 500 institutions invest in it.

Hedge funds have major differences with mutual funds.  They are allowed to have long and short positions.  They can use leverage to optimize returns.  Their universe of investments is much wider.  They are allowed to invest in 144A securities as part of a private placement, use derivatives such as futures and options and specialize in a sector or strategy.  Hedge funds are now registering with the SEC and the trend is for more regulatory oversight of them.

Some examples of each type of buy-side firm are:

• Banks - asset management arms such as Goldman Sachs Asset Management (GSAM) and Credit Suisse Asset Management (CSAM)
• Insurance companies - New York Life and MetLife
• Pension funds - Texas Teachers Retirement Systems and California Public Employees' Retirement System (Calpers)
• Endowment funds for universities - Harvard Management Company and Yale Endowment Fund
• Hedge funds - S.A.C. Capital Management, Paulson & Co and Soros Fund Management
• Mutual funds - Fidelity, Vanguard and Black Rock
• Sovereign wealth funds - Government of Singapore, Abu Dhabi Investment Authority and Permanent Fund of Alaska

Securities Lending

One of the advantages of a hedge fund versus a mutual fund is that hedge funds are allowed to short, that is bet against a stock or bond.  In order to execute this transaction, they must first borrow the shares before the trade.  Where do they get these shares?  From their prime broker.

Securities Lenders obtain access to multiple institutions that have stable holdings.  These are generally pension funds and large asset managers.  They would receive some fee from the Securities Lender in exchange for the stock loan.  Depending on the agreement between the fund and prime broker, they may even retain the dividends paid out on the securities.  Here is where an investment bank with a healthy asset management division would have an advantage.

The prime brokers can lend from this pool of securities to the hedge funds to execute their short trades.  The fund can cover their position and return the securities at the end of a profitable (hopefully) trade.

Prime Brokerage Client Services

After the sales force brings hedge funds onto the Prime Brokerage platform, the client is handed off to the Client Services Team for day-to-day management.  It is here that clear and accurate knowledge transfer of the client's needs and goals is vital.  The Client Services representative must know everything.  They will be the fund's advocate and problem solvers for the different capabilities within Prime Brokerage.  These include custody and trade settlement, financing on margin, risk management and accurate reporting of portfolio and positions on a real-time basis.  Most of their day is acting on issues on behalf of their client.

Some firms add a senior executive as a relationship manager.  They serve as an additional advocate for the fund as reinforcement for the Client Services representative.

Prime Brokerage Sales

Prime Brokerage Sales, also known as Hedge Fund Sales, concentrate on bringing new funds onto the investment bank's platform.  They may be new start-up funds or a new fund being launched by a successful organization.

Hedge Fund Sales is selling the capabilities of the bank; tailoring their pitch to the hedge fund's needs.  The fund may be interested in getting access to algorithmic trading or trading in global markets or have special trade settlement and clearing needs.  There may have been an existing relationship between the fund and bank through the Capital Introductions or Hedge Fund Services Teams.  If these prior touchpoints were positive, then the bank would have a headstart in bringing the fund onboard.

Helping Emerging Hedge Funds

The Prime Brokerage Division of Investment Banks helps seed emerging hedge funds through the Capital Introductions team.  There is another team - Hedge Fund Services - that helps start-up funds with the details and logistics of launching the fund.  They help the fund find office space and set up the nuts and bolts of the office i.e. computers, Bloomberg terminals, phones, office furniture and supplies.  The team has a contact list of specialists:  accountants, lawyers, operations and technology professionals, etc. that will work closely with the fund manager.

After the fund has been established and is growing (in assets and people), then Hedge Fund Services will aid in additional areas such as Human Resources or business development.  Like Capital Introductions, there is no explicit fee for this service but it binds the relationship between prime broker and hedge fund even tighter.

Capital Introductions

In the prior entry, I had introduced prime brokers and the special services they give hedge funds.  This affects the entire life cycle of setting up a fund.  One of the services is Capital Introductions.  It is how fund managers meet investors.  The Capital Introductions Team runs an event or round table where managers seeking seed money to initiate their fund meet institutions who are seeking to invest with the best and brightest managers.  The event is run very much like a conference.  The team does its best to match up the managers and investors with the proper investing strategy i.e. a risk averse investor would meet with an equity market neutral manager.  After the event, they would gather feedback from the investors regarding their level of interest for a manager and forward the information.  The two interested parties will then follow-up with each other.

There is no fee paid to Capital Introductions.  This is different than if the investment had been completed through, for example, the Alternative Investment Division.  In the latter case, there is a fee paid to the investment bank.

Hedge Funds

The broker vote is not as reliable a forecaster of market share for hedge funds as for mutual and pension funds.  A hedge fund should have at least 2-3 prime brokers.  These brokers supply financial services such as custody services, securities lending and financing.  We will tackle these items at a later date.  The world of prime brokers used to be dominated by Goldman Sachs, Morgan Stanley and, to a lesser extent, Bear Stearns.  Since the financial crisis in 2008, the space has added Credit Suisse and Deutsche Bank.  JP Morgan has replaced Bear Stearns because of its acquisition.  Please reference this March 2010 article for a fuller understanding of the players.  These prime brokers are also sell side firms.  Since there are already strong existing relationships between hedge funds and their brokers, the market share for hedge fund commissions are skewed in favor of them and may not follow the results of the broker vote.

Anatomy of a Broker Vote

Sample Broker Vote:

We have maintained our #3 position with ABC Management Company in first half of 2010 (In the prior voting period, we were also #3).
Few highlights:

Our breadth of coverage with ABC Management Company is good...
There are 8 analysts who vote in New York, 4-5 in London (the number depends on the US-related projects). For the first half of 2010, only 2 analysts did not vote for us.  We are doing better than the competition.

...however our depth needs improvement.
Compared to the competitors, number of points we get from each analyst is low, according to the CIO i.e. we have fewer #1 rated analysts. As a benchmark, high single digit point is good, double-digit points are considered excellent (analysts and PM's allocate 100 points). We had 2 analysts who gave us double-digit points.

Overall ranking #3, but the upside to #1 is still big.
Top 3 gets roughly 40% of the commission market share. #1 broker gets in the high teens, while #3 gets 10%.  In absolute commissions, 8% difference is equal to around US $1m.  Biggest vote upside will come from the 2 analysts who did not vote for us.

Overall competitive landscape:
* Commission shares looks much like an S-curve. Top 3 gets roughly 40% of the commissions, while there is very little market share difference for #4-9.  1-2% difference between #4 and #9.  Top 10 gets close to 75%.  Broker universe has expanded as good analysts from big firms move to smaller houses or boutiques and ABC's analysts want access.  However, they are paid minimal amounts. Analysts usually vote for 10-15 brokers.

Overall updates on ABC Management Company:
* $7-8 B in assets under management
* Tougher 2Q, but July looking better overall.  Seeing stablilization of clients flow.
* Investment making process is a bottoms-up: each analyst talks to the portfolio manager when there are an actionable investment ideas and PM will make the final decisions on the stock.

ACTION POINTS:
* Introduction of credit analyst to John Smith
* Introduction of Thomas Jones to new technology analyst
* Establish solid relationship with Allan Edwards

Reasons the Sell Side Would Vote for an Analyst

Each sell side voter and firm has its own investing philosophy.  Naturally, during voting season, they have different reasons for giving an analyst a vote.  These may be:
1.  Making a good call for buying or selling a stock
2.  Having insights into their industry or stocks
3.  Taking the trouble to meet with them personally (This applies especially for clients not in New York, Boston, California or London.)
4.  Having an interesting/fresh investment thesis
5.  Sponsoring access with corporate management via a conference, field trip or roadshow

Issuers at Industry Conferences

In prior posts, we have gone over what happens at industry conferences.  The process of allocating meetings to investors such as mutual funds, hedge funds, pension plans, etc. was reviewed.  There is another client at the meeting - the corporate representative.  This can be a high level manager at the company such as the CEO, Chairman, President or CFO or the Vice President of Investor Relations.  The investment bank asks the buy side who they want to meet.  During the scheduling portion of the conference set-up, this list is previewed by the corporate.  At this time, the corporate may edit the list.  This could be as follows:

1. I want to see these 3 investors because they are long term holders of my company
2. I do not want to see this investor because they are traders of my stock
3. I need to see this investor because they hold 5% of my company

The corporate access team at the investment banks are always balancing the needs of the buy side with the needs of the corporates.  They have to handle 2 different sets of customers.

Effect of the Technology Bubble on the Broker Vote

In the previous article, there was a short summary on the analyst level detail of the broker vote.  During the technology bubble in the late 1990's, there was a distortion in the vote.  At that time, the analysts covering the technology (especially Internet) sector received an increased number of votes at the investment banks.  This was an attempt to curry favor with the analyst in hopes of getting an allocation to a hot/oversubscribed IPO.  As with many situations in investment banking, this was unspoken.  On the whole, an analyst of the lead underwriter of the IPO would have a favorable reputation and the comment would be:  "He/she gives valuable insights."

Broker Votes for Research Analysts

Investment Banks are ranked by buy side firms during the broker vote process.  There are additional levels of detail that emanate from this vote.  Some firms also rank coverage by geographic region or country, sector or industry and individual analyst.  One of the measurements for research analysts is the broker vote.  Here is where the subjective/objective line can be crossed.  The fund managers and buy side analysts, after the initial rank, are asked to give details of who has helped them during the voting period.  This may be because of a timely stock call (buy or sell) or special insights or historical relationship.  The analysts are ranked by how many firms have voted for them.  This is done twice a year.

There are about 150-200 votes collected from buy side firms at any given time.  The top analysts generally garner votes from about 120 firms as not all buy side firms are interested in all sectors/industries.  There are also firms that refuse to give any details about research analysts.

A Quantitative Way to Rate the Sell Side - Part 2

In the last article, we summarized the basic points of the McLagan Survey.  There are some frequently asked questions surrounding it that I can answer.

Since each sell side firm sends in their commission data, how can they be sure that it is an apples to apples comparison?
McLagan holds the commission rates for each relationship between sell and buy side firms and the absolute commission dollars are normalized i.e. client a pays $0.01/share to broker 1 and $0.02/share to broker 2.  Broker 1's numbers would be doubled for a like comparison.  International trading commissions are calculated on a basis point rate multiplied by the market capitalization of the trade.  These are gross commissions.  When a sell side firm does not have a presence in a country's exchange, they pay a local broker fee.  These are included in the commission figure.  The same logic applies to soft dollar trades.  To sum up, the buy side firm will designate certain transactions as soft dollar.  The sell side firm will retain part of the commissions and use the remainder for buy side's research expenses i.e. Bloomberg terminals.

How is the survey organized?
The survey is split geographically into 3 regions:  Americas, Europe and Asia.  Americas has the most complete coverage and is dominated by the US with some Canadian firms.  Europe is next with the UK having the largest universe in that area.  Europe is split into UK/Ireland, Western Europe and Emerging Europe.  Asia is the most diverse with the major centers being Japan, Hong Kong and Australia.  Individual country reports are compiled too.

What are the products covered?
Within each region, the products are split geographically and by type.  There are ratings are for Listed (NYSE) and OTC (NASDAQ), Canadian, UK/Ireland, Western Europe, Japan, Non-Japan Asia and Australian securities.  The products are divided into Ordinary/Common Shares traded on the native exchange, American/Global Depository Receipts (ADRs/GDRs), Convertibles, Listed Options and Program Trading.  The smallest data set is the options.

As part of their service, McLagan Partners visits the sell side firms and presents the findings to management.  They will compile special reports that aggregate accounts and calculate the market share.  This can be done for a branch office, a saleperson or salestrader's account package.  As was mentioned in a previous post, this is one of the performance measurement statistics used in evaluating the sales force.  For some packages, this has to be taken with a grain of salt.  In the southwest, there are 3 large accounts and 2 of them have opted out of the survey.

A Quantitative Way to Rate the Sell Side - Part 1

As a companion to Greenwich Associates' qualitative survey, investment banks also participate in a quantitative survey created by McLagan Partners (www.mclagan.com) from Stamford. Connecticut.  Unlike the Greenwich Associates survey, trading commission numbers are self-reported by the broker/dealer community.  The assumption for this survey is that each firm will report honestly.  It is in their self-interest to have accurate information even if the news is unpleasant.

The McLagan reports are published every quarter and sell side firms value the regular and somewhat immediate feedback.  Greenwich and Institutional Investor ratings occur once a year.  Because of the quantitative nature of McLagan, they are able to cast a wider universe of buy side firms.  Instead of sending questionnaires to thousands of buy side firms, they are sent numbers by the sell side - a more limited set.  One thing in common between Greenwich and McLagan is that their results are to be kept private.  They are performance measurement services that allow broker/dealers to improve their client service.

The process begins at the end of each quarter.  A list of current buy side firms are sent to the sell side.  This list includes any changes such as re-organizations, mergers or spin-offs since the prior quarter.  McLagan asks if there are any new firms that should be added to increase their coverage universe.

The firm respects the privacy wishes of buy side firms by allowing them to opt out of the survey.  This request is usually in response to the following comment by the broker/dealer.  "Last quarter, we were ranked 3rd in your broker survey and we know that there were 5 firms with more commissions than us.  How can we get this discrepancy resolved in the next quarter?"  To avoid this conversation, the buy side will ask McLagan to suppress their records in the survey.  If too many firms are suppressed, the survey is devalued.

Each sell side firm submits their quarterly commission numbers about 3-4 weeks after the end of the quarter.  McLagan compiles the numbers and publishes the results 1 month later.  The reports are run broken down by region (Americas, Europe and Asia) and by product.  Products are split into country and type of security.  Each sell side firm is ranked in absolute numbers and given a rank out of the total number of broker/dealers that trade with the buy side firm.  Depending on where the firm is ranked, commission numbers are given at different benchmarks such as number 15, 10, 5 and average of the top 3.

These are the basics of the survey.  I will give more details in the next post.

A Qualitative Survey of Sell Side Brokers

Greenwich Associates is a third party research company that advises sell side firms on how they are currently serving their clients and how they can improve.  A review of the www.greenwich.com website lists a wider mission statement that includes both sell and buy side firms.  In this article, we will concentrate on the sell side survey.

The survey starts when Greenwich sends out a list of the buy side firms that will contribute.  The usual suspects are on the list:  Fidelity, Capital Group, Wellington Management, etc.  For these firms, the sell side nominates the contact who will receive the survey.  Also, the sell side is encouraged to add new firms to the list.  This helps Greenwich give the sell side more robust results and add new customers.  The contact for any given buy side firm is by majority vote.  So if 6 firms have John Smith as the contact and 5 firms have Pete Jones, then John Smith will be listed as the official contact.  This is called "ballot stuffing".  Obviously, if John Smith receives the survey, then the 5 firms that speak primarily with Pete Jones will be at a disadvantage.

I have not seen the questionaire but it is qualitative in nature.  These answers are compiled into a rating score on a scale of 1 to 1000.  A total result is given for the entire universe of accounts.  Then ratings are given by each role within equities:  research, research sales and salestrading.  They can be further sliced and diced by account coverage.  For any result to be statistically significant, a minimum of 5 firms have to fill out the survey.  Greenwich also provides account profiles that contain feedback from the buy side firms.  The contents are confidential to sales management.  The salespeople and salestraders covering the account are not to be informed.  However, I always wondered about it.  If the buy side tells sales management of the investment banks on how to improve client service, how would management broach the subject to their staff without giving away the source?  Especially after the Greenwich survey has been published.

Institutional Investors Magazine's Research Analyst Survey

One of the factors for measuring sell side analysts' performance in an investment bank is the Institutional Investors Magazine survey.  To sum up, the magazine has regional lists of the largest mutual funds, pension funds, endowments, etc.  Hedge funds have their own separate list.  They are known as the Institutional Investor 300 or Hedge Fund 100 lists and are ranked by the number of assets under management (in descending order).  Every year, questionnaires are sent to the buy side analysts asking them which sell side analysts have been the most effective.  The results are compiled and the top three research analysts of each industry covered are named as part of the All-America Research Team (in the US).  The names are reported in Institutional Investor.  Also mentioned are runners-up/up and comers.

There is an excellent article at briefing.com's Learning Center.  It is targeted to inform an individual investor about the process.  An important point is that an analyst's performance and compensation can be affected by this vote.

The goals in the survey are different based on the business models of the investment banks.  Bulge Bracket firms may try to be Top 3 in all industries and regions.  A boutique bank may desire to be top 3 in a particular sector.  One large firm had developed a strategy where they would have a limited focus.  They would be top 3 in the industries that had the most traded securities.  Quite simply, the stocks that generate the most commissions.  Another business strategy was to de-emphasize the regional ranking.  The firm wanted to target the firms that generate the most trading revenue - hedge funds.  Since they do not have the asset base of a Vanguard, Black Rock or Fidelity, their votes are usually watered down.  Institutional Investor's survey is weighted by assets under management.

Clarification on Portfolio Strategies

Yesterday in my summation of a presentation at the Manager Search Conference at NYSSA. I wrote that a portfolio should hold two main strategies: style-based and flexible. I should clarify these two terms. Style-based means choosing a manager that is constrained in a specific market cap or region. Some examples would be managers in small cap value stocks, emerging markets debt or Japanese stocks. A flexible strategy would allow the manager to invest in the best opportunities that they can find. The more famous managers would be George Soros, Paul Tudor Jones and Ken Heebner.

Updated Concepts in Choosing Investment Managers

One of the more interesting presentations at the Manager Selection Conference at NYSSA mentioned in the previous post was regarding selecting the right investment managers for your portfolio.  I am only the messenger here.  The following is list of ideas from the brain of Thomas Latta, Managing Director and CFA.

The financial crisis of 2008/2009 brought an end to the concept that "beating the market" was good enough for investors. If the benchmark is down 50%, is it good news that a manager is only down 45%? This provided a wake-up call to traditional money managers. The challenge is to fix this error but not commit the old error of timing the market.

This can be done by having improved risk management processes, qualitative analysis of managers and building a portfolio from a mix of different strategies. Better risk management involves managers having strict selling criteria, diversification, tail risk management and close monitoring of active risks. When managers are rated, there is a premium on experience, diversity amongst the managers (in terms of training and process experience) and knowledge of behavioral finance i.e. the science of crowds. The portfolio should hold two main strategies: style-based and flexible. However, this increases the need to monitor at a total portfolio level.

The trend for the advisor is to choose funds with concentrated portfolios of 20-30 positions in either traditional or alternative asset funds. This allows the advisor to choose managers with more freedom in investment decisions, that can manage their Beta and have lower correlation with the market.

Another Type of Conference

I had the pleasure of attending a conference that was not sponsored by an investment bank. It was held by one of the CFA (Chartered Financial Analyst) Institute societies and was decidedly more low key. The accommodations were not at a posh hotel but at the society's offices. It was an open event; there were no gatekeepers. Anyone who would pay the fee could attend. There were also no breakout meetings scheduled. Everything was on a presentation basis, either by a single person or a moderated panel.

In general, there was an industry theme - how to find and select good fund managers. Experts from different financial firms such as Brown Brothers, Bank of America Merrill Lynch and Avenue Capital spoke for about an hour on various topics in Wealth Management, took questions from the audience and gave their views on the current state of the markets. It was an opportunity to sell their products as well.

Anyone interested in experiencing a conference without being in a buy side firm can go to one sponsored by their local CFA Institute society. You can go to www.nyssa.org to view a list of conferences to attend. Unfortunately, the food is not as good as an investment bank's industry conference.

Industry Conferences

Buy side money managers and analysts are always seeking insight on the companies currently in their portfolios or on their watch lists. They are looking for any information that would affirm or change their investment thesis. One of the venues where this occurs is an industry conference sponsored by a sell side investment bank. Here, corporate clients such as Intel or Altria will send their officers to speak to the buy side either in a presentation or meeting.

This is where the size or importance of the firm make an impact. In the beginning, the salesperson will invite all their interested clients to the conference. The buy side representative will indicate which corporates they wish to speak to in a group or 1-on-1 basis. This is contingent on the corporates' availability. Some of them will only speak in a presentation setting. Others will desire to have meetings.

Depending on the conference and the sponsoring firm, conferences may or may not be exclusive. So the firm may allow all buy side requests to be approved for attending the conference. Other times, attendance will be tightly controlled. However, for all conferences, meetings and activities (such as golf outings) with corporates are controlled and scheduled by the corporate access team. The meetings and activities are where having a good research salesperson can help a buy side firm. Obviously, for the giants such as Fidelity, S.A.C. Capital or Capital Group; their requests are given precedence. But for a firm on the border, having an advocate that can persuade management to give them a meeting is invaluable and would result in a better broker vote.

A Day in the Life of a Research Analyst

Research analysts have less predictable days than either a research salesperson or salestrader. Their workday is somewhat less tied down to the market's trading hours. They are the experts of an industry or group of companies. Any news that must be incorporated into their models can arrive at any hour of the day. When an analyst has any breaking news, they want to be on the 7:30 morning call. When they are scheduled, they can be found in the office at 6-6:30; preparing for the meeting. At the call, they will present their thesis and answer any questions from the sales force. After the call, they will call their most important buy side clients while the research salespeople are calling theirs. If a particular client is interested in their viewpoint, they will ask to speak to the analyst. A highly regarded and ranked analyst can move the stock price.

Other days, the analyst has plenty of duties to occupy their time. There are financial models to be updated, clients to be called, research and marketing to be done. Analysts have 2 different client universes: buy side and corporate clients. The buy side includes the investors of the securities covered by the analyst. Corporate clients are the companies covered with the analyst. They speak with corporates to keep abreast of any industry news. Analysts also speak with third party sources such as suppliers and customers of the company, journalists and other industry experts.

Analysts also go on marketing trips. They talk to buy side clients about their research ideas. They may visit 4 cities in 5 days and have 15 meetings during the trip. This is arranged by a special analyst marketing group that parallels what corporate access does for company management.

An analyst's performance is measured by how the perform on the:

• Broker vote
• Rating by Research Sales
• Institutional Investor (II) ranking
• Greenwich ranking

Institutional Investor is a famous publication that has "All-Star teams" for each industry. It lists the top 3 analysts annually and has an up-and-coming team for promising analysts. The article is printed in 1 of II's magazines. Greenwich Associates has an annually survey that focuses on the qualitative rankings of the sell side analyst. In this survey, questionnaires are sent to be filled out by the largest buy side firms. The answers are analyzed by Greenwich and results are sold to the sell side.

Sometimes, they are also rated on the trading commissions for the stocks that they cover. This can be unreliable if they cover thinly traded securities.

You may be asking, "What about the accuracy of their recommendations?" Let me reiterate. The buy side is not solely interested on whether a stock is a buy, hold or sell. They are interested in the analyst's thought process and story.

A Day in the Life of a Salestrader

Like a research salesperson, a salestrader's day starts early. They receive the morning call's research via email or in hardcopy and have a separate trading meeting at 7:30. Talk about early. The people that distribute the research are there long before 7:30. There is a review of the yesterday's activities: how many shares were traded, what stocks were particularly active and any other market color. Then the position traders will inform them of any large blocks of stock in the firm's inventory that can be traded. They will be notified of any IPO's coming up.

Salestraders are a firm's filter for their research ideas but the focus is on short term trading. The buy side uses these ideas in hopes of making a quick profit. After the daily call, the salestraders hit the phones with their clients; putting in orders before the market opens. When it opens, there is a frenzy of activity as these orders are executed. 9:30 - 10:30 is the busiest hour of the day. When the investment bank is the lead bookrunner of an IPO, the entire first day is busy as the firm has to make a market in the new security. At other specific times, there will be a burst of trading such as after any Federal Reserve Board meetings or unemployment reports. The last 30 minutes of the trading day are also hectic.

During the day, the salestraders will be in constant contact with his clients - on the phone, through email or instant messages. They will be executing their client's trades at the best price possible. Most of the time the buy side initiates them. At this point there may be conflicts with the position traders. In order to get the best price for their clients, the position traders' p/l statement will be hit. They and management will also approve or deny requests for capital commitment on their client's trades.

After the market closes, there are client reviews and team meetings to attend. Salestraders may have a client dinner or event after the end of the work day. Again, their purpose is to build relationships with their buy side counterparts.

Goals of Research Salespeople

Yesterday, we walked through the activities of research salespeople. So how does management measure the work they do? In five ways:

1. The broker vote of their client base
2. Internal vote from research analysts
3. Market share
4. Commissions
5. Cross selling

The first two indicate how well they are marketing the firm's research capabilities. Market share and commissions are the tangible results. Market share studies are run by third party firms and will be handled later. Cross selling is harder to measure. In large institutions, management encourages referrals to other product lines. In practice, this is hard for salespeople to do because they are staking their client relationship on another person who may or may not provide excellent service.

A Day in the Life of a Research Salesperson

Work in the Securities Division starts early. Most salespeople are in the office for the daily 7:30 AM research call. (This is particularly hard for people in California.) These meetings are run by the product management group. An email is sent before the call with the daily overview of ideas. There may be twenty of them. Product management decides which stories are most compelling based on the content, the reputation of the analyst and how it will affect the markets. Then they ask the analysts to promote their ideas in front of the sales force. There is usually only enough time for three analysts. During the call, the sales force will be asking analysts questions about their research.

After the call, the sales force will call their clients. They will use their knowledge of their clients and their importance to the firm to determine the order of their calls. Some items that will influence this decision are:

1. If the client holds the security in their portfolio
2. If the client is interested in buying or selling the security
3. The time a client wants to be called
4. Amount of trading commissions generated by the client

Generally, the salesperson will reach the voice mail of their client. This is the time when preparing a good script or participating in Toastmasters pays off. If you are able to sell an idea quickly, concisely and accurately, then you will be able to call more clients. They will also send emails. For the largest clients, this all happens from 8:15 - 9:00 AM. Then second tier and third tier clients will be called. If the clients are interested in the research idea, they will call back asking for more details or to talk to the analyst.

After this initial frenzy of activity, the sales desk calms down a bit. Salespeople begin setting up follow-up calls for their clients and the analysts, interacting with corporate access to get their client into a conference or non-deal roadshow, talking to Capital Markets about future IPO deals, sending out any research reports, talking to the salestraders to get market information (or color) and addressing any issues their clients may need help with. At times, this will be interrupted by a "Midday Call". In this case, an analyst will have late breaking news and the process for the morning research call is repeated.

Another call is held after the market closes. Sometimes, the day is recapped. An analyst may appear on the call but the urgency is not as strong as the morning call. It's generally more relaxed. Then the sales force returns to serving their clients and may take the clients for a dinner or an event to build strong relationships - which are the essence of business.

Please note that the times relate to the US markets. Other markets such as London, Tokyo and Hong Kong have their own calls but the process is generally the same. This is true for all the native markets. There are salespeople that cover clients in Europe and Asia for the US markets. For a person in London, the morning call would be at 12:30 PM and the evening call would be at 9:30 PM.

Personalized Information

Access to Intellectual Capital

Buy side firms are hungry for information as more recent and more accurate data give them an advantage when deciding on investments. There are two main sources: the research analyst at a sell side firm and corporate clients i.e. the companies that are covered.

Access to the research analyst through meetings or phone calls is coveted. These interactions with the analyst allow the buy side to understand the thought process behind their recommendations. It is not the actual buy/hold/sell opinion that interests the fund. The meeting would be held with the PM or buy side analyst. During the last two years, there have been staff reductions in the research departments of mutual fund firms. The trend has been towards more reliance on the sell side analyst's ideas since some sectors are no longer covered. Outside of the financial centers (New York and London), research analysts make trips to different regions to discuss their ideas. In the centers, there is a critical mass of firms and the analyst can just take a taxi or train for a meeting. In a regional trip, the analyst may have five meetings in three cities in a day. This is called Analyst Marketing.

Corporate access comes in the form of meetings with important officers of corporate clients such as the CEO or the CFO. There are many formats. Sell side firms sponsor conferences for different sectors and/or regions. Many corporate clients are invited to speak at them and, if they desire, to hold meetings with investors. Another venue is the Non-Deal Roadshow. This is when corporate officials travel to a region(s) to tell their company story to their current and potential investors. They may also set up a Field Trip to a third site. For example, an oil company may have the investors visit a refinery or off-shore drilling rig to experience the business firsthand. These events are allocated by the sell side firm. Here is where the research salespeople spring into action and try to get their clients approved for attending the limited amount of events.

Both types of meetings are very important for client service and, hence, the broker vote.

Serving the Buy Side

Research, Sales and Trading

The main elements of the broker vote revolve around research and best execution. To better understand this dynamic, look at the traditional roles on the sell and buy sides and their lines of communication. On the sell side, there are four main actors: research analysts, research salespeople, salestraders and position traders. Their counterparts at the buy side are research analysts, portfolio managers (PMs) and salestraders.

Sell side research analysts are the idea generators for an investment bank. They follow a sector or industry and get to know the companies intimately through analyzing financial statements, talking to the company's officers, following industry news and speaking to suppliers, clients and competitors of the firm. They compile all this information into opinions about the prospects for the company's business and stock price. This is known as the "Mosaic Theory". The analysts interface with the buy side's research analysts and PMs; giving them their talking points about different companies. Their recommendation is often boiled down to a buy, hold or sell in the press. The buy side is NOT solely interested in that. They are interested in the thinking process behind an analyst's stock recommendations.

Research salespeople are advocates for their buy side clients. It is their job to obtain the resources needed by them from within the investment bank. This may be a meeting with a sell side analyst or getting them into an industry conference. They market the bank's research capabilities by acting as filters - passing on the most impactful research to a client. For example, if a client has a large position in Microsoft, the salesperson will relay any important research reports regarding that stock to them. A better salesperson may relay news regarding Dell and Hewlett Packard as their sales affect the volume of Windows packages are sold.

Sell side salestraders communicate with the PMs and buy side salestraders. They execute trades and are trying to minimize the transaction prices for the buy side. The calculation of any investment return is dependent on the price of the security when bought. They also act as filters of the investment bank's research. Their ideas are more geared to day trading than any long term investing. Most of the orders are originated by the buy side. At times, they will ask the sell side to facilitate a trade by committing capital. This is something only the largest institutional clients are able to ask for and get.

Position traders interact with the exchanges and salestraders. They have a trading book which has a profit and loss (p/l) statement that is measured constantly. When an order comes from the buy side, the broker/dealer's salestrader will execute the trade through the position trader. Ideally, it will be in the book's current inventory. This is where some friction will appear between the sales and position traders. If the salestrader executes the trade at a good price, the customer will be happy and be more willing to allocate trades to the firm. However, a good price adversely affects the trading book and the p/l statement.

All four roles are large contributors to the broker vote. Whether research or trading is more important is firm specific although each side thinks that they contribute more to the vote than the other. Beyond the client service aspect, there are other items that influence commission allocation such as:

1. Is there is a prime broker relationship?
2. Corporate access
3. Does the investment bank sell the buy side firm's funds?

We will explore these factors later.