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.