Love em or hate em. No one can deny the impact that hedge funds have had on the institutional equities business in recent years and will continue to have. That influence was subtly highlighted only last month when mutual fund giant Fidelity Investments named Brian Conroy, a hedge fund executive and former head trader at SAC Capital Management, to oversee its equity trading department. To be sure, Conroy was a well-respected Wall St. veteran-Goldman Sachs and J.P. Morgan-before moving to the hedge fund world. But the hire may indicate that the normally insular Fidelity is open to new equity trading ideas, possibly even opportunistic ones.
"That's a big statement," said one brokerage firm executive commenting on the hire. He wondered if Fidelity was looking to become more aggressive in its trading style, adding that he found it interesting it hireda person without mutual fund experience.
Separately, Janus Funds last month announced plans to move to performance-based management fees, which is a page right out of the hedge fund playbook. Granted, the money manager's upside for beating its respective bogey is a mere 15 extra basis points-not exactly the eye-popping 20 percent of the profits that hedge funds normally receive. Still, the concept forces an alignment of the shareholders and the manager's interests. That's similar to the relationship between hedge funds and their investors.
The Life Blood
How important have hedge funds been over the last few years? "They are the life blood of our industry," commented one brokerage firm executive. He added that it has been hedge fund trading that has kept many firms in the black in recent years. "They kept us afloat." Other executives agreed. "Where would institutional equity trading be today without hedge funds?" asked one executive. He pointed out that, in recent years, the order flow from traditional money managers has declined dramatically from the heyday of the late-90s. Also, some of these same institutions have cut their commission rates, due to regulatory and board pressures. These factors have forced them to take a backseat to hedge funds at brokerage firms.
"I would bet that the long-only volume from the traditional managers is about a quarter of what it was in 2000," estimated Seth Merrin, CEO of Liquidnet, a brokerage firm that electronically matches orders on buyside trading desks.
Consequently, many believe that the relationship between the traditional buyside shops and the full-service brokers has been altered due to economics: Research and trading are expensive to operate. And when full-service brokers analyzed the amount of high-touch services required by their long-time institutional accounts-clients who had just undergone a belt-tightening-they saw that hedge funds offered higher margins.
"I think the traditional long-only funds were the kings of the Street and got whatever they asked for," Merrin said. "They were the primary revenue generators."
According to Brad Hintz, a brokerage analyst at Sanford C. Bernstein, hedge funds are the fastest growing-and most profitable-segment of the asset management industry. With about $1 trillion in assets, they have expanded at a 17 percent compounded annual growth rate over recent years.
Their importance is clear: Hintz estimates that hedge funds represent 30 percent of all equity trading volume. Not bad for a group of investors that represents about 5 percent of all assets under management.
Hintz reports that hedge funds will continue to be a shaping force in the brokerage industry. But it's not just their rapid trading and frequent portfolio turnover that makes them attractive. They're the most profitable segment of the money management industry because of their need for prime brokerage services: stock and margin loans that translate into fees and interest for brokers. The fundraising horizon is also bright for hedge funds. The consultancy Tower Group estimates hedge fund assets will almost double by 2008 and surpass $2 trillion.
Who Are They?
It should be noted that the roughly 7,000 hedge funds come in all shapes and sizes. They can be fundamental investors, not looking much different from a traditional mutual fund. Or they can be quantitatively driven, using computers to execute complex strategies that require as near to instantaneous executions as possible, said Eric Goldberg, CEO of Portware, a company that provides execution management systems. Black box trading and other quantitatively driven models such as statistical arbitrage rely upon speed and superior technology for their success.
Still, each type of hedge fund requires very different services. But the one common denominator that unifies all hedge funds is an attempt to exploit a fleeting marketplace advantage, whether it is a technological or informational one.
The defining aspect of an equities hedged' fund-and what separates it from a traditional money manager-is its ability to short stocks. That offers protection on the downside of the market and is something that long-only funds cannot do.
Flexibility to make quick investment decisions is another defining characteristic. The hedge fund manager is often the trader at some shops. But that is typically in shops managing less than $50 million, said one trading exec. However, many portfolio managers at hedge funds sit on or near the trading desk. That's one reason hedge funds have the ability to react fast to value-added calls from the Street, said Darren Susi, director of hedge fund sales trading at SunTrust Robinson-Humphrey in New York. "They are very much in touch with how the sellside adds value to their success," Susi said.
Since most hedge funds have less than $150 million under management, said one trading honcho, they have a heavy reliance on the Street's services. In fact, a broker has a much clearer and quicker understanding-compared to traditional institutional accounts-about what these smaller accounts value, since there is less red tape than dealing with a large institutional manager. "Since many of these shops are two or three people, they don't have time for maintenance calls," the trading executive said. "They'll pay you right away if a call is value-added, and won't think twice about actually writing a check."
The backgrounds of hedge fund pros are varied. A number of proprietary traders have left investment banks in recent years, either to launch or to work at hedge funds. To be sure, the allure of large payouts was one reason. But after commercial banks began buying brokerage firms in the late-90s, they began placing restrictions not only on the type of investments the brokerages could make, but also on the level of risk for a given trading strategy. Consequently, these prop traders went to less restrictive hedge funds, where they could also trade across asset classes, said one prop-trading veteran of 20 years.
Other hedge fund traders came from the market making community in 2001, according to Todd Buechs, an investment analyst at Nicholas-Applegate Capital Management. Trading share volume had dramatically shrunk at the time. Ambitious traders could see they were no longer on the fast track to higher positions. "There were no more big payouts coming, so why stay?" Buechs asked.
Taking the Lead
"Hedge funds are definitely taking charge," said Rob Hegarty, who oversees the securities and investments practice at the Tower Group. He said they are leaders in deploying new technologies and trading strategies. Hegarty pointed out that it was the quantitative hedge funds that forced brokers to provide better technology. These funds were the drivers that accelerated the market's move toward electronic trading. They wanted faster access to markets, the ability to trade faster in multiple securities and better trading tools.
Unbundling
Since they were also interested only in execution services, they also, in effect, were the first clients to gain an unbundled commission rate. They didn't need research. The only service they really required was a fast pipe to the exchanges through an API and a broker to clear the trade. "They don't consume much in services," said Michael Plunkett, president of Instinet. "You could call them the pioneers of unbundling."
Both Goldman Sachs and Morgan Stanley were influenced by hedge funds to expand the trading tools and functionality on their front ends, the REDIPlus and Passport systems, respectively.
Portware's Goldberg agreed that hedge funds have driven technology. "The clients wanted to be able to enter their own orders into the market," Goldberg said. Their strategies rely on their ability to get to there fast and anonymously. Consequently, brokers have become more of a service provider to the hedge fund community. That would include providing them with a trading front end as well as clearing and lending services through their prime brokerage units. The hope of the broker is that small hedge funds grow into big hedge funds that need even more trading and other services. And the technology is a great way to get a toehold into these startups that have few resources, Goldberg said.
Many factors have helped to drive down commission rates. Technology and broker over-capacity have provided the broader framework. And many believe that hedge funds may have led the charge, but it definitely wasn't the small fundamental hedge funds that pushed down rates. These funds require a greater array of brokerage services than would a traditional money manager, said one broker. "The smaller they are, the more they need Street research," he said, adding that a commission of 5 cents or 6 cents is common. "Hedge funds require more services from the broker-dealers and they are willing to pay for it," Liquidnet's Merrin agreed.
Others said the quantitative hedge funds, which really only require technology on their desktop, and former sellside prop traders, who had moved to hedge funds, were the main drivers for lower commissions. Also, the large hedge funds with their own research staffs were another factor in pushing down commissions, many pros said.
One brokerage executive said that hedge funds pay the highest commission rates. Without citing the source for the data, he said hedge funds on average pay 4.8 cents a share for a soft dollar trade. That drops to 4.5 cents for an agency trade. Investment managers are the next highest paying type of asset manager at 4.6 cents a share for soft dollar trades and 4.2 cents for agency trades. Mutual funds, which are under scrutiny by their boards, are paying 3.9 cents a share for soft dollar trades and 3.8 cents a share for agency trades.
The influence of hedge funds is not limited to brokers. Hedge funds have also influenced traditional money managers. First, many managers have established their own internal hedge funds, having created long/short strategies. The reason is two-fold: 1) A hedge fund provides another product to sell to pension clients and well-heeled investors; 2) It also may prevent key talent from leaving the firm and launching their own hedge funds. The allure of 20 percent of the profits is a strong enticement for any investment professional, whether a trader or a portfolio manager.
Yet, as money managers look to take on aspects of hedge funds, hedge funds themselves are beginning to look to traditional managers for new product ideas. Hedge funds are launching long-only funds, according to David Quinlan, president of Eze Castle Software, a provider of trade order management systems. "They are beginning to diversify their business," Quinlan said, "and many of these former mutual fund managers who started hedge funds are going back to their roots."
One head trader at a large mutual fund complex said that firms like his have had to react to hedge funds in many ways. "They've had a profound impact on our business," the trader said. He pointed out that traditional managers have been playing "catch-up" on the technology side. The quant hedge funds have raised the bar in accessing posted liquidity in ECNs and in the NYSE order book. And, with more slicing of orders, that liquidity has grown in importance. As block trading has declined and become more difficult, the ability to beat other investors to small orders can affect a fund's performance.
Conversely, fundamentally oriented hedge funds are competing with the traditional money managers for access to a finite set of broker services such as capital, IPOs or company management. "They have really made us take our game to the next level," the head trader said.
Still, the "fast-money" stigma of hedge funds remains for some on the buyside. One trader-whose firm, incidentally, operates a hedge fund-said his greatest fear is that his orders will be leaked to an opportunistic trader at a fast-money shop. No proof, mind you, just a fear.
One veteran trader on the buyside, however, stressed the importance of hedge funds in a world of 300-share prints. "We need their volume," the trader said. "I've always said, bring on the hedge funds.' Without their liquidity, we wouldn't trade." (See sidebar "The New Market Makers.")
Quant Players
Michael Richter, executive vice president at Lime Brokerage, whose clients employ black box trading strategies, pointed out the hedge fund community is responsible for driving down the average trade size after decimalization.
Richter said he believes the traditional buyside has had to react to this new paradigm. Program trading volume, which is reported weekly by the NYSE, accounts for more than 50 percent of total Big Board volume. Yet, Richter believes that the percentage of computer-driven trading is actually greater. That's because pairs trading falls short of the $1 million definition of a program trade. A black box might trade a single strategy all day. For example, it might buy 1,000 shares and sell a 1,000 shares of two stocks that are correlated. Richter estimates that at least 10 percent of Nasdaq's daily volume stems from black box trading.
Instinet's Plunkett offers estimates that are higher than Richter's. He believes that between 15 percent and 20 percent of Nasdaq's daily volume stems from statistical models. The top 15 stat arb players are trading anywhere from 10 million shares a day to 60 million shares a day, he said. About two-thirds of Instinet's customer base is hedge funds, which account for 80 percent of its volume.
One favorite investment vehicle for the stat arbs are the exchange traded funds (ETF), according to the head of one proprietary trading desk. The stat arbs execute more than 50 percent of the volume in the ETF that is based on the S&P 500, the SPDR. "They're taking these orders and just shredding them," said the head trader, referring to the number of odd lots hedged against the SPDRs. "They've linked the markets closer than they've ever been before." Indeed, hedge funds have created greater efficiencies in the marketplace, agreed one trader at a stat arb shop. "The inefficiencies now last a much shorter time," he said
Indeed, the marketplace has become so effficient, many Wall St. pros wonder how hedge funds will continue to outperform the broader market, particularly in the area of arbitrage. Between 1994 and 2004, hedge funds earned an annualized return of 12 percent, compared to the S&P 500's 10 percent annualized return. Through August, the CSFB/Tremont Hedge Fund Index reports a 4.4 percent return, compared to a gain during the same period of 1.36 percent for the S&P 500 Index.
Still, one investment pro said there's a saturation of hedge funds employing the same strategies. The margins are bound to be squeezed, he said. His biggest concern is a market dislocation and how pension funds and wealthy investors will react. "It could get real ugly once investors realize that their hedge fund isn't hedged."
The New Market Makers
Today's hedge funds are acting much like the Nasdaq wholesalers of the 1990s. So says Rob Hegarty, who heads the consultancy Tower Group's securities and investments practice. The primary reason is that hedge funds are huge engines of liquidity. "They are trading for different reasons, but they are providing capital, taking on positions and creating tremendous turnover like the Troster Singers and the Mayer & Schweitzers used to," Hegarty said. The difference, however, is that hedge funds are not required to make two-sided markets, which gives them the benefits without the burdens, he added.
