Hedge funds compete for assets while dealers compete for funds

Competition is intensifying among European hedge funds for investor assets and among prime brokers fighting for hedge funds business, says a new study.

Greenwich Associates' 2005 European Fixed-Income Research Study suggests that a growing number of European hedge funds are relying on the capital introduction services of their prime brokers as a source of capital, as well as increasing their leverage ratios and boosting their trading volumes in an effort to achieve their target returns.

At the same time, dealers are lowering credit quality requirements for collateral on their hedge fund repo business. 'These shifts together reflect a level of heightened competition between hedge funds and among the prime brokers and dealers that service them,' says Greenwich Associates consultant Woody Canaday.

Hedge Funds: Competition for Assets

When it comes to choosing a prime broker, hedge funds consistently report that their most important selection criteria are client service, trading capabilities, and financing/repo capabilities. But from 2004 to 2005, the proportion of hedge fund respondents citing capital introduction as an important factor in evaluating prime brokers doubled from 7 per cent to 14 per cent.

'This shift clearly indicates that, as hedge funds proliferate in Europe, individual funds are having a tougher time attracting new capital,' says Greenwich Associates consultant Frank Feenstra. 'This competition for assets is making it harder for hedge funds to build and even maintain assets under management, which in turn could be prompting them to increase leverage ratios and to trade more aggressively.'

Indeed, European hedge funds increased their fixed-income trading activity last year as the typical fund turned over its portfolio three times, increased its leverage ratio and forged relationships with new fixed-income dealers.

'The average European hedge fund portfolio manager traded USD 6 billion in fixed-income securities in the past 12 months, as opposed to the USD 5 billion average reported among all the European fixed-income investors interviewed for this year's research' says Greenwich Associates consultant Peter D'Amario. 'In order to generate trading volumes of that order, however, the typical hedge fund portfolio manager had to maintain turnover ratios twice that of other fixed-income investors.'

Hedge fund trading volumes are receiving a boost from increases in leverage ratios. In 2004, about 23 per cent of hedge funds in Europe reported leverage ratios higher than three; in 2005, that proportion approaches 49 per cent. Trading volumes also benefited from a market wide pick-up in the trading of government bonds, which represented almost half of hedge fund trading flows over the past 12 months. (Credit bonds made up about 20 per cent of hedge fund trading volumes, with the majority of the remainder in agencies).

Heightened Competition in Repos

Dealers are lowering credit quality requirements for collateral on their hedge fund repo business. In 2004, more than 45 per cent of dealers refused to accept collateral of lesser quality than government bonds or agency securities; this year, nearly 70% of dealers are accepting collateral of lower credit quality. At the same time, the proportion of dealers listing below-investment grade bonds as the lowest quality of collateral that they would accept increased from 11 per cent to 38 per cent. 'The relaxation of collateral credit standards is a sign that dealers are becoming more aggressive in their competition for hedge fund business,' says Greenwich Associates consultant Giovanni Carriere.

Greenwich Associates' research suggests that brokers are taking additional steps to attract hedge fund clients. As Peter D'Amario explains: 'In 2004 and 2005, we asked hedge funds to name the most important factors that they consider when choosing a dealer for repos. From year to year, the percentages of hedge funds citing small collateral haircuts and attractive rates on financing fell sharply, indicating that hedge funds no longer find much differentiation on these factors between repo dealers.'

As Greenwich Associates consultant Robert Statius-Muller concludes: 'Taken together, these findings indicate that hedge funds are having little trouble finding dealers and prime brokers willing to take on their business on terms the funds find favorable.'

Registration and Compliance

Greenwich Associates asked its 2005 hedge fund research participants a series of questions concerning registration and compliance. Nearly 85 per cent of hedge funds in Europe are registered with at least one regulatory authority, as opposed to just 57 per cent of U.S. hedge funds. In both markets, large funds are the most likely to have registered. In Europe, for example, more than 90 per cent of portfolio managers trading volumes between USD 1 billion and USD 10 billion say that their funds are registered with regulators.

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