Institutional investors are reasonably comfortable with leveraged investing today, though investor opinion about hedge funds and leveraged investing remains mixed, according to a study by Pershing, a BNY Mellon company.
The study, Lending and Leverage: The New Securities Finance Model for Hedge Funds, examines the changing business model of securities financing for hedge funds in 2010 and beyond.
In a recent Finadium study of 92 US public pension plans, including 25 focused interviews, 56 per cent of pension funds reported having at least some investments in hedge funds or 130/30 vehicles.
This does not represent, however, a wholehearted acceptance of leveraged investing. Many pension fund managers cited their personal dislike of leveraged investing, even though their institutions were invested in hedge funds.
The market turmoil of 2008 served as a catalyst for changes to the prime brokerage industry and the decision by many global regulators to suspend short selling in 2008 created major disruptions in the prime brokerage business model. This resulted in the curtailing of client short selling in less liquid issues – the most profitable segment of the business for both hedge funds and prime brokers.
As the ruling to avoid naked short sales has been made permanent, hedge funds and prime brokers have made the appropriate adjustments in their practices, and they are aware of greater possible changes in market structure.
While the number of prime brokers has increased, access to securities lending inventory through retail and institutional programmes remains a key differentiator for hedge funds in the current competitive marketplace. Securities loans may not be as important to hedge funds today as they were in 2008, however, it is expected that securities lending will return to centre stage over the next several years.
Leveraged investing continues to be seen as a murky area full of risk and unintended consequences. Transparency in securities lending pricing creates a more productive relationship between hedge funds and their prime brokers, and it offers hedge funds new opportunities to attract investors.
According to the study, a hedge fund’s best ally in obtaining fairly priced securities loans or synthetics will be its prime broker. The critical point in choosing a prime broker is ensuring that the fund’s and prime broker’s interests are aligned; if one party looks for transparency while the other does not, regular conflicts will arise. If both parties look to capitalise on the best-priced, most accessible means of completing a trade, then both parties will benefit by creating a lasting relationship.
"The major challenge for hedge funds of all sizes continues to be access to hard-to-borrow securities. A prime broker with access to inventory, whether through electronic markets, retail pools or relationships with institutional lenders, is critical," says Craig Messinger, managing director of Pershing Prime Services. "Forging a strong operational relationship with a prime broker is critical to a hedge fund’s success, regardless of where securities loans are sourced."
Josh Galper, managing partner of Finadium, adds: "Going forward, hedge funds will need to spend more time focusing on the costs and means by which they obtain securities loans. As more transparency enters the securities lending market, investors are looking for hedge funds to demonstrate an ability to secure the best financing for their trades. This in turn places a greater emphasis on how funds source securities lending inventory and how they manage their prime brokerage relationships."
