By James Williams – With risk/on, risk/off sentiment having dominated the markets for the last 18 months, trade volumes among hedge funds – which prime brokers rely on – have dropped away. This has impacted on another key revenue driver – leverage.
Tim Wannenmacher, Head of Prime Services Asia Pacific, UBS, Hong Kong, notes: “Leverage levels went up in Q1 but came off in May and have been fairly muted since. However, while we have seen lower leverage numbers - on average, 1.5 to 2x gross – we have seen more activity on the short side.”
Wannenmacher goes on to confirm that, by category, long/short equity and credit strategies showed the highest gross leverage numbers this year “but if you look at net figures, long/short equity is among the lowest, around 20 to 30 per cent. Credit is around 30 to 50 per cent.”
From a global perspective, particularly for equity funds, the fact that they were willing to miss the start of the S&P 500 market rally in early summer to protect capital has pushed them to raise their conviction levels, albeit in a more tactical fashion.
Looking at data, shared exclusively with Hedgeweek by Credit Suisse in New York, gross leverage, as of last month, hovered around the 2.5x to 2.6x level with managers raising excess cash levels to just over 22 per cent.
As for market conviction, net long bias (that is, long/short ratio) among managers has climbed through 40 per cent in 2012. From a net long exposure perspective – that is the percentage of gross exposure of a fund to being net long the market – levels have reached a year-high of 17 per cent, with net short exposure having subsequently fallen to a year-low of 11 per cent.
Figures show that equity long/short funds have been capturing over 60 per cent of the upside in markets during Q3, and crucially, escaped all but 28 per cent of the downside when markets turned in October.
“Hedge funds have been capturing about twice as much of the upside as they are giving back on the downside. That wasn’t a particularly glamorous headline when stocks were going straight up. But with markets faltering this quarter, and hedge funds doing what they’re advertised to do, the performance gap has narrowed from about 5 per cent to 2.5 per cent in six weeks,” comments Philip Vasan, Head of Prime Services, Credit Suisse.
Going back to Wannenmacher’s point about increased trading on the short side, he confirms that activity has generally been seen across markets in Asia Pacific, with specific interest in Greater China.
“Sector-wise, it’s been a mixed bag but there’s been some notable interest in shipping, consumer stocks, slightly less in construction and property,” says Wannenmacher, who adds that clients are trading more tactically: “Recently, there’s been less of a focus on diversified portfolios and more interest in building concentrated positions while hedging against downside risk through single stocks, as opposed to earlier this year when we saw more activity in baskets.”
Adds Jack Seibald, managing member, Concept Capital: “We’ve seen a lot of short activity in the technology sector and energy sectors since mid year, and more recently again in financials.”
Looking at investor inflows in Q3 this year, they totalled USD11billion, up on Q2’s figure of USD4billion but still off the Q1 figure of USD16billion. At this rate 2012 is unlikely to exceed the net inflows of USD70billion in 2011, which is not good news for primes, but unfortunately reflects a degree of hesitation that still exists among investors, many of whom are recycling assets into new managers as opposed to necessarily committed extra capital.
Noel Kimmel, Global Head of Prime Services, Cantor Fitzgerald, says that from an asset inflow perspective “the mortgage and structured credit space has seen solid asset growth, while overall allocations across long/short equity managers have been more mixed.
“Today, we are seeing some renewed interest in long/short equity but it is much more idiosyncratic and manager specific, with allocators probing more in-depth to locate outperformers. Credit and high-yield strategies have been a bit mixed, while some relative value players have done quite well.”
Having attracted USD35billion through the first nine months of 2012, fixed income relative value strategies have already matched inflows for the whole of 2011. By contrast, equity strategies have suffered net outflows of USD9billion.
Newer prime brokers like Cantor Fitzgerald have been able to grow top-line revenue by building their infrastructure from scratch and become a multi-asset class provider from day one; thereby avoiding legacy issues that existing primes might have faced in recent times, and which have prompted some to exit the space altogether.
What is also helping firms like Cantor Fitzgerald is having a clear strategic focus: namely the mid-sized manager space.
Explains Kimmel: “We think that market has been terribly underserved since Bear Stearns and Lehman left the market. That’s the focus for us: we always say that our sweet spot is USD25million to USD750million.”
This has helped the firm build the business on solid reputational foundations.
“We’ve won mandates from managers that might be running equity strategies with some additional capital structure arbitrage, exposure to interest rates, whatever it might be. Given that we are equally capable in equities, fixed income, futures makes us unique in the middle market prime brokerage space.”
Seibald observes that tapping into different fund structures has also played a key role in business growth this year: “We’re particularly pleased that in addition to new launches we’ve won we’ve also won a fair number of established accounts from other brokers. In all cases, our comprehensive offering played a key role in the wins, with our capabilities in managed accounts being particularly important.”
Angharad Fitzwilliams, Head of Hedge Fund Capital Group, Asia, Deutsche Bank, notes that during 2012 “we’ve seen an exciting crop of new launches and have numerous talented managers in our pipeline. Many of our China long/short managers have posted very strong performance figures as have many of the managers we look after in the credit space.”
Masa Yanagisawa, Head of Hedge Fund Capital Group, Japan, Deutsche Bank, attributes increased demand from clients for segregation of assets as another important revenue driver this year:
“Deutsche Bank Prime Brokerage offers significant protection for customer assets from a legal and regulatory perspective, in addition to providing our customers with the comfort that their counter-party credit exposure is to Deutsche Bank AG, rather than a subsidiary of a bank. We think this is one of the reasons we’ve been selected as the prime broker for 28 new hedge fund launches in Asia so far this year.”
One of the objectives to being successful in the prime brokerage space is to cultivate a client base of hedge fund managers with rising AUM. Much like stock picking, primes have to select managers they think are going to grow: partnering with more winners than losers is vital to sustain a competitive advantage.
But this cuts both ways: the more high profile the manager, the more discerning they will be in choosing their prime broker. One area of increasing importance is the ability to connect managers to investors through capital raising.
“To us it’s of utmost importance,” stresses Wannenmacher, noting that it goes far beyond just introducing investors. Maintaining meaningful relationships with managers, even if they’ve closed their fund to additional investment, is essential. “We look at investor needs and concerns, what types of investors are allocating and from where they are doing so. Is Asian money looking to invest into Asian hedge funds or more globally?
“There will always be shifts among investors and some redemptions, even when performance is strong, so they need to stay close to the market and understand investor trends. Knowing where the interest is and what investors are looking for is critical.”
Kimmel confirms that Cantor Fitzgerald takes a targeted approach to capital introduction and that the firm is only doing active capital introduction “for around 25 per cent of our clients”.
Some investors looking to tap into growth opportunities in Asia are now starting to allocate to the region “opportunistically” states Fitzwilliams: “That’s why we believe funds that can meaningfully play the changes in the supply/demand of credit in the region have done so well raising capital.
“We are also witnessing investors that are more experienced in the region spend a lot more time looking at China managers. Our China-based managers in 2012 have on the whole put up strong numbers.
“Also, hedge funds have stepped up their commitments to the region with larger investor relations’ teams, more transparent reporting and better liquidity. This has resulted in AUM pay-offs for some of our more established managers.”
When asked what the most important aspect is to protect the business going forward, Kimmel says it will depend on picking the right clients.
“We want to diversify the business by manager type – mature/emerging – and also to diversify by strategy. Also, because of the way we’ve built the business across asset classes, we’re looking to diversify our revenue streams and generate revenues in at least four or five different buckets.”