In the current market environment, hedge fund allocators face a bit of a Catch 22. With markets continuing to move north – the S&P 500 was up 19.8% during 2017 (as of 28 December) – there is a strong argument to invest in long-only passive products. Even if investors, worried about a market correction, increase their exposure to hedge funds, how do they determine the extent to which a manager’s performance is alpha-driven as opposed to beta-driven?
“We did some research that looked into this a number of months ago, which at that time suggested that in the aggregate, fund performance in 2017 was being driven by the market. This research did not, however, drill down to individual manager performance,” says Jack Seibald (pictured), Global Co-Head of Cowen Prime Services LLC, the prime services division at Cowen.
“We have seen renewed interest in hedge funds among allocators, which is in stark contrast to the first half of 2016 when there was a significant dial back. They are, however, trying to be far more discerning. They are looking at managers’ performance and deciphering whether performance has been driven just by being exposed to the market or by specific security selection on both the long and the short sides of the book,” said Seibald.
“As investors are making allocation decisions, the result of that analysis is going to play a significant role in how and where incremental allocations get made during 2018.”
Seibald says that the tendency among clients to maintain a net long bias has helped Cowen grow its revenues and increase the AUM on its books; something which has proven to be a stimulus for its custody business. “To a certain extent, it has benefited revenue streams related to our balance sheet, including margin interest and short rebate revenues. With markets continuing to rise, we’ve seen some uptick in the use of margin in our book of business.”
“With respect to short selling, we’ve seen some uptick in the short book, though it appears more related to the rise in market values and perhaps the rise in interest rates that’s allowing funds to benefit. More and more, managers appear to be using indexes in their short book because they’ve been frustrated by a lack of available names or had concerns about individual issue risk. However, allocators aren’t looking for a manager to short the entire market; they want managers to pick stocks on both sides of the book,” says Seibald.
One only has to refer to a benchmark index, such as the HFRI Short Bias Index, which was down -10.28% for 2017, to appreciate just how hard stock picking has been in the markets.
Seibald says that part of the reason why things have been challenging is that as more indexes and ETFs get created and more money flows to such passive products, the more individual stocks get tied up in these products and the greater potential for them to drive up prices.
“In that sense, it is a tougher environment in which to pick your shorts. But it also means there is greater potential for active managers to make money as passive products may drag the bad up with the good (in rising markets), possibly creating better entry points. When the markets reverse, they’ll be selling the bad companies along with the good ones in a falling market.
“Increasing exposure to good companies as their price gets driven down – and by the same token covering shorts in bad companies – could produce a fertile trading environment when the eventual correction comes,” says Seibald.
This echoes the famous quote by Warren Buffett who said to be fearful when others are greedy and greedy when others are fearful.
“In my opinion, ETFs are vehicles that strive for mediocrity, not outperformance,” adds Seibald.
Cowen Prime Services has seen a steady uptick in the number of both established and start-up funds it has added to its book of business during 2017, thanks in part to the brand recognition of Cowen’s institutional businesses.
“Big firms and portfolio managers know Cowen from the institutional sales and research side of the business, so when they do decide to go off and do something themselves, there’s a touch point with Cowen already. That makes for an easier introduction and potential client acquisition because there’s already history between the two parties.
“Cowen’s Prime Brokerage team can help clients set up their hedge fund, provide outsourced trading, or any combination of things they might need. Based on the activity we’ve seen recently, our pipeline for Q1 2018 looks promising for new launches,” confirms Seibald.
On the business development side, the management team is happy with how things are developing. An important part of this was the successful acquisition of Convergex, whose integration was completed a few months ago. “Convergex’s prime team had been successfully onboarding new clients prior to the Cowen acquisition and since they’ve been fully integrated, we’ve seen that trend continue,” states Seibald.
He says that with the Convergex integration and the additional capabilities that Cowen can offer its clients, “the way we present our offerings to the marketplace is now much more compelling.”
“Cowen has a prime brokerage offering that is so broad and so deep that it puts us in a different category when compared to other introducing brokers or what one might call ‘mini primes’, and positions us as a more credible alternative to some of the bulge bracket firms. We have the ability to use our own balance sheet to facilitate securities financing and clear certain businesses internally.”
Cowen’s prime brokerage clients have the opportunity to participate in industry rebates offered by those willing to pay for the privilege of borrowing hard-to-borrow securities (for short selling purposes).
“Our access to foreign markets, and our securities finance and stock lending business, have materially improved over the last 12 months, through a combination of our own development and the Convergex integration. The offering to our clients to participate in the lending of their long-only stocks has been an attractive value-added proposition,” remarks Seibald.
One of the other benefits to expanding its overall prime brokerage business offering is that Cowen’s clients now benefit from a much larger pool of experienced professionals serving them. It has sales, trading and capital introduction teams spread much more broadly across the US (Texas, Atlanta, San Francisco, Connecticut and New York), and in Europe (London), in order to be closer to existing and prospective clients.
Seibald further illustrates the scope of Cowen’s capabilities by pointing out that it also acquired Westminster Research Associates, a pre-eminent commission management firm.
“Westminster Research Associates has a strong presence in the US and there is an opportunity now, under MiFID II in Europe, with Westminster functioning as a research payment agent, to distance ourselves from some of our peers, giving us the ability to win new client mandates.
“Convergex had a strong presence in Europe so combining the prime businesses through Cowen International Ltd is something we think can add meaningfully to our repertoire,” concludes Seibald.
