Six years ago, nobody had even thought of inventing a research function that gave trading ideas to hedge funds. Since then, with hedge funds providing ever greater commissions, brokerages have cottoned on to the idea of having research analysts who think up inspired deal ideas for hedgies. The trade recommendations began as tweaking long-only ideas, which customarily model earnings growth leading to price/earnings ratio re-ratings, which spawned recommendations – mostly advising a straight ‘buy’.
Trade ideas for hedge funds predict where value can be unlocked via identification of some impending corporate action. These can be ‘hard’ events such as special dividends, spin-offs or divestments, or ‘soft’ events driven by top-down macro occurrences.
Examples of other trade concepts being pitched to hedge funds might include pairs trading, in which a long position in one company which has a positive outlook is matched by a short position in a firm in the same business sector that is considered a likely under-performer; stub trades, which hunt out unrecognised valuations of a subsidiaries in the share price of a parent, and arbitrages between mispricings across dual listings.
Or, put in a nutshell, ‘catalysts’. This is the magic word that predominates in discussions on this whole subject.
“You know me, I’m all about finding catalysts,” enthuses one Hong Kong hedge fund manager. But he means finding them on his own, not ideas hashed by others. “Are brokers wasting their money hiring these people? No, they’re wasting my money.”
Does that imply his trading ideas are superior to the researchers? “If I wasn’t implying that, there wouldn’t be much point me setting up as a hedge fund manager, would there?”
One reason for disdaining broker-generated research isn’t always because the ideas aren’t fresh, but because the hedge fund is tight-fisted: trading on a broker’s tip costs money.
In return for trading on an idea generated by a hedge fund research team, managers pay up to 25 basis points for a DMA (direct market access) trade.
In contrast to the usual moral imperative in finance, that too much of a good thing is an even better thing, hedge fund managers don’t want to be swamped with a vast array of trading ideas. But they appreciate having access to outside opinions.
“I’d say 80% of our ideas are generated internally,” says Ashutosh Sinha of hedge fund Amoeba Capital in Singapore. “Whilst one doesn’t want to be saturated by ideas, sometimes we call the sell-side and ask them for a research view on something. Even if we ask them to work on researching a specific issue, and they subsequently make a trade recommendation, if we don’t feel comfortable with that suggestion, then of course we set it aside.”
What happens when recommendations to hedge funds go horribly wrong? Unlike longer term conventional research, with the exception of deep-value positions that can be held for years, most ideas for hedge funds have a comparatively short shelf life, which also means that bad calls and mistakes are still fresh in the memory. Hedge fund managers are mindful that research ideas frequently tell them when to get into a trade, but not when to exit it.
“It’s important to continuously monitor investment recommendations; a salesman should ‘own’ the idea and see it through even if it goes wrong, “says Charles Blake, director of equity sales for Citigroup in Singapore, who specialises in giving trade ideas to local hedge funds. “If the markets surge and look stretched, and the client is not keen to sell his investment, we'd look to recommend cheap downside protection in the form of put options on the index or on liquid blue chips.”
Citigroup conducted a straw poll of hedge fund managers and was told there was room for improvement in the packaging of sell ideas. Citigroup thinks that one solution here might be to use existing internal resources such as its quant team to find and screen shorting ideas.
Some hedge funds are concerned that the ideas provided have already been circulated to a multitude of other hedge funds, and they might be last in line, by which time the market has moved. More particularly, they are worried that the proprietary trading desks at the institutions have gotten hold of the ideas and acted on them.
Institutions might attest to having Chinese walls, but anyone who has worked in an investment bank know that such walls are perforated with holes. Firms all claim their Chinese walls are rock solid. Few acknowledge the potential conflicts that can occur when people are chatting in the gents’ washrooms, or can prove they take the ethical steps to fix it.
Credit Suisse liked its hedge fund ideas team so much it took it in-house to support its own traders, thus removing the potential conflict of interest. At a later date, it built another team, and subsequently took staff from that desk internal as well, where it is now known as the ‘Internal Return Group’.
How do the reports look? They’re a sexed-up version of a good old-fashioned SWOT analysis: terse but brainy. The style is hyper-abbreviated. It is taken to such an extreme that it sometimes makes the underlying reasoning opaque.
Nobody is saying that hedge fund managers need to read literary masterpieces, but they also don’t want to plough through sentences with nutty syntax that read like cryptic crossword clues. The ideas might be good, but the layout and presentation is psychedelic. Is it really worth eliminating line breaks just to cram everything on two pages?
The problem with traditional equity research is that it is so intellectual and hypothetical – and long. It is predicated on complex financial models with predictions about the numbers which, whilst not guesswork, are extremely hard to get right.
In any case, the reports are usually long since thrown in the garbage can and forgotten before they are proven inaccurate.
Some observers think that the way forward is to fix that regular research first, which is aimed at the traditional long-only fund and skewed towards ‘buy’ recommendations.
“Most hedge fund research teams in investment banks are still looking just at equity, because investment banks are stuck in their product buckets,” says Todd Martin, head of alternative trading strategies at CLSA, which talks to 60 hedge funds. “CLSA is a cash equity house, so there is not much point making debt recommendations. We act like hedge fund analysts, which is a resource a smaller fund might find expensive to assemble. Citadel and the larger funds can afford to specialise and hire a full team of analysts. We have the big advantage of being on the CLSA floor and are party to the information flows.”
Traditional researchers know their topics in awesome depth. They spend all day thinking about something arcane like Indonesian banks, or Thai petrochemicals companies, yet they produce research ideas that always revolve around equities and seldom tell funds to look at debt, warrants or options, even if the opportunities are better in those asset classes than in the stock.
On the other hand, the researcher producing research for hedge funds does possess that ability to look, in a multi-dimensional way, across asset classes, thinking laterally about where opportunity lies to take positions.
“We don’t just look at one-dimensional equity situations, but at opportunities in liabilities, debt and volatility,” says David Kwan, managing director at specialist hedge fund brokerage KE Absolute.
Might the hedge fund-oriented researcher lack the in-depth knowledge of companies, sectors and geographical markets? That’s not intended as a negative observation; it is a physical impossibility for smaller research teams servicing hedge fund requirements to know as much about those Indonesian banks as a traditional, long-only researcher who just covers that market 24/7. The hedge fund whiz has to think of ideas that cover a multitude of different industries and countries.
“Our reports are not supposed to be thematic pieces. Our three-page reports just highlight the catalysts. If we wanted to produce a 30-page report we could,” adds David Kwan.
An attractive solution for the future then is to have equity researchers who combine the traditional fundamental skills and knowledge of their specialist markets, but accompanied by knowledge of asset classes conceptualised by the specialist hedge fund idea man.
Or put another way, that conventional equity research itself changes in order to adopt the philosophies of the hedge fund researcher.
After all, the hedge funds already account for 40% of brokerage revenues, and significantly more in some Wall Street firms, so this looks like the inevitable way the tides will flow.
This article first appeared in AsianInvestor magazine, March 2007.