The emergence of the hedge fund sales desk among the region's stockbrokers raises questions that are not answered merely by embossing Hedge Fund Sales on someone's business card, even if that individual is intimately aware of how hedge funds operate. I have been examining these questions recently while building a hedge fund training business, tapping into my ongoing conversations with hedge fund managers themselves and memories of life as a sell-side equity analyst.
The bottom line is that a couple of salespeople on their own is not the most effective mechanism for an investment bank to service hedge funds. To put the entire onus of trade idea generation, risk management advice and actual selling onto a handful of individuals is impractical at best, especially in cases where much of the needed expertise exists elsewhere in the bank.
It seems to me that traditional institutional stock broking needs to evolve in three areas, if their hedge fund sales efforts are to be a success. These can be summarized as follows:
- Coordination of equity, fixed income and derivatives functions
- Effective education on how a hedge fund actually works
- Appreciation of where a hedge fund manager's incentives lie
Hedge fund investing in Asia often involves several asset classes. Independent sales calls from a broker's equity, fixed income and derivative desks run the risk of neither salesperson establishing a clear picture of how the portfolio is managed. This is a much larger concern than is true with the vast long-only institutional market, which more or less operates off a homogenous benchmarking strategy. Individual hedge funds, in contrast, are much more unique.
This is especially true as hedge funds actively manage risk, which of course is why they are named as they are. Whereas a mutual fund's answer to risk management is to advise holding through the cycle since over the long term markets always go up, a hedge fund is far more concerned with the risk of losing money today. But, where one hedge fund manager believes the greatest risk to lie may not be the same as another's perception.
To hedge risk on a long equity position, for example, might be best achieved through shorting a stock in the same industry. However, if the manager's main concern is market risk, then the right answer may be to short an index futures contract. Working together, equity and derivative sales specialists can provide a far more effective service.
In another context, a derivative salesperson may recommend being "long volatility" on a convertible bond. This trade involves buying the CB, shorting the underlying equity in the right proportion, and shorting an appropriate debt instrument. In this instance, the derivative specialist needs help from the fixed income desk.
Incorporating equity research into the equation is more challenging, since analysts are simply not trained to cater to hedge fund needs. Relative performance recommendations and regular calls aimed at earning points at the next quarterly vote might be fine for serving Fidelity, but it is of no use to a hedge fund. This problem can be partly solved by greater integration with the hedge fund sales effort, but the problem also highlights the need for investment in education.
It takes a radical shift in mindset to go from serving mutual fund clients to hedge funds. The first step is to begin thinking in absolute performance terms. This should be an easy one to take, since most analysts and salespeople view the performance of their own assets in this way.
The difficult step is incorporating risk into the profile of the recommendation. Since the goal is positive returns, not outperformance, analysts and sales need firstly to understand what risks there are in the recommendation, and secondly how to hedge the risks which are undesirable. This means not only understanding the factors that could affect the security price performance, but also applying that same logic to the foreign exchange and commodity risks. Whether or not to advise hedging these risks should account for the practicality and economics of actually doing so.
For example, a short recommendation on Sony includes the risks that money will rush into Japanese equities, that the Yen will appreciate, that the electronics sector will soar, and that the cost of borrow will erode returns if the holding period is too long. The first three factors can be hedged explicitly, at a cost, while the fourth needs to be incorporated into the expected return calculation.
The analysis is more complicated if the recommendation is to short Sony convertibles, instead of common shares. In addition to all of the above, there are also the risks of a spike in volatility, a contraction in Japanese credit spreads and a surprise reduction in market interest rates.
There is also the risk that Sony's share price rises on the company's own merits. Since the point of the short would be to exploit the stock's over-valuation, this risk would not be hedged. The loss in this instance would be due not to poor hedging, but to poor analysis. It is worth remembering this point, since under the strict regime of absolute returns, the quality of advice needs to be higher than in the looser relative performance world. After all, portfolio theory says that all stock specific risk should be eliminated through diversification.
Finally, the impact of funding costs on the economics of a trade can be significant, as shorting a security incurs costs which do not exist when going long. Of note is the cost of borrow which, for Asian equities, can be as low as 50 basis points per annum for the most liquid names, and as high as 10% or more for hard-to-find stocks. Finding out the rate for any specific security is where support from the stock lending or prime brokerage desks is needed.
Additionally, if a dividend is paid while the short is on, the borrower owes the lender that income, which would normally be earned directly from the dividend-paying company had the short not been in place. And, of course, if the trade is a geared one, then the cost of the borrowed money also needs to be accounted for. To provide financially sensible advice for hedge fund managers, therefore, a recommendation must account for not only price, volatility or spread performance, but also for the perfectly predictable costs of actually putting on a trade.
Hedge funds are for the most part entrepreneurial enterprises. The managers are owners of the business, and have a vested interest in the performance of both the fund and the management company. This incentive is especially true as managers often invest a significant portion of their net wealth in the fund, both to profit from their own trading skills, but also to demonstrate to investors the depth of their conviction.
The vested interest does not end there. As a rule, hedge funds charge their investors a performance fee, as well as a management fee. Unlike a mutual fund, therefore, the management company of a hedge fund profits from the fund's performance, not just from raising assets.
Furthermore, hedge fund strategies are niche affairs, taking advantage of pricing anomalies which may only exist for a short period of time. Hedge funds, therefore, need to be nimble, and this naturally limits the amount of assets they can accumulate and still run their strategies effectively. Fund capacity, as it is known, is therefore generally much smaller than for mutual funds, increasing the significance of the performance fee.
The key point for stockbrokers is that hedge fund managers have a personal interest in seeing their trades work profitably. Care needs to be taken in the quality of advice, therefore, since the cost of poor recommendations is felt personally by the manager. Brokers may find that a good meal or a few friendly drinks will not be enough compensation to overcome careless advice.