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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
Coordination
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.
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.
Incentives
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.
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