There was a time when prime brokers had well-defined roles among the hedge funds they worked with: they focused specifically on settling trades and lending securities to cover shorts and financing portfolios.
Technology and new products introduced post-financial crisis have created a more efficient and faster market, requiring hedge funds to find new ways of creating value and generating alpha for investors.
As market shifts impacted hedge funds throughout the industry, their trading and financing partners also had to re-think their value propositions. These changing dynamics and a more rigorous regulatory environment created an even more intertwined relationship between hedge funds and prime brokers.
It is fair to say that prime brokers have become critical to the success of hedge funds and these relationships are more connected, and more valuable than ever. Here are the four trends that have changed the dynamic.
1. The ever-higher regulatory bar
Hedge funds must deal with the increased cost of complying with regulations. These operational and regulatory demands have created greater hurdles for hedge funds to conduct business. As a result, hedge funds are more dependent on prime brokers for data. Primes can help drive operational efficiencies and ensure that clients meet regulatory and transparency requirements.
2. Changing market dynamics
More efficient markets and the rise of index funds, which in recent years have created competition and an alternative to active managers, have put pressure on hedge funds to prove their value and stand out from their peers.
Hedge funds are not only being asked to prove their success in driving alpha, but are increasingly being asked about how they differentiate their strategies and whether those strategies are repeatable.
In this environment, investors are increasingly scrutinizing returns and fees, causing funds to review their prime broker relationships. The result is a more diligent approach to borrowing money and securities and a greater focus on how this contributes to alpha-generation. In turn, hedge funds are constantly re-evaluating the types of risks they take in the market and the cost of carrying their portfolio. Additionally, prime broker stability is an important consideration.
3. New investor demands
Hedge funds as an investment class are designed for different types of investors; such as ultra-high-net worth investors, pensions and endowments. Each type seeks greater transparency and asset protection in the form of more frequent and customized reporting, counterparty jurisdiction, greater detail on valuation and operational processes.
In a world where hedge funds must continually demonstrate value and drive deeper engagement with clients, operational alpha is becoming even more critical. As investors look to hedge funds to deliver better value, managers are turning to prime brokers for more diversified offerings and products to help them satisfy client needs.
The outsourcing of middle office, accounting, reporting functions and other non-investment tasks is becoming more critical in reducing costs and freeing up valuable time for honing strategies.
Service offerings such as capital introductions, access to new client segments—such as registered investment advisors—and custodial services are helping prime brokers address client needs in a more comprehensive way and, as a result, drive additional value in areas from which they were previously absent.
4. What to expect in the future
With many new products and investment vehicles, as well as a market made more efficient by technology, the search for alpha continues to become more challenging. With the client composition of hedge funds also evolving, could other constituents like 401(k)s gain more traction?
Hedge funds are expecting more from their relationships with their prime brokers to compete in this new environment. Primes, in turn, are becoming more transparent and are evolving to be more comprehensive partners by delivering greater value and helping them address some of their biggest challenges. As the industry matures, the ongoing interconnectivity between hedge fund and prime brokers will continue to solve challenges and create efficiencies.
Published in HFMWeek, August 22, 2019.
Mark Aldoroty is a Managing Director for BNY Mellon | Pershing. He leads Pershing’s Prime Services and Collateral Funding and Trading teams. Prior to this role, Mark led the Prime Services Sales and Relationship Management teams.