"This battle for yield will have a serious significant impact on the industry," writes Josh Galper, director at TABB Group and author of the 61-page report, the result of interviews with senior management at 63 hedge funds across multiple asset classes and sizes collectively managing $110 billion, 11.8% of the $930 billion hedge fund industry. "Initially, it will force funds to change their overall investment strategies, invest in new analytics to more aggressively look for opportunities and focus on reducing costsâ¦which for many large funds will be fairly new in a burgeoning industry more return-focused than cost-focused."
As many 500 new funds emerged in 2004 bringing the total number 8,600. TABB Group believes that with increased fund management overhead and the rising specter of regulation, there will be a decrease in the number of funds over the next few years due to consolidation. Says Galper, "while we are not expecting many large hedge funds to acquire small ones, we do see funds of funds as well as more traditional asset management businesses launching or acquiring small funds under their umbrellas to fend off the threat posed by large funds, using their scale, talent, technology and distribution to protect their core business activities."
"However," explains Larry Tabb, CEO and founder of TABB Group, commenting on the reportâs findings, "the struggle to improve yields was the primary concern driving most of the funds interviewed. The diverse, across-the-board response reflected rather deeply held concerns about the prime brokerage relationship, which is certain to evolve, especially in US equities due in part to a continuing contraction of commissions, to a continuing move away from phone-based communication, to fundraising, managing risk and the rise of new multi-asset classes and multi-strategy models."
The Report was developed to "shine a clear light into the inner world of hedge funds," says Galper, focusing solely on business issues, including trading, regulation, risk, the prime brokerage relationship, trading, fundraising, build versus buy technology options, and sales and marketing. "While we primarily interviewed US multi-asset class and equity-based funds, many of them were expanding the styles, asset classes and geographies of their investments."
Key statistical findings drawn from the report include:
Operating at the cutting edge in their deployment of advanced trading technology, 47% of the fundsâ order flow goes through low- or no-touch channels, e.g., direct market access, algorithms and crossing networks, versus 53% being routed via FIX or transmitted by phone. Additionally, low- or no-touch order flow is projected to increase to 57% by 2007.
Goldman Sachs and Morgan Stanley are the two largest prime brokers. Each garners over 40% of hedge fundsâ prime brokerage relationships.
As many as 50% say their broker relationship directly dictates which algorithms they use.
The primary reasons funds use on brokers beyond trading and financing are research (66%), technology (52%) and capital introduction (39%).
Nearly 40% are increasing their broker relationships, the major reasons being the need for increased research (31%), product diversity (24%) and improved trading technology (21%).
Of the 20% of firms that are reducing their broker relationships, 68% cited the need to consolidate their execution platforms.
While 69% believe they should be registered (regulated), only 50% of large funds believe in regulation.
Looking ahead, the Report warns of cautionary times. While TABB Group is not raising any red flag, yet, "the next few years will see a delicate balancing act between yield, cost management, service provision, institutional investment and regulation," writes Galper.
Agreeing, Tabb adds, "Without a doubt this is clearly a dynamic industry, both expanding and contracting, where size actually does matter, where some feel managing risk is still more art than science, where regulatory forces are threatening to look at, legislate and license your business. Months after putting this industry under our microscope, two questions continue to loom: who will actually survive, who will prosper?"