Written by: Scott Coey | Managing Director, Head of EMEA Relationship Development – Hedge Fund, ETF and Structured Products, BNY Mellon
Hedge funds are the millennials of the investing world. Growing up in the nineties alongside the technology revolution, hedge funds had a future every bit as bright, comfortable and optimistic as today’s twenty-somethings. However, hedge funds today may not be especially optimistic. Having performed well during the financial crisis, hedge funds have since lagged meaningfully over the last seven years. The hedge fund manager’s bonus pool, the ‘2 and 20’ is now very much a relic of the noughties and with alternative asset levels eclipsed by the much more rapid growth of the passive end of the management spectrum, hedge funds seem to be in challenging times.
The financial crisis also hit the alternatives space hard, and an inevitable avalanche of regulation then followed. The prime broker model has changed almost beyond recognition. Rehypothecation, the practice by counterparties of reusing client assets posted as collateral, became unpopular in the post-crisis environment as investors woke up to the very real possibility of evaporating capital. Meanwhile yields have steadily declined while governments sought to prop up the global economy.
The world that emerged from the last financial crisis is one that plays by different rules. Led by investors, aided by their risk and compliance managers (who would have brought a CCO to an investor pitch in 2007?), the focus has shifted clearly and deliberately to more stable returns and more transparent governance. These hedge fund millennials are paying attention to liquidity, safety, stability and of course regulation. Hedge funds that survive and intend to thrive are forging new partnerships and developing new operating models to address the new reality.
As luck would have it, just as millennials had Generation X to forge a path for them and build a fairly stable foundation on which to construct their new future; fully connected high-tech hedge funds have found a shoulder they can lean on. It comes in the form of the global custodian who has been there, done that and who knows the rules of this new, regulated world.
Today, hedge funds are forging partnerships with global custodians, not as a replacement for the prime brokerage model that had served them so well but as a complement to it. In doing so, they are finding new opportunities to enhance their offerings. The global custody business is one that has safety, stability and transparency encoded in its DNA and is proving that it can be every bit as dynamic and flexible as the prime brokers. On the whole, global custodians remain well focused on maintaining the safety of their capital bases, which aligns exceptionally well with the interests of hedge fund managers and their institutional investors. This capital base gives confidence and commitment, something that hedge funds can lean on and build from.
Of course, the odd couple has a certain amount of learning to do about each other. Alternative managers are a special breed of money manager. Highly specialised, they live with a dynamism that is unmatched in the traditional long-only investing world. That brings a wealth of innovation and knowledge but at the same time there is less interest in building out the large back office functions needed to support the current world order. As a result global custodians are proving themselves as being very capable service providers adept at showing hedge fund managers how they can actually enhance their operational performance and keep their investors satisfied.
Today, the custody world is learning and learning fast. They understand what makes hedge fund managers tick but they also know what those managers need. Custodians do one thing extremely well and that is holding and maintaining assets. They have the systems, the governance and the controls to make sure assets are safe and exactly where they should be at all times, every day. Settlement, an art to the uninitiated but a science to the professionals, can be a thorn in the side of fund management when it isn’t completely seamless. Hedge fund managers need to be sure that when they enter into a trade, the asset will end up where it is supposed to be. Custodians will manage that settlement risk very closely and ultimately allow the manager the freedom to trade without worrying about where the trade ends up.
The low yields persisting around the world have caused headaches for many portfolio managers. Custodians have led the charge in showing that just because assets need to be in safe custody does not mean they have to be dormant. Putting portfolio assets to work by lending them out, or using them as collateral for various tri-party transactions with the benefit of a stable credit-worthy global custodian in the middle has proven a welcome boost to yield.
This Prime Custody activity (for this is what we call it) even allows hedge funds to keep in touch with their old friends, the prime brokers, as custodians use their technological muscle to move assets around from collateral accounts to portfolio accounts and back again, facilitating access to leverage.
The ultimate impact of the partnership between hedge funds and global custodians is one which will truly echo into the future. Armed with a new understanding of how millennials work, generation X has adopted technology as never before. Global custodians are now the leading lights in the FinTech world, using new technology for everything from data mining to information delivery to artificial intelligence and blockchain. Underlying that is a new culture of agility that delivers more transparency and fosters innovation. Clients are demanding more insightful and timely data. The global custody world is responding by building an entire ecosystem that digitises systems and processes all geared toward assisting efficient decision making.
Millennials are growing up and realising the world continues to change. Generation X is adapting to stay relevant. Together though, both generations have much to offer the other and bridging the gap is not at all as difficult as it first seems – especially when there is so much to gain.