Buyside and sellside must learn to pull together

Banks are feeling the effects of hedge funds’ woes, says William Hutchings

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There has traditionally been tension between the sellside and buyside but as a prolonged dearth of liquidity is turning the capital markets into deserts, the mutual dependence of investment bankers and asset managers is becoming more apparent and their future success will depend on how well they adapt to each others’ needs.

Bankers have earned four times as much money from taking trades from asset managers as they have from underwriting new issues of securities, according to financial data published by US trade body, the Securities Industry Association. The asset managers benefit from being able to trade when they want. The cost of all the trading is ultimately borne by the investors in asset managers’ funds.

Bankers have done well over the past five years from the rise of hedge funds, some of which traded far more frequently than traditional asset managers. The banks also made a lot of money from lending money to hedge funds.

But this arrangement has been upset since July, because investors, desperate for liquidity, began withdrawing their money from hedge funds. Redemptions are wreaking havoc in the hedge fund industry, with bankers and investors estimating that its assets under management will soon have shrunk from about $2trn to $1trn.

The massive reduction in hedge funds has already resulted in substantial job cuts in the investment banks’ prime broking divisions, the units responsible for lending to hedge funds. Their client trading departments are trying to shift their focus back to the traditional end of the asset management industry, which itself has struggled as market liquidity has dried up. But the traditional asset managers, which are trying to pare back all the costs they can, are ready for them.

Jim Connor, a partner at Morse, a management consultant to the asset management industry, said: “Investment banks will redouble their efforts with traditional asset managers. But transaction costs will come under pressure. The EU’s markets in financial instruments directive, which concerns best execution, paves the way for this by putting an obligation on asset managers to ‘do right by clients’ in this respect. Moreover, asset managers have been rationalising their broker relationships and this competitive dynamic will be a catalyst for reducing costs.”

Peter Preisler, Director and Head of Europe, the Middle East and Africa at US asset manager T Rowe Price, said: “Any kind of cost is a negative, so anything we can do to minimise the cost of trading we will do. That doesn’t always mean trading cheaply, because settlement is a discipline itself these days.

“We have benefited enormously in the past three to six months by having in-house traders. In a market with less liquidity, the ability to read the market and place transactions where there is liquidity is highly valuable. Liquidity has often dried up in the past six months, for example in high yield bonds, and you need to know who is in the market and have good relationships.

“But the obvious way to minimise trading costs is to trade as little as possible. In most strategies we turn over our portfolios only once every one to five years.”

Research the key
Investment banks will try to use their in-house research, in particular equity analysts’ reports and stock recommendations, to resist the pressure on trading commissions. The bankers reckon asset managers using their research will accept higher transaction costs. An investment banker said: “We have begun holding back the details of our research for our best clients – in accordance with regulations, we are disseminating our views and the bones of our arguments to everyone, but keeping the colour and depth for those who give us a call or who are our highest-paying clients. This has become general practice in the industry in the past couple of months. In any other business in the world you would treat your best clients better.”

The bankers’ negotiating hand has been strengthened by cost-cutting among the asset managers. Job cuts so far have mostly been restricted to marketing staff, but the prospect of continued falls in the value of assets under management, and hence annual management fee income, means some chief executives of asset management companies are reconsidering whether they want to employ as many research analysts as they have done, particularly when compensation for a senior analyst can reach £500,000. Those asset managers that cut back on their in-house research operations will be asking investment banks for more research.

In addition, the discrediting of the ratings agencies over the course of the credit crisis has led investment bankers to anticipate greater demand from asset managers for research on bonds. Demand for analysis of sovereign risk, pertaining to countries, is also expected to rise.
However, asset managers will resist the temptation to use more of the banks’ research. Mr Preisler said: “The market environment will lead certain asset management firms to rely more on sellside analysts. This won’t be the case at T Rowe Price and our competitive advantage will become even stronger.
“Sellside analysts have a sales role and their compensation is dependent on asset managers turning over their portfolios. From their point of view, the best recommendation should be a Buy and the second best should be a Sell; no one can do anything with a Hold. If a sellside analyst does a serious piece of research and comes up with a Hold recommendation, it’s really a problem. It looks as if they’ve wasted their time relative to generating business. So only a minority of sellside recommendations are Hold.

Sticking to the Hold
“By contrast, the majority of stocks rated by our in-house analysts have a Hold rating. Part of our analysts’ compensation is by the quality of their recommendations and having their recommendations used by the portfolio managers, and the pattern of our recommendations seems to be a lot more balanced than the pattern of sellside analysts’ recommendations – which it should be.”

Martin Gilbert, Chief Executive of UK-quoted Aberdeen Asset Management, said: “We have long been an advocate of in-house research, so we won’t be asking for more research from the banks. We just look for access to company management, but there also we find that most companies know we are long-term investors and are happy to talk to us.”

Aberdeen is another asset manager that trades rarely, often holding on to its investments for a decade.

This has led to stiff competition for limited resources. But there may be a way forward that will benefit both sellside and buyside. Asset managers will be making greater use of derivatives, according to surveys by Morse and risk management consultant Protiviti, and this could be a significant source of revenue growth for investment banks.

Protiviti said in a report toward the end of last year that asset managers’ use of derivatives would rise over the next 12 to 18 months, with 79 percent of asset managers saying they would use them more. One of the strongest drivers behind this is the need to contain the risks of a portfolio on a daily basis, to obtain approval for a fund under the European Union’s Ucits III mutual fund structure, which is becoming the norm for all investors, including those outside Europe.

Rob Nieves, a director of Protiviti, said: “The asset management industry has reached an inflection point in its use of derivatives. In many cases, it would appear that derivatives strategies helped firms remove at least some downside risk and our survey suggests that derivatives will play an increasingly important role in asset management.”

Huw van Steenis, Financials Equity Analyst at Morgan Stanley, said: “We believe derivatives will be an area of growth for investment banks. There will be much more demand for derivatives offering downside protection – it will be a paradigm shift, though there may be less for taking more risk.

“Absolute-return funds will have a place in investors’ portfolios and some will be distributed using the Ucits III mutual fund structure, which will become more broadly used because distrust of non-regulated funds has grown and because investors are confident of the liquidity they offer. These funds will be buying market protection using derivatives. It is expensive now, but volatility will go down and it will become more and more common.”

If derivatives trading is to come to the rescue, the bankers will need to reassure asset managers on counterparty risks, which have taken on alarming proportions since Lehman Brothers filed for bankruptcy protection in September. Bankers will also need to soothe the managers’ perennial concerns about conflicts of interest, particularly front-running – using knowledge of a client’s intentions to make a profitable trade just ahead of it.

The codification of good practice embodied by Mifid has imposed a strict discipline on investment banks in this regard, and that should help. Better still will be the reassurance that arises from feeling that regulators have their eye on the ball.