It’s been a difficult year for hedge funds with many managers struggling to match the returns of broad-based indices such as the S&P 500.
Looking at the asset-weighted performance of hedge funds through the first six months of 2019 we find that on average they returned +5.70%, according to data from specialist research house HFR. That compares to a return of more +19.0% from the S&P 500 over the same period. Though we should note the S&P figures are calculated assuming the reinvestment of dividends.
Those hedge fund returns are on the low side but they are at least positive and come after a very difficult end to 2018 that saw many managers finish in the red.
Hedge funds remain under pressure their traditional two and twenty fee structure is hard to justify to investors who can, on the face of it, get the market return for a fraction of those costs, simply by allocating to an index-tracking ETF.
However, despite this, it seems that money is flowing into smaller funds once more and that they seem to be growing in number. We got to take a peek behind that curtain this week, thanks to a marketing drive from Interactive Brokers Prime Brokerage unit.
Interactive Brokers (ticker IBKR) is one of the USA’s largest electronic brokerages and in recent years it has expanded its activities into the prime brokerage space competing head-on with the investments banks, who have traditionally been the main players in this business.
Interactive Brokers PB unit seems to have had a very successful 2018, according to the data contained in its marketing pitch, the company acquired 34 new hedge fund prime brokerage accounts, the unit finished last year with 282 accounts, winning ten more PB hedge fund mandates than its nearest competitors.
So just how have Interactive Brokers and other smaller Prime Brokers been winning the business off of the investment banks and why?
The answer appears to be two-fold the bankers have been rationalising their cost and operating bases taking a long hard look at those areas of business that make money for them and those that don’t.
In the past, they may have been happy to accommodate smaller less active hedge funds within their prime brokerage division, even if they were a loss leader, simply because there was always the chance that those funds could grow and become much bigger clients.
But margins being what they are in modern banking today, banks are just as likely to show those type of clients the door and indeed they have been doing so.
At the same time, hedge funds have been looking for ways to reduce their own costs.
Interactive Brokers built its reputation on offering low-cost high-quality execution and brokerage services and that mantra has migrated across to the prime brokerage operations.
The fact that Interactive Brokers market cap is north of U$$20 billion, with more than US$ 2.50 billion of cash on the balance sheet, is also likely to be a draw.
The forces that are reshaping the prime brokerage landscape are not fading away either.
Indeed at this very moment, hard-pressed Deutsche Bank is in the midst of transferring its prime brokerage business to French rival BNP Paribas. Suggesting that there could be both clients and talent on the street in the run-up to Christmas.
In the past when banks have removed themselves from a business area it’s allowed new entrants to the market to spring up. A previous and prime example of this type of activity would be in deliverable/physical foreign exchange.
I think we can expect to see new players emerge in the PB space in a similar vein, whilst the established second-tier firms such as Interactive Brokers are likely to continue to grow.
Increasing competition should be beneficial to all, the only question mark is how well would new entrants perform under duress? As we move ever closer to the eleventh anniversary of the bull market in US equities that’s certainly something worth pondering.
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