AS TRADITIONALLY MANAGED, hedge funds and long-only funds are different breeds not just in their strategies and structures but also in whom they rely on for operational support. Hedge funds are closely aligned with the prime brokerages that handle their complex trading and help with capital-raising and financing. Mutual funds and other institutional managers rely on custodian banks for transition management, recordkeeping and other back-office needs.
But as distinctions between the fund types blur -- mutual funds' 130/30, or "hedge fund lite," strategies being a case in point -- those servicing relationships are no longer so clear-cut. In fact, they are up for grabs, and the servicing forces are on a collision course. "Just as hedge funds and traditional funds are converging, so too are their service providers, prime brokerage and custody," says Nicholas Thomas, managing director of structured products at HSBC Securities Services in London.
A 130/30 fund, which offsets long positions equivalent to 130 percent of its assets with 30 percent in short positions, requires a conventional mutual fund's custody and fund accounting and a hedge fund's securities lending and collateral management functions. That opens up new opportunities for prime brokerages and custody banks to expand their respective customer bases and servicing portfolios, even as they try to defend their historical turfs. It's a battle worth fighting: Charles Shaffer, 130/30 product manager for Merrill Lynch Global Markets Financing & Services, estimates that these vehicles, which currently manage less than $100 billion, could grow to as much as $1 trillion in five years.
Seeking to preempt prime brokerages' moves, Chicago-based custodian Northern Trust Co. has introduced such prime services as short-selling through its Northern Trust Securities arm. "Our audience isn't the uberaggressive hedge fund," says Terrence Ransford, senior vice president of trading and technology. "We're going after the core global custody base of pensions, foundations and endowments."
Ransford concedes that Northern Trust Securities wouldn't stack up well on the criteria that distinguish such big prime brokerages as Goldman, Sachs & Co. and Morgan Stanley. The firm gears its services for securities in developed markets, rather than those of emerging markets or the esoteric derivatives that hedge funds go after. It wants to address specific problems, such as the lack of centralized, integrated capital and investment-position reporting that, Ransford says, plague institutions that use prime brokerages and custodians simultaneously. Northern Trust has developed unified systems to aggregate risk, performance, attribution and execution data for pension plans and others.
Although it tailored its prime brokerage services for current custody clients, Northern Trust is in a strong position to bring in additional business. In the wake of the subprime mortgage meltdown, many hedge funds are thinking twice about concentrating their assets in the prime brokerage operations of Wall Street firms that were whipsawed in the summer's volatile markets.
Equinox Partners, a $1.3 billion hedge fund in New York, recently moved some of its prime brokerage business to Northern Trust from an undisclosed incumbent. The bank holds Equinox's long assets in custody, while the hedge fund uses prime brokerages, including Northern Trust Securities, for alternative investment assets. Equinox benefits because custody assets are legally segregated and protected if the custodian's parent goes bankrupt. Usage of custodians also provides reassurance to institutional investors that are concerned about operational risks as they put a growing portion of their portfolios into hedge funds.
Bank of New York Mellon Corp., which owns a prime brokerage through its Pershing clearing division, recently rolled out a service that marries custody, hedge fund administration and prime capabilities. Its 130/30 offering is part of a repositioning of the Pershing prime brokerage that was once owned by Donaldson, Lufkin & Jenrette and became part of BoNY in 2003.
"With the separation of alpha and beta, you're seeing growth in 130/30s and in exchange-traded funds," says Joseph Keenan, head of relationship management and sales for BNY Mellon's U.S. asset services business. "It's incumbent on us to capture that market share."
Jack Huber, head of prime services product management and development at Pershing, sees the 130/30 services as the ultimate cross-selling of custody, accounting, collateral management, securities lending and prime brokerage. "We're in a lucky spot," says Huber. "It's all under one roof."