July 2008

SECURITIES LENDING: Jostling for Position

The growth of 130/30 funds means more customers for the securities lending industry. Prime brokers are battling it out with custodians to service these new types of client, writes Lynn Strongin Dodds ... Before the sub-prime crisis cast a dark cloud over financial markets, securities lenders were rubbing their hands in anticipation over the 130/30 phenomenon. The predicted onslaught has not yet happened in Europe although both custodians and prime brokers are gearing up for the eventual wave.

Currently, most of the activity is in the US, with almost two-thirds of corporate defined benefit pensions having already launched or considering a 130/30 strategy in place of long-only mandates. Ucits III, which was fully implemented last February, was expected to spawn a plethora of new funds in Europe, but the credit crunch, volatile equity markets as well is poor performance has dampened enthusiasm.

According to industry reports, nearly three-quarters of funds in the US over the year to date to the end of April, failed to beat the S&P 500 index. The proportion dropped to half for the shorter terms of one month and three months. Meanwhile, in Europe, half beat the MSCI Europe index for the year-to-date period, although this figure rose to 60% for three months, but dropped to one in ten for one month.

Attractive proposition
Of course, it is still early days for many of these funds and managers need time to prove their mettle. The general consensus is that the concept will become a permanent feature of the product offering because the main driver – alpha generation within a risk adjusted space – remains an attractive proposition. These strategies enable managers to short-sell up to 30% of their portfolios, and use the proceeds to buy an extra 30% long, while maintaining a full market exposure.  Moreover, in the long run, the concept could prove particularly appealing in a difficult market because if stock prices continue to drop, some money can still be made on the bearish bets.

Ed Oliver, senior business consultant with Spitalfields Advisors, a securities lending advisory firm, notes: “Last year, there was a great deal of excitement over 130/30 funds but in the current environment things have settled back down. Fund managers now have to prove to their pension fund clients that the 130/30 is a good investment strategy. This is difficult to do without a track record but if they are successful, then these types of funds will be a strong source of revenues for securities lenders.”

According to a report by Spitalfields Advisors commissioned by Deutsche Bank last year, if the long/short strategy attracts the scale of predicted investment, this could generate an additional $600bn of borrowing demand by 2010. Tabb Group, a global research firm, predicts that the 130/30, which is currently estimated at $140bn assets under management, could potentially accumulate $2 trillion AUM in the next three years.

Against this potentially lucrative background, it is no wonder that prime brokers and custodians have been jostling for position. In the US, the custodians control about 79% of 130/30 assets but 44% of institutional investors surveyed by US based consulting firm Vodia Group said they prefer to use their prime broker for their 130/30 assets. This is because shorting is unfamiliar territory for the long-only custodial world but not for prime brokers who have cut their teeth in the cut and thrust hedge fund world.

Brad Taylor, global head of investment finance and hedge fund services with RBC Dexia, says: “The marketplace to service these types of funds has become much more competitive. Prime brokers have strong relationships with all asset managers through their trading activity and they are seeking to leverage these relationships to cross-sell their products. The custodians, though, are developing services to defend their assets and are offering clients a whole package that includes securities financing, execution and back-office services.”

In general, asset managers seem to be pursuing different strategies depending on their own experience levels. Some are administering these long/short funds internally while others are handing over the whole package to their prime broker for a full service of securities lending, borrowing and collateral management, as well as execution services for both the initial short sale and buyback. There are also those who are using their tried and tested custodian, who in turn partners with a prime broker, while some firms are opting for universal banks who are increasingly offering an integrated prime brokerage and custodial service.

Under Ucits
In Europe, the scenario is different if a fund is launched under the Ucits regime. Managers are not allowed to physically short but have to use derivatives to create what is called a synthetic short.  Things are changing in that Ireland-domiciled funds are now allowed to physically short and although Luxembourg is expected to follow suit, few are willing to predict the timescale. In this domain, most long-only fund managers typically employ a prime broker for the synthetic swap component of the 130/30 strategy and continue using their custodial bank for the rest of their administration needs such as collateral management, fund accounting, transfer agency and performance measurement.

Relationship building
According to Alistair Sayer, investment director, multi-strategy equities with Henderson Global Investors: “We have strong relationships with the top ten prime brokers for our hedge funds and use one or two for the synthetic service for our 130/30 funds. We are thinking of extending this to three to four to diversify our counterparty risk. We view this arrangement as a natural extension of our relationships. We feel that the prime brokers have years of experience dealing with long/
short strategies. We use custodians for our long-only assets but felt it prudent to bring in specialist providers for our  synthetic financing.”

Morley Fund Management, on the other hand, runs its own stock lending programme and prefers to let JPMorgan Securities Services handle the rest. The fund management group outsourced its back-office operations to the US bulge bracket four years ago. Jez Bezant, head of business management at Morley Fund Management, says: “There are many services offered by prime brokers but larger organisations such as Morley manage hedge funds, have their own stock lending programmes and can also trade OTC (over-the counter) derivatives. There is little else we would need from prime brokers to enable us to effectively operate 130/30 strategies.”

There is no custodian in the mix for Barclays Global Investors funds, according to David Geffen, managing director and head of financing and prime brokerage at BGI. “In all cases when we have put together 130/30 funds, we use a traditional prime brokerage relationship. Over the past five to ten years, these firms have upgraded their systems to co-mingle all of their transactions, including physical positions and related OTC derivatives. Some firms talk about splitting the process – with prime brokers handling the shorts and custodians the longs – but it is not that simple. It becomes operationally complicated. For us, it is much more efficient to use a prime broker.”

Looking ahead,  Jim Connor, partner and investment management and systems specialist at UK-based consultancy Morse, says: “Personally, going forward, I think the integrated model will become the more popular because in the 130/30 world you need elements of both services. Either it will be from the universal banks such as Citi or JPMorgan, or custodians and prime brokers striking partnerships to offer clients securities financing and derivative capabilities combined with fiduciary and portfolio servicing".

Leader of the pack
JPMorgan is thought to be head of the pack in integrating its global custody and investment banking services. Last summer the bank merged its OTC derivative operational support teams from its global custody and investment banking businesses. As a result, it can handle the main activities of a prime broker in 130/30 strategies – securities lending, collateral management, cash management, custody and accounting. It also has its so-called MasterSwap product, a synthetic prime brokerage service that can be tailored to a client’s particular needs.

Bank of New York Mellon is forging its own path, having combined all of its hedge fund services and traditional fund accounting and custody services into a new alternative investment services group. According to Staffan Ahlner, managing director at the Bank of New York Mellon, global collateral management, the bank can also provide a full prime brokerage service through Pershing. Launched last July in the US, it offers finance for equity and fixed income securities and securities lending, as well as execution, clearing and custody. About half of its 20 clients are engaged in 130/30 strategies. ©  2008 funds europe

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