How Basel III and CRD IV are killing the hedge fund model

Basel III and CRD IV are impacting banks’ leverage ratios, capital requirements and consequently all market participants with smaller balance sheets. Tier 2 and 3 buy-side entities like small pension funds will find that banks are now offering them much less services. The banks have started to cherry pick their clients as they no longer have the capacity in their balance sheets to service all clients they were once able to. Therefore, small buy-side entities, sell-side entities and small banks are all going to have to find a way to hedge their tail risk in order to have the same exposure without using OTC products but listed instruments instead. The bigger you are, the more choice you will have, whereas in the case of a smaller entity, the impact will be far greater on their business model and strategy going forward.

In hedge fund land that means prime brokers are now also starting with cherry-picking their clients. They will generally be careful with the type of managers they want to keep. The brokers are already increasing the financing rates and they could put further pressure on their least profitable clients like the ones with a low portfolio turnover. Funds are forced into discussions with the sell-side around the question of how much revenue the manager can guarantee them. As a result, one could expect a hedge fund manager to reduce the number of prime brokers in an effort to rationalise their models with less appointed prime broker relationships. Hedge fund managers will also beef up their treasury solutions to optimise their cash exposures among their selected custodians.

On the other side, the banks point to the fact that they are very constrained and suffer from a lack of manoeuvre because their balance sheets no longer allow them to extend credit lines as they previously could. These issues even trickle through into the domain of hedge fund administrators. Once you look into this a little deeper it becomes apparent how changes in market structures have come about as both a direct and indirect consequence of regulation.

Despite smart beta craze, two-thirds of stock returns still not explainable

The smart beta or factor driven investment sector is growing massively at this point. More and more smart beta factors find their way into systematic strategies. Just in the ETF space alone, their growth rate is twice that of the other vehicles. Smart beta has also helped weeding out fake active managers. Fifteen years ago investors were charged active management fees just for buying low P/E stocks. That’s beta, quite frankly and it shouldn’t be paid as active management. But we now have tools to analyze that and to potentially invest in all those forms of beta.

However, it is probably not the next style index or the next style ETF that the industry needs, but actually good asset allocation methodologies and algorithms. That is the missing part. Investors are increasingly becoming aware that they have all these great new “bricks” to play with, active and passive, but the question remains what should they do with them?

Still, smart beta or factors isn’t all there is. Academic research suggests that about two-thirds of stock returns are still not explainable or not explained, even if you put all the smart beta and factors in there. So two-thirds of stock returns are still potentially alpha for which you should, by all means, be paying. But at least for one third you should be paying 50 basis points or less.

The Opalesque 2015 U.K. Roundtable, sponsored by Eurex and Maples Fund Services, took place in April 2015 in London with:

  1. Renaud Huck, Senior Vice President, Eurex Group
  2. Stephen Lewis, Director of European Business Development, Maples Fund Services
  3. Eric Lonergan, Portfolio Manager, M&G Investments
  4. Benjamin Day, Head of Sales, Stratton Street Capital
  5. Peter Coates, CEO, Omni Partners
  6. Tommaso (Tom) Cotroneo, Ph.D., CFA, UniCredit
  7. Pierre Crama, Deputy Head of Operational Due Diligence, Tages Capital

The group also discussed:

  • Creditors versus debtors: Earn more by lending to the most creditworthy nations
  • Why traditional benchmarks can ruin a fixed income portfolio
  • Tages Capital & Omni Partners: New seeders emerge
  • What are second generation smart beta products?
  • Opportunities in UK property lending, event, M&A and energy
  • Is it possible to set up a frontier market fund of hedge funds?
  • Eurex’ new products to help players who are mandated by regulation to exit OTC
  • How to survive the oligopoly of hedge fund administration firms
  • Assessing the odds in Global Macro: Why M&G’s hedge fund outperforms
  • Why P/E rule of thumbs will break down in equities as markets enter “super moderation”
  • Why Mario Draghi really stands out as extraordinary politician
  • How negative interest rates create havoc in asset valuation models
  • Solvency II: Investors focus on “return on regulatory capital”
  • Finally! Some real innovation in hedge fund fees