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Another reason why family offices won’t like hedge funds

These days, hedge funds need all the friends they can get and new research has suggested they can rely on their prime broking advisers to come up with helpful stock tips.

A research paper published by the Journal of Empirical Finance says investment bank analysts working alongside prime brokers systematically upgrade ratings for stocks, where big positions have recently been accumulated by their hedge fund clients.

Moore Capital, Tiger Global, Coatue and Maverick Capital are among a growing number of hedge funds re-routing their research dollars to venture capital

The paper, Hedge Funds and Their Prime Broker Analysis, has been produced by researchers from Singapore Management University and Wayne State University. 

They say stock upgrades by prime broking analysts tend to be generous when hedge funds generate high trading commissions, to the potential cost of subsequent buyers.

None of this will impress, or surprise, family offices wary of the tricks used by hedge funds to boost returns which often fail to cover fees of 2% plus a 20% performance charge.  

Oliver Bergmann, investment chief at Global Pacific Securities, commented on Linkedin: “If this comes as a surprise consider a career somewhere other than Wall Street. When gambling, if you don’t know who the patsy is, it’s you.” 

The research paper expresses surprise that analysts are still exposed to conflicts of interest, no less than twenty years after US regulator Elliott Spitzer stopped bank analysts benefiting from fees paid by corporate clients.

Prime brokers offer hedge funds services such as trading, leverage, custody, technology and introductions to capital providers. They generated total turnover of $30 billion in 2020, according to Aite Group.

Prime brokers have been losing ground as a result of hedge funds reducing their market exposure, or getting out of the sector altogether. They have pushed the envelope in an attempt to reboot their income.

Data provider Pivotal Path has confirmed that hedge fund closures rose 20% in 2020, easily outpacing launches. Many of the closures have been instigated by long-standing players who feel they are not living up to their glorious past. 

Whitney Tilson shut down Kase Capital in 2017, to take up blogging. On shutting, he said: “My favorite safe stocks don’t feel cheap, and my favorite cheap stocks don’t feel safe.” 

Difficulties in reading a market flooded by liquidity have become common. A lack of volatility has flattened returns. Moore Capital, Tiger Global, Coatue and Maverick Capital are among a growing number of hedge funds re-routing their research dollars to venture capital.

The going got tougher for prime brokers in April, which saw the $20 billion collapse of Archegos Capital Management, which cost eight prime brokers a total of $10 billion. 

Now they need to deal with the Singapore Management report: “Our empirical analyses reveal that analysts are more likely to upgrade stocks purchased by prime broking clients in the last quarter, and downgrade stocks sold by the clients.

“The relation is not significant with the trades of hedge funds that are not clients, which appears to eliminate the possibility of alternative explanations.”

It says stock recommendations are driven by a desire to generate trading commissions. The presence of a hedge fund on a share register can add speculative interest to a stock, although the research shows the subsequent price performance is disappointing.  

The analysis extended over many years. It points to a sharing of data between prime brokers and hedge funds relating to corporate events, which further underpins the trading relationship.

“Our evidence reveals prime brokers’ biased preference for hedge fund clients over customers who pay for unbiased equity research.” The research concludes the price recommendations were “overly optimistic.”

 

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