At the recent Fund Forum conference in Monaco, one of the main subjects of discussion was the increasing involvement of institutional investors in hedge funds and alternative investments. As these alternatives move further into the mainstream, institutional investors are putting pressure on hedge fund managers to be more transparent in the information they supply and more rigorous in their risk controls.
In its 2007 Annual Hedge Fund Research Study, State Street said some hedge funds were adopting new business models, while some traditional investment vehicles were adopting hedge fund like characteristics. "This environment may one day lead to the eradication of boundaries between hedge funds and conventional investment vehicles, as all asset managers gain the authority to hedge and apply a degree of leverage to their investments. But, for the foreseeable future, delineations remain between these two worlds," the report said.
State Street predicted that "at some point in the not too distant future", hedge funds would constitute more than 10% of pension plan portfolios. Hedging strategies would become the norm for active managers and larger organisations would polarise around the production of inexpensive beta and the generation of alpha. Better pricing models would encourage further investment and consolidation in the industry would continue.
This shift in focus by institutions is one their securities services providers will have to follow. Tony Solway, head of BNP Paribas Securities Services in the UK, says: "As the convergence between traditional long only managers investing in equities and bonds moves into new asset classes hitherto the province of so-called alternative asset managers and hedge funds, the traditional long only equity and bond custodians will have to change their operating models considerably. The impact of coping with derivative strategies and alternative investments - such as real estate and commodities and long/short strategies - is significant. The additional complexities around the trade process, accounting, valuation and reporting of derivative instruments, for example, are increasing the cost and risk associated with the management of the funds within which these instruments are being used. This is compounded by continuing innovation in instrument types and a general shortage of experience across all parts of the industry."
The shortage of experienced staff was another subject raised at the conference. In May, BNP Paribas was granted £3.7m (€5.5m) by the Scottish Executive for capital investments and recruitment in order to expand its fund servicing operations in Scotland. Solway says the grant will enable the bank to support growth in its operations centres in Glasgow and Dundee, "accessing the local markets, which are rich in talent".
Custodians are beefing-up their offerings in response to this convergence, going on the acquisition path to add the expertise they have not traditionally needed. Citi acquired Bisys Group, a US-based outsourcing service provider for $1.5bn (€1.1bn) in cash. The Bisys business will improve Citi's fund of fund and mutual fund servicing capabilities as well as its private equity fund services.
Last year, JP Morgan acquired the middle- and back-office operations of Paloma Partners, a privately-owned investment management group based in the US. It set up JP Morgan Hedge Fund Services and a few months later won a mandate to provide middle- and back-office services for the hedge funds of London-based global asset manager Henderson Global Investors, which comprise 14 hedge funds representing around $2bn of assets.
In June, State Street launched an upgraded real estate servicing capability, which includes a range of online performance analytics and risk assessment tools to enable institutional investors to monitor their entire real estate investment portfolios. State Street says real estate investing requires comprehensive monitoring of key assets and portfolios to evaluate risk and make more informed investment decisions.
One of the first users of the new service is California State Teachers Retirement System. Chris Ailman, chief investment officer at the fund says: "This technology will give us the type of portfolio management tools our staff has had for public market securities and it puts us one step closer to integrating all our asset classes into one comprehensive system."
Where once the large custodians would boast that the bigger they were the more economies of scale they could deliver to clients, now they have had to add specialisation to their box of tricks.
That is not to say consolidation is not still happening among the custodians. In February, State Street acquired Investors Financial Services Corp, a similar investment services provider based in Boston in a stock deal worth $4.5bn. The acquisition propelled State Street to the number two spot in the global custody league with $14trn in assets under custody behind Bank of New York Mellon Corp.
As Solway points up, the impact of coping with derivative strategies and alternative investments is significant. This is making the securities services business an ever more complex one and it does not take a genius to figure there will be more consolidation on the way.
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