Hedge funds could make inroads into market-making and asset servicing in a bid to counter competition and fill gaps left by banks and broker-dealers.
Traditional lines distinguishing hedge funds from their clients and competitors are “increasingly blurred”, experts at Boston Consulting Group (BCG) argue.
As a result, services routinely provided by sell-side firms, including liquidity provision and custody, may start to appeal more to alternative managers.
“Banks and broker-dealers are responding to burdensome new regulations and reduced returns by contracting their capital market offering,” writes Brent Beardsley, a New York-based senior partner at BGC.
“This gives hedge funds the opportunity to enter new lines of business, such as lending, market-making and asset servicing,” he adds in a new report, entitled ‘Hedge Funds – Down But Not Out’.
Large banks operating as custodians, such as BNY Mellon and JP Morgan, have doubled down on their asset servicing commitments in recent years – boosting their technology spend and enhancing client service.
However, regulations have added complexity to the business along with considerable margin pressure. New technologies, notably blockchain, are also forcing incumbents to revisit their operating models.
Aside from asset servicing, certain hedge funds have already begun to provide more liquidity in foreign-exchange markets as traditional dealer banks step back due to stricter legislation.
Direct lending is another area of opportunity for alternative managers amid still tight lending from traditional bank sources.
Hedge fund struggles
Average hedge fund gains totalled 7.4% in 2016 according to data from Preqin - the best showing in three years.
However, experts at the firm said managers will be aware that in recent years returns have "still fallen short of other alternative asset classes and public market indices".
This is especially pertinent in the wake of some high-profile investors eliminating or reducing hedge fund investments from their portfolio, such as giant state pension plans in New Jersey and Rhode Island.
Meanwhile some largest hedge fund clients, including sovereign wealth funds, are becoming more sophisticated and often now use the same tools and technologies to execute their own investment strategies.
Asset managers are also encroaching on hedge funds’ territory by investing in liquid alternatives or by acquiring or partnering with hedge funds.
In a worst case scenario, BCG’s report predicts industry-wide hedge fund assets could shrink by as much as 30% by 2020 and margins could fall by 20% as a result of fee reductions and increased capital expenditure.
Even in a more favorable so-called “momentum scenario”, hedge funds will have to retool and reorganise, according to BCG.