Regulatory scrutiny by the SEC and the brutal dogfight for scarce alpha are pushing US hedge funds to implement a more rigorous and formalized trading process, according to the eighth annual benchmark study from TABB Group.
At the same time, hedge funds are working with their sell side counterparts to bring additional cost-efficiency to an industry seeing revenues fall for the fourth straight year, the report says.
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According to TABB, each decision in the trading process must be empirically defensible and contribute positive value to alpha capture. Where possible, an electronic trail of decisions made by portfolio managers and buy-side traders as well as the surrounding communication should be captured and analyzed, everything from the broker vote and the timing of trades, to the use of dark pools and commission-sharing agreements (CSAs).
The study report found that a more dramatic than usual shift in presence is seen among the top five overall and top five algorithm brokers in 2012, driven by changes in the sell-side trading landscape and an increased focus on broker relationships over execution performance.
Hedge fund traders have become more receptive to integration of brokerage services since 2012, the report added.
The lack of differentiation among broker algorithms does not mean there is no differentiation among the overall service. Two-thirds of the firms have already established a formal broker-vote process; among these funds, 70% conduct the voting process on a quarterly basis, at a minimum.
Regulatory change notwithstanding, beyond the trading desk, the role of the hedge fund trader continues to be dynamic, says Adam Sussman, a TABB partner and director of research who co-authored the study with research analyst Colby Jenkins.
"There is increased pressure to formalize trading and brokerage relationship practices in response to investor demands, regulatory oversight and a mature organizational management layer. Although the core processes are not changing, business conduct is becoming more rigorous.
"Despite these pressures, a significant portion of the market is playing catch up," he added.
The study is based on interviews with head traders between January and April 2013 at 63 US-based hedge funds trading equities with aggregate global assets under management (AuM) of US$301 billion.
