Prime Brokers And Hedge Funds Prefer A Friends-With-Informational-Advantage Relationship

It pays to have the right prime broker.
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Brian Smithson

Courtesy Flickr user Brian Smithson.

In most corners of the investment banking world, there exists a subtle differential between services advertised and services actually rendered. Equity analysts not only analyze equities but also amplify hedge fund clients' trading ideas. M&A teams not only arrange deals for big clients but also help them acquire smaller clients on the cheap. Sometimes when I-bankers court potential business partners they're also courting their prospective clients' romantic partners. These services might not show up in marketing copy or quarterly reports, but they provide the lubricant that keeps the whole machine chugging along.

A team of economists has now elucidated another unspoken relationship: that of prime brokers, hedge funds, and the tips that flow between them. On paper, prime brokers merely arrange financing and push securities around, along with a few other unglamorous custodial tasks. But those relationships come with the notable benefit for hedge funds, which appear to receive some hot tips regarding companies that work with their same banks.

That is the conclusion of a new study, titled Prime (Information) Brokerage:

We focus on the flow of information from prime brokers to hedge funds for two reasons. First, as a key participant in the capital markets, broker-dealers often receive private information regarding their corporate clients as part of their advisory and origination activities. Second, the highly profitable nature of prime brokerage services could incentivize the brokers to “tip” information to their hedge fund clients. Although Chinese walls are set up to prevent such information transfer, various academic studies and regulatory reports find that these information barriers are often not adequate. Consistent with this idea, we document strong evidence that hedge funds make abnormally large and profitable trades in stocks on which their prime brokers have private information.

It's a pretty simple model. Prime brokers have the inside scoop on big publicly traded stocks. These brokers can (if they wish) divulge this information to hedgie clients in order to take their relationship to the next level. According to the data, they do: Hedge fund trades in stocks with a prime broker connection “generate superior performance of 2.1 – 4.0% on an annual basis,” the study finds.

An illustration might help. Say that Alpha Capital Management owns stock of both A Corp and B Corp. Alpha's prime broker Bank A has a relationship with A Corp but not B Corp. This makes Alpha a “connected hedge fund” when it comes to A Corp. In the quarter before a new loan announcement between Bank A and A Corp, the well-connected Alpha will, on average, load up more on shares of A Corp than B Corp. Let's say further that Beta Partners, which also has A and B stock, uses some other prime broker, which doesn't work with A Corp. In this case, the unconnected Beta is less likely to up its A Corp holdings in advance of the announcement.

The purported tips aren't bad, either. Trades by connected hedge funds outperform other stocks in these funds' portfolios by as much as 2.4 percent in the quarter of the loan announcement. And trades by connected funds outperform trades in the same stock by unconnected funds by up to 4 percent on an annualized basis.

Of course, all of this would amount to a slight gap in the vaunted Chinese Wall that divides up different divisions of investment banks. Prime brokers aren't supposed to be gabbing with their hedge fund clients about sensitive deals being hashed out at other parts of the bank. Why, that's illegal! Is this rational behavior?

The data says yes. A rational prime broker would be more likely to go out on a limb for big, heavy-trading funds than smaller ones that trade infrequently. Indeed, hedge funds with AUM in the top quartile earn up to 8.3 percent more on trades in broker-connected stocks as compared to smaller funds. And funds with more turnover and higher leverage – i.e., the ones that drive fatter brokerage revenues – also get better tips, trading returns suggest.

Needless to say, this looks icky for prime brokers – none of whom are singled out in the study. But there's a silver lining for hedge funds: Alpha is not dead.

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