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Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization
Act alternative mutual funds, ETFs and alternative
UCITS. These investment pools are wholly contained
within the convergence zone illustrated in Chart 5.
Between 2007 and 2013, assets in this convergence
zone grew from $2.2 trillion to $3.4 trillion—an
increase of 55%. Over the next five years, we see that
rapid growth continuing, with funds being managed in
this convergence zone nearly doubling to $6.6 trillion
in 2018.
This forecast has several implications for asset owners:
1. Managers with long-only benchmarked or
unconstrained long funds will be under increased
pressure to maximize their returns to demonstrate
outperformance and differentiate themselves
from cheaper passively managed ETF and index
products and from other active managers that
can use a broader set of investment techniques
to drive absolute return and reduce their beta
risk. In such a highly competitive landscape, the
incremental return provided by effective re-use of
assets takes on increased importance.
2. Options for the re-use of assets are expanding.
Strategies within the convergence zone require
cash for financing or margin postings. In Europe,
where cash is not accepted for UCITS fund
margins, cash can also be used in reverse repo
arrangements to acquire high quality liquid assets
(HQLA). Depending on market circumstances,
demand for this cash from convergence zone
managers may offer better yields than reinvest
options. Moreover, convergence zone strategies
compete for securities from asset owners to help
cover corporate events and short exposures; hedge
market exposures as a part of a swap transaction;
or post as collateral on derivative positions. This
greatly expands the potential paths each asset
could be used to support. Modeling the economic
benefit of each potential re-use path will ensure
that asset owners use their supply in the manner
that will garner them the most return in alignment
with their risk guidelines across this entire set
of options.
3. Opportunities to evaluate their asset pool for
transformation trades will also become more
common as there is an increased drive to ensure
liquidity across the set of convergence zone
strategies. Transformation trades can help asset
owners unlock the potential of illiquid securities;
facilitate upgrade or downgrade trades to help
counterparties manage their collateral posting and
liquidity requirements; or be done synthetically to
create, neutralize or hedge exposures.
4. Those asset owners with investment management
capabilities are likely to also begin to evaluate
the potential of insourcing lending programs
and making them part of their holistic liquidity
management regime. Many traditional asset
managers already have or are looking to launch
alternative products in the convergence zone.
Many hedge funds and private equity firms now
also have funds that have large pools of long assets.
Internalization opportunities and the potential
to better deploy their cash and collateral across
their full set of funds could provide the impetus for
some firms to invest in their own lending teams.
Each of these impacts is likely to be exacerbated by
shifts in the regulatory environment that are changing
the economics of lending, cash and collateral
management. These changes will be explored at
length later in this report. To understand the scale of
these changes, we will first review how major lending
and cash management programs have changed in
response to the events of the Global Financial Crisis
(GFC) in 2008.
Readers familiar with the history of how lending
programs evolved in the post-crisis years should
skip to Section IV on page 40 to understand the
new influences emerging to shape the industry.