New York, NY – Yesterday House Republicans introduced their own version of the STOCK Act, banning federal employees from using information obtained from their jobs to insider trade.  Unlike the Senate bill passed last week, the new House bill does not include the requirement that political intelligence firms register due to a concerted lobbying effort by Wall Street investment banks.

Last week the Senate passed its version of the STOCK Act by a vote of 96 -3, including an amendment by Senator Chuck Grassley (R-Iowa) that political intelligence firms register like lobbying firms.  This requirement is similar to the language included in House bill H.R. 1148 proposed by Reps. Louis Slaughter (D-NY) and Tim Waltz (D-MN).  The new GOP bill eliminated this requirement, replacing it with a Congressional study of the political intelligence industry.

Since the passing of the Senate bill, Wall Street banks and broker-dealers have been aggressively lobbying Congress to either remove the registration requirement or to alter the definition of what comprises “political intelligence” activity due to the extremely broad language currently included in the bill.

The language of the Grassley amendment suggests that any firm or individual that makes one contact with a covered legislative branch or executive branch employee to gather information on pending legislation, rules, regulations, executive orders, or policies for use in analyzing securities or commodities, or in informing investment decisions must register as a political intelligence provider.  These firms would have to register as a lobbyist does today, provide a list of all firms that receives this research, and list how much these clients pay for the research.

Many Wall Street firms employ internal lobbyists who lobby on behalf of their employers, collect political intelligence for bankers and analysts, publish research on legislative and regulatory policy issues for their clients, and who set up meetings between their clients and Washington insiders.   Based on the Grassley language, these firms would have to register as political intelligence providers.  However, some smaller broker-dealers argue that traditional research activity by their stock analysts, macroeconomists, or strategists could also force them to be registered.

What is interesting about this registration requirement is that Wall Street firms that use an existing “political intelligence” provider to obtain the information that their bankers or analysts need to conduct their business won’t need to register themselves.  Instead their providers will be required to.  But at least this keeps them from having to publically report their client and payment information on a regular basis.

Using data from Investars, research firms with strong performance for buy and sell recommendations over the three years ending December 31, 2011 were B. Riley & Co., MKM Partners and Market Profile Theorems (MPT).  Also of note was the performance of Haugen Custom Financial Systems, Inc.

Investars, a New York-based performance measurement and commission management specialist, calculates performance information on approximately 100 research providers in the data provided to Integrity Research.   Investars calculates the performance for buys and sells by estimating a return based on the buy and sell recommendations, ignoring any hold recommendations. In other words, a buy remains a buy until changed to a hold or a sell.  Sell recommendations are treated like short sales (declines in the stock are good) until changed to a hold or a buy.

Reviewing performance for the period December 31, 2008 through December 31, 2011, as tabulated by Investars, the research firms with the best performance for buys and sells were B. Riley, MKM Partners and MPT, with 238%, 151% and 139% performance respectively.  Each of these firms also showed strong performance for the buy recommendations alone.  Also notable was Haugen Custom Financial Systems with 3 year buy recommendation performance of 146%.

B. Riley and MKM Partners had a limited number of buy recommendations over a 1 year period, reflecting smaller coverage universes relative to the other providers.  B. Riley and MKM Partners also had longer average holding periods for their buy recommendations, with holding periods averaging 5 to 6 months, whereas the other providers shown had short holding periods, averaging a month or less.

When we look at the volatility of the research recommendations as measured by the standard deviation of the weekly returns over the three year period, we see that the volatility of the recommendations was in line with the majority of providers tracked by Investars.  The chart above plots 3 year buy recommendation performance versus the standard deviation as calculated by Investars.  The lower the standard deviation the better, so the firms on the lower edge of the cluster tend to have the better risk/reward profiles.   Haugen, B. Riley and MPT all tend to align with the firms with lower risk/reward profiles.

New York, NY – Last week, the Stop Trading on Congressional Knowledge (STOCK) Act passed in the Senate with a 96-3 vote.  The bill would ban members of congress and the executive branch from insider trading based on information collected while on the job.  In addition, the bill mandates that individuals or firms that collect political intelligence from political insiders for investment purposes must register the way that lobbyists do.  This bill is likely to have a major impact on the firms that provide policy research and political intelligence services to investors.

The STOCK Act

While members of Congress are already subject to insider trading laws, it has historically been unclear whether this applies to non-public information obtained from pending legislation or other policy deliberations accessed by members of Congress, congressional staff, or other employees of the executive branch.  The STOCK Act attempts to widen traditional insider trading rules to address this nonpublic information.  The bill passed by the Senate last week includes the following:

• Members of Congress and their staffers are banned from trading stocks, futures, or swaps based on material non-public information relating to any pending or prospective legislation obtained as a result of that person being a member or employee of Congress, or information obtained from any member or employee of Congress.
• Members of Congress and their staff are required to report all trading activity above $1,000 in stocks, bonds, futures, or other securities within 30 days after the purchase, sale, or exchange of these securities.

The following are a few of the most noteworthy amendments to the original bill which were voted on and passed by the Senate.

• The 28,000 government workers in the executive branch were added to the bill, including the president, vice president and members of the Federal Reserve Board.
• All individuals or firms that collect and sell access to “political intelligence” intended for investment purposes must register as lobbyists.
• All members of the Senate would have to post their annual financial disclosure statements online instead of making only paper copies available on request.
• Representatives convicted of committing a felony while serving as elected officials will lose their pensions.  In addition, all congressional pensions of former representatives convicted of corruption while serving in any elected capacity would be forfeited.
• Various loopholes in anticorruption laws would be closed, including increasing sentencing for corruption cases.  In addition, investigators and prosecutors would be granted more time to go after corruption, and clears up language that could be ambiguous or create further loopholes.
• Congress and the Executive Branch would be required to disclose mortgage information on their residences, including the mortgage holder, date, range, and interest rate.
• All bonuses for senior executives at Fannie Mae and Freddie Mac while the agencies are in conservatorship would be prohibited.
• Trades in mutual funds would be removed from the STOCK Act requirements.

Registration of Political Intelligence Providers

One amendment to the STOCK Act bill passed by the Senate which we believe could have a significant impact on the research industry was proposed by Senator Chuck Grassley (R-Iowa).  Initially, the Senate bill called for a GAO study on the political intelligence industry, whereas the House bill, H.R. 1148, required registration of these firms.

Grassley’s amendment requires that individuals or firms involved in contacting any covered executive branch or legislative branch employee to obtain information on pending federal legislation, regulations, policies, or other positions of the US Government that is intended to be used in analyzing securities or in informing investment decisions on behalf of clients must register as lobbyists.

In our opinion, this will mean that both independent and sell-side providers of policy research, and lobbyists, law firms and consulting firms that collect information from political insiders will be required to register as “political intelligence” firms.  This is because all of these firms source information from covered executive or legislative branch employees, and they provide either the information, or analysis based on this information, to clients to inform their investment decisions.

“Political intelligence professionals aren’t considered lobbyists, so they don’t have to disclose that they’re seeking information and are paid for it” when they meet with elected officials or staffers, Grassley said in a statement.  “As a result, members of Congress and congressional staff have no way of knowing whether such meetings result in information being sold to firms that trade based on that information.  My amendment would shed sunshine on this kind of political intelligence gathering.”

According to research conducted by Integrity Research Associates, the global market for policy research and political intelligence services totaled $402 million in 2009.  This includes an estimated $120 million that buy-side investors spent on policy research produced by independent research firms; $246 million that investors paid for sell-side generated policy research (typically bundled in equity commissions); and $36 million that institutional investors paid to lobbyists, law firms, consultants, and others for political intelligence services.

“You have a growing industry with no transparency,” Sen. Grassley said in a statement. “If a lobbyist has to register in order to advocate for a school or church, shouldn’t that same lobbyist have to register if they are seeking and getting inside information to make a profit on? This is especially true if that information would make millions for a hedge fund or a private equity firm.”

Consequences of this bill

It is our view that the STOCK Act could have a significant impact on providers of policy research and political intelligence services for a number of reasons.  A few of these reasons include:

The STOCK Act passed by the Senate clearly establishes a duty of “trust and confidence” for members of Congress, their staffers, and employees of the Executive Branch regarding non-public information about pending federal legislation, regulations, policies, or other positions of the US Government.  Consequently, individuals or firms that provide nonpublic information from these sources to investors that is deemed to be material could be found guilty of tipping material non-public information.  Investors who trade on this information could be seen to be guilty of insider trading.

We suspect that the passage of the STOCK Act will decrease buy-side investors’ interest in collecting potential MNPI from political insiders.  As a result, we would not be surprised if “political intelligence” services provided by lobbyists, law firms, and consulting firms will decline in importance.  However, we believe investors will continue to value policy research firms which provide an objective analysis of legislative, regulatory, treasury, and monetary policy developments and what sectors or industries they are likely to impact.

We also would not be surprised if the passage of the STOCK Act will force all policy related research firms to implement more stringent compliance policies to control the way they collect information, and institute procedures to keep MNPI from being passed on to their clients.

The registration of firms that are involved in political intelligence activities will also exacerbate investors’ concerns about hiring lobbyists, law firms, or consulting firms to find out what is likely to take place in Washington DC.  We don’t think hedge funds will want to share who they have hired and how much they are paying to collect information from political insiders.

Consequently, we believe that the eventual passage of the STOCK Act could have a significant impact on firms that provide policy research and political intelligence services.  Not only will this bill reduce clients’ interest in receiving potential MNPI from political insiders, we think it will also force traditional policy research firms to adopt more rigorous compliance policies to protect their clients.

Kaufman Bros. LP, a minority-owned investment bank, ceased operations as of the end of January, according to a notice posted on its website.  The firm had a small equity research team focused mostly on technology.

Kaufman was founded in 1995 and billed itself as “the country’s largest minority-owned and operated investment banking and advisory firm” focused on technology, media, telecommunications, green technology and health care.

The firm added 6 equity analysts beginning in 2010.  Analysts were seasoned technology analysts averaging over 10 years experience.  The roster of analysts and coverage can be found at http://www.kbro.com/EquityResearch/Overview/tabid/74/Default.aspx.

Kaufman Brothers joins Ticonderoga Securities and WJB Capital in closing during January.  Combined, they have put 20 senior analysts out on the street.  The failures underscore the pressure on all cash equity participants brought on by low commission volumes.  If January is a harbinger for 2012, we have a rough year ahead.

The FSA’s insider trading case against David Einhorn and his fund, Greenlight Capital, highlights the differences in insider trading regulations between the U.S. and the U.K.  Many of the compliance controls used by U.S. asset managers and research firms are triggered by confidential information, but the Greenlight case illustrates that confidentiality protections are not effective in the U.K.

Interactions with Company Management

As we noted last week, one important distinction between U.S. and U.K. laws is the fiduciary duty placed on U.S. publicly traded companies and their advisers by Regulation Fair Disclosure (Reg FD).  A U.S. issuer would be unlikely to tell Einhorn about a pending offering because Reg FD prohibits issuers from selectively disclosing market-moving information.   The broker involved, Bank of America Merrill Lynch, would be viewed as a “temporary insider” under Reg FD, and also precluded from selective disclosure.

The case highlights the role of ‘corporate brokers’, a function unknown in the U.S.  Corporate brokers are  investment bankers who serve as a liaison between public companies and their institutional investors.  As illustrated by the Greenlight case, corporate brokers in the U.K. can legally provide material non-public information to investors who agree not to trade on it in order to gauge the sentiment of their investors ahead of important corporate actions.  The U.K.’s Financial Services Authority is reportedly planning to fine the broker involved in the Greenlight case £350,000 pounds ($549,674), presumably for disclosing confidential information even though Greenlight expressly did not want to receive it.

As some commentators have pointed out, even offering an investor the opportunity to “cross the wall” could provide tradeable information, especially in cases such as Punch’s, in which an action such as the rights issue has been long speculated in the market.

Confidentiality

U.S. lawyers also question whether the Greenlight case would hold under U.S. insider trading law.  The U.S. rules on insider trading say that a trade is illegal if it is based on information that is not only market-moving but also obtained or leaked in violation of a duty to keep it confidential.  Einhorn’s refusal to “cross the wall” and receive confidential information would have gone a long way to protecting him under U.S. law.  However, in the U.K. insider trading rules are broader, allowing regulators to bring actions even where inside information has been received unintentionally or inadvertently.  The FSA claims that Einhorn should have known that he was no longer able to trade once he received the information from the corporate broker, even though he had not requested it.

Compliance officers at U.S. asset managers were shocked by the FSA’s action, while U.K.market participants were wondering why Greenlight had not been criminally prosecuted since to them Einhorn’s actions were so clearly a violation of U.K. market abuse rules.  However, criminal insider dealing requires deliberate intent, whereas the FSA has successfully brought civil cases involving “inadvertent” or “unintentional” violations and successfully defended them on appeal.

Implications

U.S. asset managers have gone to great lengths to implement protections against receiving confidential information.  Analysts and portfolio managers are trained to be alert to confidential information and to ensure that sources of information are not violating fiduciary duties of confidentiality.  U.S. research firms have implemented similar safeguards.  Expert networks have extensive protections against experts passing confidential information to clients.  Channel checking firms try to ensure that its sources are not violating duties of confidentiality.  The Greenlight case highlights that these compliance procedures offer no protection under U.K. insider trading law.   U.S. asset managers and research firms will need to make adjustments to their compliance practices if they are operating in the U.K.

The Greenlight case also highlights the grey area of corporate brokering.  Although corporate broking is unknown in the U.S., it does have a related activity — corporate access.  Corporate access, which is a common practice in U.S., differs from corporate broking in that investment banks facilitate meetings between investors and company management, which the bankers may or may not attend.  Nevertheless, it is clear that regulators on both sides of the Atlantic are taking a closer look at all activities which can potentially generate insider information.

New York, NY – An article published last week in the Financial Times indicates that US financial regulators are planning to issue new rules in the next few weeks requiring that the conflicts of interest associated with sell-side fixed-income research be addressed in a similar manner as the conflicts inherent in investment bank’s equity research.

Proposed FINRA Rule

According to the FT article, “The staff at the Financial Industry Regulatory Authority, at the urging of the US Securities and Exchange Commission, are set to file new rules with the SEC in the coming weeks that would also bind analysts who cover bonds by some of the same rules.”

This follows an initial rule proposal by FINRA last April where the US regulator said it “observed increased retail investment risk in complex debt securities.”  Click here for our previous discussion on FINRA’s preliminary proposal.

Earlier this month, the Government Accounting Office published a report to Congress called “Additional Actions Could Improve Regulatory Oversight of Analyst Conflicts of Interest”.  In this report, the GAO explained:

“FINRA also has been working to finalize another rule proposal that would address conflicts faced by debt research analysts. The current SRO research rules do not cover debt research analysts, although these analysts face conflicts of interests similar to those faced by their equity analyst counterparts. In the absence of an SRO debt research rule, the SROs have relied on antifraud statutes and SRO rules requiring ethical conduct. They also have encouraged firms—with limited success—to comply voluntarily with industry-developed principles designed to address debt analyst conflicts. FINRA plans to package its two rule proposals together and submit them to SEC in the first half of 2012.”

The final FINRA rule is likely to require that fixed-income analysts who publish research read by retail investors abide by the same rules addressing conflicts of interest that publishing equity analysts are required to follow. There are expected to be exceptions for swaps research, as well research discussing company creditworthiness.  Research targeted to institutional investors is expected to be exempt from these rules, though some form of additional warnings are probably going to be required.

Market Opposition

A number of financial market participants oppose FINRA’s proposed rule for a variety of reasons, including the existence of voluntary guidelines for fixed-income research, and the lack of reported harm to investors.  The Bond Market Association established voluntary rules for fixed-income research in 2004.

However, the GAO reported that as a result of the NASD and NYSE joint interpretive guidance on better managing conflicts of interest in fixed-income research in July 2006, they found that many firms had failed to adhere to BMA’s standards.  The examinations also found several cases where firms failed to establish, maintain, and enforce written supervisory procedures in the fixed-income research area — a fundamental obligation under their rules.

In its January 2012 report, the GAO also discussed one example where conflicts of interest in fixed-income research could have harmed investors.  In this case, a sell-side fixed-income analyst who covered Enron’s debt securities testified in 2001 that she perceived pressure from her superiors not to issue negative public comments on Enron because of Enron’s importance as an investment banking client of the broker-dealer.

Integrity’s View

We are a little surprised that everyone is so worked up about extending equity research rules regarding conflicts of interest to the fixed-income markets.  First, the new FINRA rules are expected to apply only to fixed-income research that is published and distributed to retail investors.  It is our understanding that very few retail investors actually receive fixed-income research.  Consequently, the new rule probably should not apply to most fixed-income research.

Secondly, feedback we have received from market participants suggest that very little fixed-income research is being published today.  Instead, most fixed-income research is provided by “desk analysts” who provide their insights verbally to institutional customers rather than through traditional research reports.  This is unlikely to fall under the new rules as it is not considered actual “research”.

However, any new FINRA rules regarding fixed-income research will mean that regulated firms that produce it will have additional compliance rules and regulations that they will need to comply with – an issue that will cost these firms additional compliance time and money.

According to a study recently conducted by The Wall Street Transcript group, close to half of all asset managers they spoke with still conduct their regular broker voting process using spreadsheets, despite the development of more sophisticated broker voting systems over the past decade.

Broker Vote Survey Results

A white paper, recently published by The Wall Street Transcript’s EasyBrokerVote group reviews a survey conducted last year of asset managers on the current state of the broker voting process. The survey suggested that spreadsheets are widely used by asset managers to complete a vote.   Some key findings from the survey include:

1. 48% of respondents use spreadsheets to conduct a broker vote
2. One quarter of firms have a system to track corporate access and research provided
3. 40% of respondents provide feedback to the sell side on request with 15% providing no feedback

EasyBrokerVote

Last year The Wall Street Transcript group launched a low priced web-based application to help asset managers conduct a broker vote called EasyBrokerVote.  The Wall Street Transcript’s MeetMax software division has been providing corporate access and sell-side event registration, scheduling and reporting software since 2003.

The installed base of broker vote applications among asset managers is still relatively limited despite the fact that at least two products have been available for some time (Cogent and Markit WSOD).

The EasyBrokerVote product is targeted at asset managers who require an application to enable a broker vote process to be completed quickly but require greater functionality that spreadsheets. Specifically asset managers who want to vote easily beyond the firm level to capture different services such as corporate access and research.

For more details on the survey and the product offering please contact easybrokervote@twst.com.

New York, NY – Earlier this week, David Einhorn and his US hedge fund, Greenlight Capital Inc., was fined by the UK’s Financial Services Authority for alleged insider trading, indicating that regulatory concern about insider trading has traveled outside the US.

FSA Ruling

The FSA fined Einhorn and Greenlight a total of $11.2 mln for information that Mr. Einhorn received in a 2009 conference call with management of UK-based Punch Taverns, PLC.  The FSA alleged that the trades that Einhorn made as a result of the information obtained in this call enabled his fund to avoid $9 million in losses.

Although Einhorn claims his innocence in a letter to investors, he has agreed to pay the fine and not fight the FSA’s charges.

Details of the Case

According to the FSA, Mr. Einhorn learned of a plan to issue a significant amount of new equity by Punch Taverns’ company management during a conference call held on June 8^th, 2009.  The call was arranged by a Bank of America Merrill Lynch broker, Andrew Osborne.

Immediately following the call, Einhorn directed traders at his firm to sell their holdings of the company.  The firm sold 11.7 million shares of Punch Taverns.  Apparently, the price of Punch shares dropped by a third after the call.

On June 15, 2009, Punch publically announced a “rights issue” where the company offered existing shareholders new shares at a discount.  The price of the company’s shares dropped further is response.

The FSA said that Mr. Einhorn’s actions were a “serious breach of the expected standards of market conduct.”  The FSA also admitted that additional investigations relating to the case are ongoing.

Issues Raised by the Case

The FSA’s fine of Einhorn and Greenlight Capital raise a few interesting issues for investors.  These include:

• Einhorn was held personally responsible for the purported insider trading.  As a result, both he and the firm were fined.  This is a rare stance for the FSA.
• The $11.2 mln fine is the second largest ever imposed by the FSA on an individual in a market abuse case.  We think this reflects the FSA’s desire to communicate how seriously they take insider trading.  Unlike the US, the FSA has not brought a large number of insider trading cases in the past few years.
• Even though Einhorn received this information in a management conference call, he was held responsible for trading on the information about the “rights issue” as it was both nonpublic and material.
• The lack of Regulation FD in the UK allowed Punch Tavern’s management to discuss their plans for the rights issue with investors without any concern of regulatory response.

Ticonderoga Securities, an agency broker which had absorbed research staff from Soleil Securities and Pali Capital, will be shutting down this week.  The firm’s failure underscores the pressure on all cash equity participants brought on by low commission volumes.

Ticonderoga Securities launched in 2009 and took on former Pali Capital traders and research staff in 2010.   The firm merged with Soleil Securities in May 2011, adding to its research and trading staff.

According to Traders Magazine, the Soleil deal never delivered the business that Ticonderoga had hoped.  Much of Soleil’s business was reportedly paid with a check through commission sharing arrangements, not helping Ticonderoga’s trading desk.

Ticonderoga had listed 14 research analysts covering 12 sectors on its website prior to closing.  The firm also had a distribution arrangement with Shenyin Wanguo Securities (H.K.), a Chinese securities firm, to distribute research on 350 Chinese A & B listed companies and 150 Hong Kong listed H Share companies.

Ticonderoga’s demise highlights the difficult environment facing all equity research participants.  Equity trading volumes are down prompting asset managers to reduce their research payments and shift more payments through CSAs to stretch commission dollars further.

The pain is particularly acute among agency brokers.  WJB Capital, which distributed third party research, shut down earlier this month.  Susquehanna Financial Group, with research coverage of around 300 stocks, fired 15% of its cash equities staff, roughly 30 people earlier this month.

A key factor in our relatively sanguine outlook for independent research in 2012 is the state of the hedge fund industry.  If hedge funds languish, it is unlikely the research industry will flourish since hedge funds are large consumers of investment research.

2011 Performance and Assets

2011 was a challenging year for hedge fund performance, with the industry posting its second largest annual loss (the largest being -20% in 2008).  Hedge funds on average lost 5% in 2011, according to Hedge Fund Research (HFR).  Eurekahedge Hedge Fund Index declined 4 percent last year, according to preliminary data.  Overall, 40 percent of investors saw lower-than-expected returns in 2011, according to a survey conducted by market data provider Prequin.

The second half of 2011 was brutal for hedge funds, with assets under management dropping below $2 trillion, only to rebound as markets recovered in the fourth quarter.  Nevertheless, investors allocated $70 billion of net new capital to hedge funds across all strategies in 2011. Despite disappointing third-quarter performance, the industry saw net outflows of only $127 million in the last three months of the year.

Macro hedge funds had inflows of $7.9 billion in the fourth quarter, the most of any hedge fund strategy. Investors allocated $27.9 billion of net new capital to macro funds in 2011, according to data from Hedge Fund Research.

Equity Hedge Funds

More problematic for the equity research industry, equity hedge funds suffered $8.6 billion in net outflows in the last quarter of 2011 reducing full year inflows to $2.2 billion. The HFRI Equity Hedge Index finished 2011 down 8.25%. According to HFR, 60% of all hedge funds experienced outflows during the fourth quarter.

Large hedge funds continue to receive the bulk of new assets.  Hedge funds with over $5 billion in assets accounted for $50 billion of the total $70 billion in net inflows in 2011, with smaller funds capturing $20 billion.

We were also concerned by reports from commission management professionals at major broker dealers that a large number of hedge funds were closing at the end of the year.   High-profile closures in the U.S. were Arrowhawk Capital Partners, Sursum Capital Management and Goldman Sachs’ Global Alpha.  Asia reportedly saw the most hedge fund closures since the financial crisis first hit in 2008.

Hopeful Surveys

Two recent surveys suggest that investors plan to increase allocations to hedge funds.  Barclays released a report predicting an inflow of $80 billion in new capital to hedge funds globally this year, the most since 2007.   About 56 percent of investors surveyed by Barclays plan to increase hedge fund investments in the coming year, more than seven times the number that plan to reduce their allocations.

Barclays predicted pensions will provide about half the net inflows this year, followed by $20bn from private banks and their clients, $8bn from insurers, and $6bn from endowments and foundations, and family offices.  The survey included 165 investors who, in the third quarter of 2011, had about $500bn invested in hedge funds.

Meanwhile a survey from SEI showed nearly four out of 10 institutional investors investing in hedge funds intend to increase their allocations to hedge funds this year.

Barclays predicts that smaller hedge funds will get funding this year.  According to their report, investors will increasingly invest in hedge funds with less than $1 billion of assets this year, Barclays said.  Smaller funds already doubled their share of the net industry inflows to 18 percent last year over 2010, it said.

Merlin Securities sees more interest developing in equity hedge funds.  “Event-driven and global long/short are two strategies where we’re seeing new assets flowing for the first quarter of 2012,” says Ron Suber, the head of global sales and marketing at hedge fund brokerage Merlin Securities.

Barclays is less sanguine.  “Equity hedge funds should prepare to fight for reallocated flows, as they are likely to see $100bn of reallocations but close to zero in new flows. We expect a ‘shakeout’ in the equities space as many investors will use 2011 performance to separate ‘winners’ from ‘losers’,” the bank said.

More Regulation

The increased institutional interest in hedge funds will also result in more regulation.  For one thing, institutional investors conduct extensive due diligence of hedge funds.  The process of identifying, evaluating and then investing in a hedge fund will easily range between six and nine months, according to Sameer Shalaby, the president of buy-side technology provider Paladyne Systems.

During that period, Shalaby says, investors will be looking into a hedge funds’ performance, technology, trading platforms and the quality of its leadership. They’ll also investigate a firm’s accountants, lawyers, fund administrators and prime brokers before deciding whether or not to invest. “In general the process is tougher, and we expect it to get worse,” Shalaby says.  Research providers, especially expert networks, are also becoming part of the due diligence process.

“[Hedge funds] kind of have to behave as if they were regulated, because their clients are,” said Ross Ellis, a vice president at SEI.  More regulation among hedge funds implies more scrutiny of the research providers they utilize.