The trading relationship between the buy-side and the sell-side continues to change due to more accessible liquidity, increased technology advances and shrinking commission pools to go around.

As new hedge funds crop up, their need for a global, multi-asset broker becomes greater, and, as a result, the services provided by their brokers is becoming more sophisticated and complex, according to a report, "Institutional Equity Trading in America in 2006: The Return on Relationship," by the TABB Group of Westborough, Mass. The financial market research firm interviewed 61 head traders at traditional asset management firms with aggregate assets of nearly $10 trillion.

The bond between buy-side traders and sell-side traders has changed as increased regulatory scrutiny and a shrinking commission pool has made it difficult for brokers to know their clients and inspire loyalty, the report states.

While mutual fund growth has been impressive and firms continue to bring in new assets, hedge fund flows continue to increase steadily. Hedge funds are capturing more assets as investors are taking risks and seeking a diversified cash model. Pension plans, foundations and endowments are starting to pour assets into hedge funds.

More than half of traditional long-only managers have developed hedge fund products, and 17% of participants that have not launched a hedge fund plan to do so by 2008. "The question in the coming years will be, does it make sense to still segment the two markets?" said Andy Sussman, senior analyst and author of the report, during a web seminar last week.

A more useful way to segment investment managers could be long only versus long/short, broad-based versus narrow sector or region, fundamental versus quantitative and alpha seekers versus beta enhancers, Sussman explained.

Firms are under pressure to better manage commission dollars, and the pressure has increased over last year, Sussman continued. With soft dollar regulations, there are much tighter regulations on what firms can acquire with commission dollars, and there has been more transparency in the whole process.

Commission recapture-which essentially unbundles commissions from total execution costs, returning a portion of the commission back to the pension or investment fund-will continue to dwindle over the next few years. Sixty-four percent of participants are subject to commission-recapture agreements, but it is trending down as traders begin to feel it is in conflict with best execution, Sussman said.

More than 20% of buy-side funds saw a decrease in commission-recapture business in the past year. "Commission recapture will be the first thing to change, especially because the buy-side and the sell-side agree on the matter," Sussman commented. In the U.S, institutional cash equity commission revenues will decrease by approximately $1.7 billion, or 6%, by 2009, TABB Group forecasts

Broker relationships will change over the next two years as investment managers will look to cut back on the number of brokerages they use in order to allocate commission dollars to their most valued providers.

Investment managers usually segment their brokers into tiers, with the core group receiving the bulk of commissions. The selection process for core brokers is crucial to the success of a fund, especially those launching new vehicles, according to the report.

Brokers that provide the most value with the least commoditized services, such as innovative ideas and certainty of execution, will continue to do well in the market. The buy-side prefers full-service brokers, and the top three brokers by commissions that participants cited were Lehman Brothers, 42%, Goldman Sachs, 33%, and Merrill Lynch, 29%.

At the same time, more buy-side firms are embracing electronic trading. "The job of a trader has been and always will be to find liquidity," Sussman explained. In the past year, 24% of participants stated that they have added electronic trading to their platform, as it is easier, cheaper and can help find liquidity. Forty-six percent of participants said finding liquidity is a driving trend in the industry.

Buy-side firms believe that internal and external crossing networks are the best mechanism to find liquidity because they reduce market impact, exchange fees and execution costs, according to TABB Group.

"Buy-side traders are challenged with balancing the line between fiduciaries, regulation and internal needs," said Sussman. "The buy-side is being pushed in conflicting directions. There is the search for alpha versus commission management and regulation."

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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