How to Generate Greater Alpha, Safely

Integrating Capabilities to Support Long and Short Funds via a Single Provider

As institutional investors and asset managers strive to find new ways to maximize returns in an uncertain economic environment, interest in long/short funds has intensified. If structured properly, these funds can provide the trifecta of enhanced returns, asset protection and transparency.

But there's a catch.

While providers of both prime brokerage and custody services have entered the market or expanded their long/short offerings, most are not structured to service clients efficiently and effectively. Nor do they have deep capabilities across the entire long/short portfolio and the investment life cycle. Clients such as asset managers and pension funds, therefore, face compromises that make long/short strategies costly and challenging to maintain, which can distract them from their key objective: generating greater alpha.

"The key is to deliver end-to-end custody, accounting, administration and financing across both longs and shorts, in a structure that also provides protection of assets," says Michael Minikes, Head of J.P. Morgan Clearing Corp., which delivers Prime Broker Services. "This is best achieved through the effective integration of global capabilities across prime brokerage and operational services under a single roof. Otherwise, clients are forced to use multiple providers and will therefore likely face higher financing costs, inefficient use of collateral, and fragmented reporting, operations and service."

So, when it comes to long/short strategies, what are the most important considerations?

Protection of Assets
Many providers are unable to provide clients with adequate levels of asset protection for several reasons. Some lack the structure to segregate the unencumbered cash and securities. As a result, clients often resort to a dual provider approach, splitting responsibility for the unencumbered assets and short positions between two providers. The traditional prime broker model has historically not held clients' unencumbered assets in separate custody accounts, pooling them instead into the brokerage account. Segregating unencumbered assets into a bank depository assures immediate access to those assets in the event of a bankruptcy of a prime broker.

Another important point to consider is the overall soundness of the institution with which clients' assets reside. Hedge funds, for example, typically hold their assets with multiple prime brokers. From an individual client point of view, it is not always transparent where these assets sit or who holds them. Knowing which institution actually holds the assets and the extent to which those assets are protected, and the safety and soundness of that institution, are fundamentally important.

"The best option, from a protection of assets perspective, is to work with a world-class commercial bank that has a robust prime brokerage platform and therefore can effectively service both unencumbered assets held in a segregated custody account and short positions in a brokerage account," explains Minikes. "Even if the institution falters or fails, the structure of holding unencumbered assets in custody accounts provides greater protection of the assets."

Minimizing Costs
When clients split long and short positions between firms, they incur parallel accounting, administration and reporting systems-in a sense, paying twice for similar services. In addition, it becomes the client's responsibility to consolidate the two streams of information and documentation into a single view. The inefficiencies and cost associated with the dual-provider approach have led some asset managers and institutional investors to question long/short strategies altogether.

Using a single firm streamlines the administration and can reduce costs significantly. "This is easier said than done," says Conrad Kozak, Head of J.P. Morgan Worldwide Securities Services. "Most providers do not have the operational and technology infrastructure, let alone expertise or experience, to service both long and short positions end to end."

Also, with collateral potentially sitting away from prime brokers as required, for example, by the Investment Company Act of 1940, financing costs can become expensive. Finding ways to minimize these costs is crucial to the viability of a dual provider strategy. Utilizing a service provider with the appropriate solutions, such as securities lending, is critical.

Improving Transparency
The dual accounting and reporting streams of a two-provider approach also make full consistency and transparency difficult. Fund reporting-including trades, fees, taxes, collateral, margin reports and returns-from two providers challenges clients to set a daily NAV and provide timely and accurate information to investors and regulators.

"The same efficiencies that reduce costs when using a single provider will also increase consistency and transparency," says Kozak. The ability of a single provider to produce a consolidated end-to-end view of both long and short positions means that critical reports and analyses will be more timely and complete, and data quality will be higher.

Streamlined Operations and Service
The dual-provider approach clearly creates inefficiency. But even many single providers lack the operational processes and technology infrastructure necessary for cost-effective, end-to-end accounting, administration and reporting. Common reasons can include inadequate long-term investment in technology, poorly integrated services, and lack of experience and expertise.

Among the challenges these issues create are: slow onboarding, multiple service touch points, and poor coordination and issues resolution on the provider's part. In addition, providers without automated collateral management can be an operational headache to the client, currently burdened with this daily, manual process. An inefficient process could also leave the collateral accounts over- or undercollateralized at any given time. "Providers need integrated technology platforms specifically engineered to support the requirements of both long and short positions," says Sandie O'Connor, Global Head, Financing and Markets Products, J.P. Morgan Worldwide Securities Services. "A well-designed platform will also enable strong end-to-end operational processes. The optimal model includes a single point of contact across long and short positions, reports and information delivered through one platform and tool set, and integrated collateral management."

J.P. Morgan has recently enhanced one of the industry's only consolidated offerings for long/short strategies. The service features automated collateral movements between collateral accounts and unencumbered long custody accounts, reduced financing costs through smart securities lending, a single point of contact for service and consolidated reports for long and short positions available through a single portal.

Clients receive a fully integrated offering based on the capabilities and expertise in J.P. Morgan's Worldwide Securities Services and Investment Bank divisions. Both are leaders in their industries, and key businesses at JPMorgan Chase & Co., one of the most stable and respected financial institutions in the world. Says Kozak, "Our experience is unrivalled: we have delivered integrated long and short capabilities to more than 100 accounts for more than a decade. We apply an integrated, global approach, providing a single set of services, which enables our clients to focus on their primary goal: generating greater alpha, safely."