Zack Miller's  Instablog

Success in the markets comes from knowing what and whom to follow.  As Professor Seyhun proved in his research on insider trading, investors would do well to follow the buys and sells of corporate insiders, especially high ranking executives.   Wall Street essentially does the same.  Given the intricate, interconnected web of broker/dealer relationships, client feedback, and prop desk perspective, vertically integrated Wall Street firms have a clear view into where the business is headed.

For investors and industry analysts, hiring trends of Wall Street firms should be top of mind to get a feel for where the smart money is headed.  Today’s WSJ article, Wall Street’s Key Hirings, takes a look at who is hiring and where.

Those firms who picked up key hedge fund prime brokerage business during last year’s downturn are turning their sites to do more of the same in 2010 and are hiring key executives to make attracting new business a reality.  Prime brokerage continues to heat up.  We wrote about 4 new entrants in the hotly contested biz last week.

For example, DB has hired two new heads for its Asian prime brokerage business as the firm expects to double headcount to continue wooing Asian hedge fund business.

“We’re going to see a significant flow of startups and spinoffs. We feel like that has hit the bottom and is going to trickle back up, but we don’t really see the acceleration yet,” said Jonathan Hitchon, Deutsche Bank’s co-head of global prime finance.

Beyond custodial, reconciliation and stock lending, brokers provide a suite of profitable services to hedge funds ranging from electronic trading platforms to the writing of complex derivative contracts.

It’s interesting to see that in a post-2008/2009 world, top hedge fund employees are actually migrating back to previous posts inside investment banks.  As much of the asset base of the hedge fund bubble has been lost or flowed elsewhere, many second lieutenants may find the upside more compelling back on Wall Street and not in Stamford.

The competition for assets in brokerage and investment advisory hasn’t been lost on prime brokers. In New Kids on the Prime-Brokerage Block on the WSJ, reporter Jenny Strasburg does a good job describing how new players in prime brokerage are challenging the old guard.

Strasburg specifically cites 4 newish entrants into the prime-brokerage pool:

1. Cantor Fitzgerald
2. FBR
3. Jefferies and Co.
4. Merlin Securities

These new entrants are all looking to take advantage of the carnage that occured during 2008 and early in 2009.

With the meltdown that took place last year, we saw an opportunity,” said Christopher Nealon, managing director in the institutional brokerage at FBR.

This news follows on the heels of an announcement by JPMorgan Chase last week of a combined service offering from Bear Stearns.  After purchasing Bear Stearns last year, JPM has been working to combine their own prime brokerage service with that of Bear’s.  Together, the new service offers a power-packed combinating of brokerage and custody.

In an interview with Financial Planning, the new head of this combined unit, Devon George-Eghdam, said of the offering:

“One of the major catalysts of the acquisition was Bear’s equity prime brokerage offering.”  JPMorgan Chase did not know that it would create this platform when it bought Bear Stearns, George-Eghdami said. “It was an evolution,” she said.

“When we bought Bear Stearns in the spring, it took us some time to digest this purchase. By the fall, there was a real focus developing on segregating custody accounts. That was when it became important to hedge funds to have specific, segregated custody accounts associated with a strong custody bank.”

To compete against the big-boys like Goldman Sachs and JPMorgan Chase, these smaller players are targeting the assets of smaller asset managers.  Many of these are hedge funds with under $300 million in assets.

While competitive on fees, these smaller clients are still feeling the pinch as they do pay more for these services than their larger competitors.

What this means is that combined with increased regulation and scrutiny, these higher fees make it harder for smaller asset managers to run profitable businesses.  Look for more consolidation — at prime brokers and hedge funds — in the near future.

Check out the whole WSJ article here.

Regulators have their sights set on restructuring the market for leveraged, inverse(short) and commodity ETFs.  Increased scrutiny for these index shorts and leveraged bets have the ETF industry running for cover and it’s already impacting existing shares in common ETFs tracking commodities and sectors, like Oil and Financials.  Advisers commonly use these products for hedging or sector themes and were spooked earlier this week when Deutsche Bank’s Power Shares announced it was shuttering the PowerShares DB Crude Oil Double Long Exchange Traded Note, an exchange traded note (ETN) tracking 2x the change in oil prices.  Here’s what’s going and what you need to know.

• 6/2009: FINRA issues a notice reminding firms and brokers that “recommendations to customers must be suitable and based on a full understanding of the terms and features of the product recommended; sales materials related to leveraged and inverse ETFs must be fair and accurate; and firms must
  have adequate supervisory procedures in place to ensure that these obligations are met.”
• 8/18/09: Finra issues an investor alert entitled: Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors specifically aimed at warning retail investors of the risks associated with investing in leveraged and inverse index securities.
• 8/19/2009: The U.S. Commodity Futures Trading Commission (CFTC) said that it withdrew exemptions it had granted two Deutsche Bank commodity ETFs years ago on speculative limits on corn and wheat contracts setting up as it commits to investigating speculation in the commodities market via exchange traded securities.
• 8/27/2009: UBS joins Edward Jones as brokerage firms restrict sales of leveraged and inverse ETF products.
• 8/28/2009: Barclays Global Investors (BGI), owner of the largest family of ETFs, iShares, announces it will no longer create new shares in its iShares S&P GSCI Commodity-Indexed Trust (GSG), citing troubles
• 9/1/09: Finra expands margin requirements for accounts holding leveraged and/or inverse ETF products to be enacted December 1, 2009.  Finra spokesman explains, “[Investors] are buying a leveraged ETF, then taking on additional leverage through a margin account. We felt it needed to be addressed.”  Margin requirements were previously set at 25% and are set to double for 2x funds and triple for 3x funds, yet won’t meet 100% of the security’s market value.
• 9/3/09: A variety of class action lawsuits launched against ETF fund family, Proshares, and its Ultra Short products, ETFs including the UltraShort Oil and Gas (DUG) and Ultra Oil and Gas Funds (DIG), as well as the UltraShort Financials (SKF) and Ultra Financials (UYG), in which investors have suffered substantial losses.
• 9/4/2009: Invesco’s PowerShares DB Crude Oil Double Long Exchange Traded Note (DXO) announces that it will redeem all outstanding shares of the ETN.

What’s happening

Premium/Discount for UNG from ETFConnect.com

In the wake of all this, many inverse and leveraged funds have stopped issuing new shares. Consequently, many of these funds have begun to trade a huge premiums over NAV as investors, aware or unaware of what is underway, continue to bid them up.  One fund, the DXO referenced above, is closing completely and retuning money to investors amidst rising inability to effectively track their index.

See what’s happening to one of the most popular commodity ETFs, the United States Natural Gas Fund (UNG).  It’s premium over NAV has exploded in September.

Advisers need to be aware of what’s occurring in this environment and adjust accordingly.  Everything is game right now: commodity ETFs, leveraged ETFs and inverse ETFs.  Here’s a short summary of some of the fund families and tickers that may be affected:

Commodity ETFs: See SeekingAlpha’s list of commodity ETFs and ETNs to determine if you or your clients own any of these products.

Leveraged ETFs: Ditto on the leveraged market cap ETFs, leveraged growth/value ETFs, and leveraged sector ETFs.

Inverse ETFs: Look into inverse market cap ETFs, inverse growth/value ETFs and inverse sector ETFs.

Expect some more fund closures and weird skewing of security prices away from NAV.  More brokerage firms will make it harder to sell and buy these securities either directly or through an adviser.  Don’t expect the ETF industry to roll over and go away, though.  A lot of money and time has been committed to these products and a lot more innovative products are in the registration pipeline.  One way that ETFs may escape scrutiny, at least for those that use futures for leverage, is to switch from a daily tracking strategy to a monthly one.  The daily strategy has proven a disaster in most cases as a structural tracking error erodes returns no matter where the underlying assets trade.  Again, outside of the structural flaws of using a daily tracking strategy, these securities are not necessarily the problem.  They’re useful for a lot of things like easy, cheap ways of shorting and leveraging up without requiring clients to sign options papers.  Regulators are throwing everything they’ve got as these securities have become the whipping boys of 2008 investor losses.  Everyone just needs to make sure buyers understand how they work and how leverage affects potential losses.