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Introducing KUBS Faculty Publication | Prime Broker and Hedge Fund – Professor Ji-Woong Chung
What Effect Does Prime Broker Have on the Hedge Fund?
What Effect Does Prime Broker Have on the Hedge Fund?
A joint research paper titled “Prime Broker-Level Co-movement in Hedge Fund Returns: Information or Contagion?,” by Professor Ji-Woong Chung at Korea University Business School (KUBS) and Professor Byoung Uk Kang at Hong Kong Polytechnic University, is published on the Review of Financial Studies.
Prime broker is an indispensable financial intermediary in the hedge fund industry. Compared to regular brokers who simply make orders for clients, prime brokers provide a variety of services such as securities lending, financing, clearing and management/settlement, risk management to hedge fund clients. The relationship between the prime broker and hedge fund is often compared to marriage, and it would not be an overstatement to say that hedge fund operation is impossible without prime brokers. After the legalization of hedge funds in the mid-2000s, business circles and supervisory authorities in Korea have been putting much effort to develop the prime broker industry.
In this research, the research team analyzed how the prime brokers affect the investment behavior of their hedge fund clients. On the first half of the paper, they documented strong co-movement in the returns of hedge funds sharing the same prime broker and later investigated which attributions of the funds and prime brokers underlie this co-movement of returns.
The research team tested various hypotheses on the causes of the return co-movement. Among those, the common information hypothesis where the co-movements were the results of the common investment information provided by the same prime broker is supported the most. Prime brokers find information about various investment opportunities through in-house research or using their network, and share them to their client hedge funds. These industry practices seem driving the return co-movements among client hedge funds. Also, funds with stronger co-movements show higher returns. However, the authors cannot observe how the information is created, acquired, and shared, so the research team does not know if this information is legally acquired. The return co-movement can also be driven by the fact the prime brokers expose their clients to “the common risk.” During the early phase of the financial crisis, Lehman Brothers went under bankruptcy, and simultaneously, many of its hedge fund clients also experienced unusually high rate of failures. This “contagion” has happened because Lehman Brothers could not finance their clients properly, client hedge funds had to fire-sell their assets and suffered huge losses. However, the study shows that this contagion story is not the main cause behind the return co-movement especially during non-crisis periods.
The results of this study also have important policy implications. For the purpose of monitoring systemic risk and illegal investment practices in the hedge fund industry, it seems helpful for regulators to cooperate with prime brokers.
In this research, the research team analyzed how the prime brokers affect the investment behavior of their hedge fund clients. On the first half of the paper, they documented strong co-movement in the returns of hedge funds sharing the same prime broker and later investigated which attributions of the funds and prime brokers underlie this co-movement of returns.
The research team tested various hypotheses on the causes of the return co-movement. Among those, the common information hypothesis where the co-movements were the results of the common investment information provided by the same prime broker is supported the most. Prime brokers find information about various investment opportunities through in-house research or using their network, and share them to their client hedge funds. These industry practices seem driving the return co-movements among client hedge funds. Also, funds with stronger co-movements show higher returns. However, the authors cannot observe how the information is created, acquired, and shared, so the research team does not know if this information is legally acquired. The return co-movement can also be driven by the fact the prime brokers expose their clients to “the common risk.” During the early phase of the financial crisis, Lehman Brothers went under bankruptcy, and simultaneously, many of its hedge fund clients also experienced unusually high rate of failures. This “contagion” has happened because Lehman Brothers could not finance their clients properly, client hedge funds had to fire-sell their assets and suffered huge losses. However, the study shows that this contagion story is not the main cause behind the return co-movement especially during non-crisis periods.
The results of this study also have important policy implications. For the purpose of monitoring systemic risk and illegal investment practices in the hedge fund industry, it seems helpful for regulators to cooperate with prime brokers.