Executive Summary
Global hedge fund assets under management will reach an all-time high at an estimated $2.2 trillionin 2011 due to stronger inflows and better market performance. Yet equity funds continue to struggle with challenges of uncertain equity volumes, market fragmentation, and restricted commission wallets.Sluggish trading activity is reflected in the gross equity commission revenues and the continued downward pressure on commissions makes it even harder to pay for all of the the services needed.

In addition torestricted commission wallets, many hedge funds expect to reduce their broker lists in 2011. Model-driven funds are eliminating brokers with archaic technology or ones that lack ideas; idea-driven funds are using commission sharing agreements (CSAs) to pay tertiary brokers. Across the board,hedge funds are shortening broker lists and concentrating activity around their core brokers.

Brokers need to concentrate on retaining larger clients and need to find new ways to steal each others’ flow.To increase revenues in a declining market, rather than grow organically, brokers will need toentice market share away from each other. But while many products and services are being incrementally improved, only a few brokers are breaking the execution mold. Performance is still king, and proven products to help trade blocks, sniff out liquidity in small caps or access unique pools of liquidity stand the best chance of winning order flow.

Commoditization keeps the incumbent brokers on their toes, yet it equally makes well-performing brokers very hard to displace. Althoughholistic relationshipsare becoming more important, research, ideas and prime brokerage are the key drivers for allocation of order flow.A strong prime relationship can cause a hedge fund to spend more of its commission dollars with that firm, highlighted by the high percentage of equity commission dollars that are paid to prime brokers. As hedge funds look to concentrate partners further, prime brokers will be an important part of this decision.

Longer term, elusive opportunities in the US equity markets are creating pressures to expand investment strategies; overseas markets and new asset classes offer opportunities for brokers to provide new e-trading services.Although only some hedge funds will expand beyond US equities, new regulations are being closely watched as they risk changing both investment and trading behaviors.

US Hedge Fund Trading 2011: The Challenge Is the Opportunity
For this year’s buy-side trading study, TABB Group spoke with 45 individual US-based hedge fund companies, including many of the largest hedge funds running US equity strategies.The firms participating in this study manage an aggregate $107 billion in assets, or 5.6% of the industry total. Conversations covered the views of head traders on a wide range of topics: commission rates and trends; broker lists; order flow allocation across high- and low-touch trading venues; commission allocation drivers and splits to core and prime brokers; leading brokers and prime brokers; block trading; investment in new countries and assets; and views on what it will take to win their order flow.