Hedge funds now rank as the most important clients of many major equity brokerage houses and some firms might be generating as much as half of total revenues from hedge funds, suggests new research from Greenwich Associates.

Greenwich Associates gathered data from more than 250 institutions on how much they had paid in U.S. equity brokerage commissions during the 12-month period ending February 2006. The 44 hedge funds included in this group that reported commissions accounted for 22% of the total.

“As impressive as it sounds, that share probably understates hedge funds’ actual role in the U.S. equity business,” says Greenwich Associates consultant Jay Bennett. “Greenwich concentrates its research on the largest and most actively trading hedge funds in the U.S. and other markets, meaning that there is a significant pool of brokerage commissions paid by other hedge funds with smaller annual trading volumes or assets under management. Based on our research results and conversations with major brokers, we estimate that hedge funds could now account for as much as 30% of brokers’ U.S. equity commission flow.”

Commission payments represent only a portion of the revenues that hedge funds produce for brokers, the firm noted. Prime brokerage is becoming a bigger part of the business for almost all the major brokers. Besides the prime brokerage business, hedge funds generate considerable revenues in stock lending, swaps, structured products and other non-commission business. “When you take prime brokerage and these other products into account, hedge funds are the single most important client segment for some of the major brokerage houses,” says Greenwich Associates consultant John Colon.

During the 12-month period covered in the Greenwich study, the typical hedge fund paid $35 million in U.S. equity brokerage commissions while larger hedge funds managing over $3 billion in assets under management averaged $54 million, it reported. This compares to $20 million generated by the typical long-only investment manager, an average of $52 million by mutual funds, $11 million by pension funds and $16-$17 million by banks, it added.

Greenwich Associates consultant John Feng explains that hedge funds have a basic difference in philosophy compared with other types of institutions. “Long-only funds are increasingly focused on trading costs due to bottom-line and best execution concerns brought on by regulators, while hedge funds emphasize overall performance,” he points out. “Because trading costs have an impact on performance, hedge funds are careful in managing commission rates and monitoring their costs for research and other sell-side services. But in the end, if hedge funds feel that they are getting adequate bang for their buck from brokers, they will concentrate more on the value they derive from their brokerage relationships and less on driving down costs.”

This difference in philosophy is having some profound effects on the equity brokerage business, Greenwich says. “For brokers, falling commission rates and the increasing use of low-cost electronic trading systems are cutting into the profitability of cash equity trading franchises. At the same time, brokers are still trying to find the correct strategy for their research departments, which can no longer be supported by investment banking revenues. As a result, they are increasingly viewed as P&L cost centers,” it says.

“In a sense, the shrinking margins in cash equity trading have created something of an auction for broker sales coverage, research and other services,” says Bennett. “The clients that generate profits for brokers get the resources, while those that are unprofitable or even less profitable get scaled back. In this competition, hedge funds are winning hands down.”

Greenwich Associates hedge fund specialist Karan Sampson concludes: “At hedge funds… the trading desks are smaller, and the traders generally have the authority — and the large, consistent trading volumes — to allocate trades almost on the spot in order to reward brokers that provide high quality research. It seems ironic, but when it comes to the competition for broker services, hedge funds’ primary advantage might well be their transparency.”