When the big banks exit a market niche, it turns out small, entrepreneurial hedge funds have been filling the gap with interesting results.

Big Banks

Big banks cutting risky trading operations

As the big banks cut back on their risky trading operations – that are likely to become more risky now that markets are allowed to be so easily manipulated – they are also cutting research on small and mid-sized firms, known as small cap stocks.

A Reuters report points out that 4 in 10 European stocks covered by bank analysts are now without coverage as a result of bank employee cut backs.  The report, citing Reuters calculations, says that Europe’s 30 largest banks have slashed 80,000 jobs in 2013 alone.

The cut in big banks research has created opportunity for entrepreneurial hedge funds to play a common market role: when market inefficiency occurs due to the lack of information, there is an arbitrage play afoot.

While the example of Gotham City Research, which has initiated scathing activist short attacks on firms such as Quindell PLC (LON:QPP) (OTCMKTS:QUPPF) and LET’S GOWEX SA (BME:GOW) (OTCMKTS:LGWXY), centered on criminal fraud charges, big banks research typically didn’t dive in this deep. Its research was mostly used by larger hedge funds and focused on more traditional issues, leaving fraud detection mostly to the more aggressive activist investors.

With the absence of traditional bank research, however, other hedge funds are finding opportunity.

Big banks research to be replaced by hedge funds

“If it’s shrinking, that research is going to be replaced by independent research firms and hedge funds, which are doing their own deep dive and explicitly investing behind their ideas,” Soren Aandahl, head of research at activist investor Glaucus, was quoted in the Reuters article saying.

In an era of 24/7 business “news” coverage, is there actually less trade-able information?  The article noted there is less analysis and this has resulted in strong investment ideas going undiscovered, which is the thesis of investment opportunity.

What is happening as a result of less bank coverage is the need for entrepreneurial forces in research to enter the fray, those who question the establishment and dig below the surface for a story that has trading value.

The move by banks out of areas where markets are documented to have been manipulated has created a new business model dynamic for a variety of organizations, not just traders.