Three of Wall Street's biggest investment banks - Morgan Stanley Dean Witter, Bear Stearns and Goldman Sachs - have cornered 70 per cent of the market in providing financing, research and administrative services to hedge funds, giving them the edge in offering access to hedge funds to private clients within their private banking divisions. The findings are based on research collated by HedgeWorld from 998 hedge fund managers who between them handle approximately $100bn in funds. These banks, in other words, are offering prime brokerage services to the hedge funds and also helping to set funds up. The survey sample was drawn from the investment research database at TASS, the on-line database of hedge fund performance which HedgeWorld distributes, and ranges over a quarter of the industry's assets.

The value of this dominance on the prime brokerage side is considerable for the private banks of the three firms. As demand continues to escalate to allocate into alternative investment, the constant threat remains the inability of banks to source the approrpriate investment strategy. Being near the centre of information flows enahnces the hedge fund service which they can offer to private clients. The maximum amount of access to hedge fund managers is very important for banks that want to recommend hedge funds to private clients and monitor them. The role of prime broker enables the institutions to have the best opportunity to examine and undertake due diligence on the black box strategy of the fund manager and ensure it is ideal for their client base.

Matthew Sola of HedgeWorld told Complinet that the brokers profited as much as the private banks from the relationship. “Hedge funds have been growing in number as investors seek returns that aren't correlated to stock and bond markets. People think of them as volatile, but in the first quarter of this year they were less volatile than the markets.”

Sola confirmed that the relationship between service provider and fund manager is key, but it can also give the bank advance warnings of troubles ahead. “These guys live and die by the markets. They, too, want to stay with the flow of information and the big banks are attractive to them for two reasons. Firstly, if you are at the trading desk of Goldman Sachs you stand as much chance of finding out what’s going on in the markets as anybody else. Secondly, the big players can do due diligence. For example, when the case blew up at Manhattan Capital Management a year ago, it was a prime banker at Bear Stearns who smelt a rat and blew the whistle by contacting the Securities and Exchange Commission.

Figures from the survey confirm these last remarks: the CSFB/Tremont Hedge Fund Index was flat for the first quarter, compared with a 12 per cent decline in the Standard & Poor's 500 Index and a 14 per cent decline in the MSCI World Index. Meanwhile, TASS estimates that investors committed $8bn in new capital to hedge funds last year.

Although the hedge fund prime broker business is clearly concentrated among the three brokerage houses, the market is hardly an oligopoly. Competition is fierce and there are still opportunities for niche players. Morgan Stanley is the most popular broker for both the largest funds in the HedgeWorld survey - those with more than $1bn in assets - and the smallest, with less than $10m. Morgan Stanley also topped the list of brokers for hedge fund managers who pursue a long/short equity strategy, which involves balancing investments in certain stocks against bets that other stocks will fall, and the global macro strategy, which takes big directional bets on interest-rate and exchange-rate movements.

Bear Stearns scored best with managers who specialise in convertible arbitrage, which involves buying a convertible bond and selling short the common stock of the same company, and in fixed-income strategies. ED&F Man Group is the most popular broker for managed futures, while equity managers who bet exclusively on declines in share prices singled out ABN AMRO as their favourite.