Hedge Fund Outlook

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A key factor in our relatively sanguine outlook for independent research in 2012 is the state of the hedge fund industry.  If hedge funds languish, it is unlikely the research industry will flourish since hedge funds are large consumers of investment research.

2011 Performance and Assets

2011 was a challenging year for hedge fund performance, with the industry posting its second largest annual loss (the largest being -20% in 2008).  Hedge funds on average lost 5% in 2011, according to Hedge Fund Research (HFR).  Eurekahedge Hedge Fund Index declined 4 percent last year, according to preliminary data.  Overall, 40 percent of investors saw lower-than-expected returns in 2011, according to a survey conducted by market data provider Prequin.

The second half of 2011 was brutal for hedge funds, with assets under management dropping below $2 trillion, only to rebound as markets recovered in the fourth quarter.  Nevertheless, investors allocated $70 billion of net new capital to hedge funds across all strategies in 2011. Despite disappointing third-quarter performance, the industry saw net outflows of only $127 million in the last three months of the year.

Macro hedge funds had inflows of $7.9 billion in the fourth quarter, the most of any hedge fund strategy. Investors allocated $27.9 billion of net new capital to macro funds in 2011, according to data from Hedge Fund Research.

Equity Hedge Funds

More problematic for the equity research industry, equity hedge funds suffered $8.6 billion in net outflows in the last quarter of 2011 reducing full year inflows to $2.2 billion. The HFRI Equity Hedge Index finished 2011 down 8.25%. According to HFR, 60% of all hedge funds experienced outflows during the fourth quarter.

Large hedge funds continue to receive the bulk of new assets.  Hedge funds with over $5 billion in assets accounted for $50 billion of the total $70 billion in net inflows in 2011, with smaller funds capturing $20 billion.

We were also concerned by reports from commission management professionals at major broker dealers that a large number of hedge funds were closing at the end of the year.   High-profile closures in the U.S. were Arrowhawk Capital Partners, Sursum Capital Management and Goldman Sachs’ Global Alpha.  Asia reportedly saw the most hedge fund closures since the financial crisis first hit in 2008.

Hopeful Surveys

Two recent surveys suggest that investors plan to increase allocations to hedge funds.  Barclays released a report predicting an inflow of $80 billion in new capital to hedge funds globally this year, the most since 2007.   About 56 percent of investors surveyed by Barclays plan to increase hedge fund investments in the coming year, more than seven times the number that plan to reduce their allocations.

Barclays predicted pensions will provide about half the net inflows this year, followed by $20bn from private banks and their clients, $8bn from insurers, and $6bn from endowments and foundations, and family offices.  The survey included 165 investors who, in the third quarter of 2011, had about $500bn invested in hedge funds.

Meanwhile a survey from SEI showed nearly four out of 10 institutional investors investing in hedge funds intend to increase their allocations to hedge funds this year.

Barclays predicts that smaller hedge funds will get funding this year.  According to their report, investors will increasingly invest in hedge funds with less than $1 billion of assets this year, Barclays said.  Smaller funds already doubled their share of the net industry inflows to 18 percent last year over 2010, it said.

Merlin Securities sees more interest developing in equity hedge funds.  “Event-driven and global long/short are two strategies where we’re seeing new assets flowing for the first quarter of 2012,” says Ron Suber, the head of global sales and marketing at hedge fund brokerage Merlin Securities.

Barclays is less sanguine.  “Equity hedge funds should prepare to fight for reallocated flows, as they are likely to see $100bn of reallocations but close to zero in new flows. We expect a ‘shakeout’ in the equities space as many investors will use 2011 performance to separate ‘winners’ from ‘losers’,” the bank said.

More Regulation

The increased institutional interest in hedge funds will also result in more regulation.  For one thing, institutional investors conduct extensive due diligence of hedge funds.  The process of identifying, evaluating and then investing in a hedge fund will easily range between six and nine months, according to Sameer Shalaby, the president of buy-side technology provider Paladyne Systems.

During that period, Shalaby says, investors will be looking into a hedge funds’ performance, technology, trading platforms and the quality of its leadership. They’ll also investigate a firm’s accountants, lawyers, fund administrators and prime brokers before deciding whether or not to invest. “In general the process is tougher, and we expect it to get worse,” Shalaby says.  Research providers, especially expert networks, are also becoming part of the due diligence process.

“[Hedge funds] kind of have to behave as if they were regulated, because their clients are,” said Ross Ellis, a vice president at SEI.  More regulation among hedge funds implies more scrutiny of the research providers they utilize.

 

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