The institutional foray into hedge fund strategies is changing the way they invest. In turn, the hedge fund industry is being shaped by this now dominant investor base, writes SIMON MUMME.

Just two years ago, scathing accusations were hurled at hedge funds. Many of the strategies are correlated with public markets, investors complained. They use too much leverage, impose lockups that don’t match the liquidity of underlying assets and are unresponsive to investors’ requests for greater transparency. For all of this, too, investors pay fortunes in fees. As about $600 billion drained from the industry, underperforming managers or those with insufficient scale went out of business. Stronger managers endured tough times, such as the final quarter of 2008, when about US$150 billion in redemptions requests were made. Cambridge Associates, an asset consultant, describes this as the “emotional nadir” for the hedge fund industry during the crisis, in which its aggregate funds under management (FUM) fell 30 per cent to US$1.3 trillion, and the number of managers dropped 11 per cent to 8,923.

But two years later, in the final quarter of 2010, hedge funds netted US$150 billion in new commitments, according to Hedge Fund Research, and many of the managers who survived 2008 and 2009 have regained or grown their market share. Cambridge says the industry’s total FUM has returned to its pre-crisis peak of US$1.9 trillion. Its poor fortunes have clearly reversed. The industry is, however, in the grip of fundamental change. Its funding base is now dominated by institutional investors, whose demands for more nuanced strategies, greater transparency and risk controls, and better fee and liquidity terms make the traditional hedge fund investor, high-net-worth individuals, seem low-maintenance. Since the crisis, it’s become apparent that institutions are using hedge fund strategies in smarter ways.

David Saunders, co-founder of K2 Advisors, the hedge fundof- funds (hedge FoF) based in Connecticut, says these investors “have a clear picture in their mind of what they want their portfolio of hedge funds to do in their asset mix”. Saunders, who will give the keynote address at the 2011 Annual Alternatives Conference in September, which is presented by Investment Magazine, says the concept of an alternatives ‘bucket’ is becoming passé: “Hedge funds invest in everything within the typical capital structure and across asset allocation bands”. As a result, the strategies are becoming “ingrained” in asset allocation modelling. Some investors ask for long-volatility programs to hedge their exposures to the equity risk premium, he says. Others want active overlays to protect their portfolios or to exploit short-term inefficiencies in particular sectors. These are far cries from the role that hedge FoFs still performed a decade ago: providing access to portfolios of selected hedge funds. When K2 Advisors launched in 1994, it served as a guide for primarily high-net-worth investors seeking access to its portfolio of chosen hedge funds. But in 2001, as its client base became increasingly institutionalised, it reached a turning point for its business: a client asked the firm to build a customised hedge fund program from environmental, sustainability and governance strategies. Similar requests came, and the trend to customisation among K2’s clients began.

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