Investors Shift Search Pattern from Top-Down to Bottom-Up
One of the major themes presented in BHA’s Quarterly Research Report for the second quarter of 2010 was investors increasing demand for liquidity. This demand has continued in the third quarter since market uncertainty is still prevalent. During the first six weeks, 88 percent of hedge fund investors and 85 percent of funds of hedge funds investors sought monthly or quarterly redemption periods. Many of these investors also avoided funds with lock-ups.
This trend is not too surprising given market conditions. However, what is remarkable is that liquidity concerns have affected how investors conduct fund manager searches. In discussions with investors, it has become apparent that they are increasingly using a bottom-up approach in their searches.
Typically investors’ first criterion is fund strategy. Then they determine which managers meet their other requirements, such as the amount of assets under management and liquidity terms. This is the standard top-down approach.
Being able to easily pull money out of funds has become so great a concern, however, that this process is being reversed. Many investors are now using liquidity requirements as their first filter and then moving onto strategy.
This bottom-up approach is causing investors to be more open to more strategies. Filtering first for very liquid funds often greatly decreases the number of potential funds. To have a wider selection of funds to evaluate, investors are considering strategies they would not have in the past.
An example of this shift is a fund of funds based in London. In 2009, the firm was searching for a few strategy-specific hedge funds. At the time, it noted it was not concerned with liquidity terms. In recent conversations with this firm, it stated that it has shifted to a bottom-up approach. Its main focus is liquidity, so it first filters for funds providing quarterly liquidity or better, then moves onto evaluating the managers, and finally considers the strategies of the remaining funds.
In evaluating the strategies, the firm no longer has a few specific ones in mind. Rather, the new bottom-up approach has caused this firm to look at a wider range of fund strategies that fit under a nondirectional umbrella.
Many other investors seem to have followed suit, stating to BHA analysts that they are primarily focused on finding very liquid funds and are open to a wide range of fund strategies.
Thus, we can see that there has been a ripple effect. Poor returns have caused investors to demand better liquidity terms from fund managers. However, the difficulty of finding such funds is causing investors to shift to a bottom-up approach, with liquidity as the first filter in their research process. However, this approach decreases the number of potential funds with a specific strategy. To remedy this, investors are broadening their strategy search.
As a result, there is an opportunity for some fund managers that provide good liquidity terms. Investors that may not have looked at their funds in the past may be more receptive because of this shift in priorities. At the same time, funds that have longer redemption periods may want to restructure their liquidity terms to remain attractive to investors.