Since May 1, the VIX, a measure of the volatility of the S&P 500, increased from 20.19 to 33.73—a 67 percent increase in just over one month. With such high volatility, investors are looking for ways to mitigate the inherent market risk present not only in the U.S. but also worldwide. Some investors have turned to short-biased funds, which can capitalize on recent slides in stock markets, while others feel that the path to a successful investment portfolio is through broadly diversified exposure.

During the month of May, BHA analysts gathered 126 mandates for long/short equity funds. In evaluating this data, a telling trend has emerged. In three of the four major regions in which BHA gathers investors’ preferences for country-specific and regionally focused funds, investors overwhelmingly favored regionally focused funds.

In Asia (including Australia), Latin America, and Europe, investors favored funds with a regional focus to those that concentrated on the equity markets of a single nation. In fact, only in North America were investors more interested in a country-specific fund (U.S. focused) than a regionally focused opportunity.

In the Middle East and Africa, BHA does not collect data on country-specific funds so a comparison is not possible here. However, it is worth noting that nearly 10 percent of all long/short equity mandates were for MENA or frontier market funds.

Of the mandates that specified some interest in pan-Asian investments, 56.5 percent were for funds with a broad focus across the region. The remaining 43.5 percent of investors specified an interest in country-specific funds within the region, mainly China, India, and Japan.

In Latin America, a similar trend was evident. 52.6 percent of mandates gathered for the region were interested in funds investing across Central and South America. The remaining 47.4 percent of investors were considering country-specific funds, predominantly funds focused on Brazil.

The comparison was stark when we examined preferences for managers within Europe (including the U.K.). Investors looking for funds in this part of the globe favored those investing across European equity markets 78.9 percent of the time. Only 21.1 percent of investors were interested in country-specific funds, predominantly U.K.-focused managers.

One possible explanation for this overwhelming trend towards regionally focused managers comes from the simple theory of portfolio diversification. With volatility rampant across global markets, many investors fear that funds concentrated on only one country’s stock market are exposing themselves to unnecessary risk.

Other investors may simply believe that country-specific funds are too focused and that the domestic market alone does not provide ample investment opportunity. Such investors would be driven to a regional fund as it can provide (in sheer quantity) more investment choices, as well as more complex arbitrage opportunities as fund managers are able to capitalize on pricing inefficiencies across international markets.

Furthermore, many investors believe that small domestic markets have few genuine shorting opportunities. In such markets, funds often short indexes as opposed to the stock of individual corporations. While this technique may accomplish a similar goal to shorting corporate stocks, many investors prefer funds that can generate alpha due to their unique understanding of individual listings and an ability to stock pick more effectively than their peers.

Whatever investors’ rationale, it is clear that there is a strong preference for long/short equity managers that are focused regionally as opposed to their country-specific counterparts.

The recent news that the European Union will commit, with assistance from the IMF, upwards of $1 trillion to stymie financial panic created by massive public deficits in the PIIGS, most prominently Greece, has helped calm anxious investors. However, couple this fundamental issue in credit markets with a “flash crash” in U.S. equity markets, and investors across the globe have been an unwilling participant on a financial rollercoaster. While this volatility may have some investors lining up at the world’s first gold-vending ATM for what many consider the safest investment in times of high volatility, some money managers are turning to the very markets where volatility is prevalent.1

Emerging markets have historically suffered more than their developed counterparts during economic turmoil. However, many industry professionals believe this dynamic is changing as emerging markets begin to drive global demand. Furthermore, many emerging countries have seen their credit ratings increase, which has attracted more investors worldwide and increased demand for sovereign debt.

Because their financing needs are relatively modest, many of these nations have no need to offer massive quantities of debt to cover public spending. As such, a shortage in the supply of emerging market debt is appearing due to the unmatched increase in demand. Because of these trends, many investors see huge opportunity in the bond markets of emerging economies.2

An example can be seen in the actions of a prevalent London-based hedge fund manager. The firm is shifting the focus of its Special Situations Fund (which returned an impressive 45.3 percent in 2009) to capitalize on the investment opportunities present in emerging market debt.3

However, this firm is not the only investor increasing its focus on emerging market credit; money is pouring into the market at a record pace. Thus far in 2010, $24 billion has flooded the emerging economy debt market. This is already an annual record, but with over half of the year remaining, JPMorgan Chase estimates that this number will top $40 billion before the ball in Times Square drops again.4

Echoing these industry trends, BHA analysts have seen strong demand for emerging market debt funds during the second quarter. Thus far, 46 hedge fund investors have specified an interest in the area. A London-based fund of hedge funds has a specific interest in an Asia-focused credit fund because it feels there is unique opportunity present in the distressed space.

Should volatility persist in public equity and bond markets, it is possible that the trend toward low-yield, emerging market debt will continue for some time.

1 International Business Times, “UAE opens world’s first gold ATM,” May 14, 2010.

2 The Wall Street Journal, “Emerging Markets’ Low Yields Still Find Fans,” May 6, 2010.

3 Financial Times, “Finisterre to shake up special situations fund,” May 16, 2010.

4 The Wall Street Journal,” “Emerging Markets’ Low Yields Still Find Fans,” May 6, 2010.

By some estimates, almost $1 trillion of high-yield debt and leveraged loans will mature and need refinancing between 2012 and 2015. Distressed and special situations funds will be able to help fill this need by injecting necessary funding into capital hungry firms. In a report on its outlook for the 2010 private equity market, a prominent asset manager proclaimed: “Distressed situations, with a focus on the U.S. and Europe, should continue to be available throughout the economic recovery given (i) the ongoing difficult operating environment, characterized by depressed demand, low capacity utilization and restricted pricing power; (ii) negative pressure on recovery from relatively high unemployment and ongoing issues in the real estate market; (iii) historically high default rates; and (iv) a looming non-investment grade debt refinancing overhang.”1

Distressed and special situations investment firms often get a bad rap for preying on the weak and feeble. However, by investing in companies facing bankruptcy or other serious financial strains, these firms can help support job retention, or at least slow job loss, at a time when unemployment is at its highest levels since 1982-1983. In fact, before the current economic downturn, unemployment of at least 9 percent has happened only twice in the U.S. since World War II: May 1975 and from March 1982 to September 1983. Today, unemployment stands at 9.7 percent and has been more than 9 percent since May 2009.2

Combing through the countless firms in financial peril is the first step in the process of identifying a viable investment with a sustainable business model. As one industry professional said at a Harvard Business School Private Equity conference, “the key to [distressed private equity investing] is determining between the train wrecks and the company that is just underachieving but has lots of potential.”3

With so many companies currently unable to finance day-to-day activities and operate efficiently, there are many firms which fall into the “underachiever” category. If these businesses do not receive financing of some kind, they will file for bankruptcy or close their doors. This is where the distressed and/or special situations investor enters the picture. By providing long-term plans and necessary capital to promising firms, distressed funds infuse stability and help retain jobs.

BHA analysts have seen a sizable increase in demand for distressed funds in the past months. During the fourth quarter when unemployment was at or slightly above 10 percent for three consecutive months, 44.5 percent of all private equity leads were for distressed or special situations funds. In the first six weeks of the first quarter, that number jumped to 47.4 percent. Finally, during the week of February 15, 50 percent of all private equity leads were for distressed or special situations funds. It is clear that private equity investors are increasingly turning to this type of fund to fulfill their private equity commitments. This is due to the vast opportunity within this investment realm.

Many critics believe that distressed and special situations funds are poachers that invest in promising businesses when they are most vulnerable and are at the mercy of their creditors. However, to those critics one can say, What would happen if these funds never made the investment? Most likely, the companies would continue to struggle until they shut down or filed for bankruptcy, neither of which are desirable outcomes.

Rather, with commitments from distressed and special situations funds, these companies are able to keep doing business and retain jobs in a time when every job counts. Furthermore, because these businesses are not closing their doors today, they provide added potential for economic output in the future.

In a time of widespread economic uncertainty, it seems these occasionally mislabeled villains should be lauded. Whether or not distressed and special situations funds get the appreciation they deserve, however, look for these funds to retain investor interest throughout 2010.

1 PEHub.com, NB Alternative Advisers, “2010 Private Equity Outlook,” January 2010.

2 U.S. Department of Labor, Bureau of Labor Statistics, “Unemployment Rate (Seasonally Adjusted.”

3 Harvard Business School Working Knowledge, “Distressed Private Equity: Spinning Hay into Gold,” February 16, 2004.

BHA estimates that there are about 10,000 hedge funds in the world. Of those, there are thousands that fall into the emerging manager category: funds that have a track record of less than two years or less than $100 million under management. The question for many of these emerging managers is, How do I get to the point where I am no longer considered ”emerging” and can legitimately market my fund to institutional investors? The short answer to that question is, raise $100 million and run a profitable business for at least three years. But, there are other bridges to cross in order to be able to effectively market to institutional investors.

Building a solid infrastructure around the fund’s management team is extremely important. Institutional managers almost never invest in a fund run by a few brilliant traders and a Bloomberg terminal, regardless of the fund’s AUM, performance, and track record. These types of investors need to see strong risk management capabilities and individuals dedicated to handling investors’ needs, among countless other compliance and operational officers.

This is even truer today after the meltdown of 2007-2008. During that period many firms’ invested assets plummeted in value by 20 to 25 percent. Therefore, institutions need to feel comfortable with a fund before making an investment. Having the confidence and trust of any investor is the path to an investment.

The first place most fledgling fund managers turn to raise capital is their personal and professional networks. Here, the relationships have already been built. All a manager needs to do is convince these friends, family members, former colleagues, and business acquaintances that he has a good, profitable product. Once this network has been exhausted, however, the fund manager has to begin tapping new resources to find investors. Sadly enough, the days of sitting back and waiting for an onslaught of investors clamoring to give you their hard-earned dollars is long gone (especially for emerging managers). Managers looking to raise capital need to engage in outbound marketing.

Established managers with a significant revenue flow from management fees often look to capital introduction services or third-party marketers for outbound marketing support. However, these options often come with large price tags or an asset sharing structure that is less than ideal for a fund that needs to keep every dollar it raises in pursuit of the illustrious $100 million mark.

Other managers may turn to a service like BHA’s that is more affordable and doesn’t take a cut of allocations gathered. However, for emerging managers still building their internal infrastructure, a simple contact database or list is perhaps the most cost effective means for identifying new investors.

Some of these contact lists come from fellow managers trading data sets; others are purchased online from third parties. However, the problem with many contact lists is that their information is either out of date or very out of date: at least 12 to 18 months out of date. This means that the fund’s marketer has to spend valuable time verifying contacts instead of building relationships. BHA analysts estimate that it takes five to ten phone calls (spanning the course of two to three weeks) to gather the relevant information about who the proper contacts are and what the firm is currently looking for. Thus, with a standard contact database, the fund’s marketer has to make those verification calls before a legitimate introduction can be made.

Everyone knows the old adage that time is money, and here, clearly, time and money are being wasted due to the stale data that the marketer is using. What emerging managers need is a product that provides fresh, accurate data about investors and their search preferences. This way, marketers can effectively target investors interested in their funds, and get in touch with the right people at those firms without having to make five to ten verification calls.

With an effective and targeted marketing process in place, emerging managers can focus on their performance. With a marketer targeting legitimate prospects, and the fund putting up respectable numbers, productive relationships can be built with investors. From these relationships stem new allocations, whether the investment is in the near term or at some point down the line. After these allocations push the fund above $100 million, larger institutional investors will consider the fund. From there, it is up to the marketer to correctly locate these new investors while the manager complements those efforts with impressive performance to keep the process rolling.

With credit markets thawing and government stimulus plans taking effect, financial markets have seen strong gains this year. The HFRX Global Hedge Fund Index indicates that the hedge fund industry is up 11.89 percent year to date. So it seems reasonable to ask, what strategies are in demand among alternative investors and how are they making their selections?

Performing a bit better than the Global Hedge Fund Index, long/short equity funds are returning 13.2 percent on average. These funds have been specified in 59.2 percent of the mandates received by BHA analysts in 2009. Given the strategy’s above average returns, this is not surprising.

Complex hedge fund strategies, which often rely on intricate trading methods and advanced microeconomic analysis to capitalize on price differences across markets, can provide excellent returns in favorable markets. But regardless of their recent performance, these types of funds remain a minority interest in the marketplace. For example, the best performing strategy has been convertible arbitrage, returning 37.7 percent year to date. However, demand for convertible arbitrage funds remains quite low: only 16.9 percent of the mandates received by BHA analysts in 2009 have specified the strategy.

Conversely, the HFR Macro Index has returned a dismal -7.42 percent year to date. Yet, of 1,872 mandates collected from 1,095 companies thus far in 2009, 854 have indicated an interest in global macro funds. In other words, of the mandates received this year, 45.6 percent have stipulated a fund type that has woefully underperformed relative to its competitors.
Many industry professionals often claim that investors chase returns, so changes in demand come about months after changes in performance. If this is the case, convertible arbitrage may be awaiting its big debut, while global macro fund managers may want to pack up shop.

However, it seems unlikely that this will be the case. Looking at data gathered by BHA analysts, it is apparent that certain investors feel comfortable investing in more complex strategies, while others prefer straightforward funds. Thus, it seems that demand for fund strategies is not significantly affected by their prior performance.

The last months of summer have seen notable developments in the debate over reform of the alternative investment industry in the United States and the European Union. After a financial collapse in 2008 that many believed was fueled, at least in part, by hedge funds that took on too much risk in the form of highly leveraged positions, it seemed a sure bet that strict financial reform was to cast a shadow over the alternative investment industry by mid-to-late 2009. In both the U.S. and the EU, reform talks have been heated, and the arguments for and against are numerous. One would suspect that increased regulation would lower the demand for a fund governed by any of these regulations. Furthermore, if EU reforms were to be significantly harsher than U.S. reforms, a corresponding shift in relative demand from the EU to the U.S. would be a reasonable conclusion.

BHA analysts have been gauging demand for funds all over the world, analyzing hundreds of mandates received in the second quarter and the first two-and-a-half months of the third quarter. From this analysis, encouraging and counterintuitive data has emerged that these reform talks have not significantly changed investors’ demand for funds in the U.S. and the EU. Furthermore, it is apparent that the level of relative demand between the two regions has not changed drastically. These two striking conclusions signify that alternative investors are not being swayed by financial reform talks in either the U.S. or Europe.

In the U.S., reform talks have seen both strong opposition and support. Supporters of regulation believe that unchecked hedge fund activity was one of the major causes of the current economic downturn. These supporters have been calling for increased transparency requirements and mandatory registration with the SEC, which would be given nearly unlimited authority to regulate these funds. Critics of reform suggest that the real cause of the financial meltdown was the excessive use of leverage, which has already been removed from the market by almost all banks’ inability to lend. For this reason, they see excessive regulation as overkill that will ultimately be detrimental to the industry. Reform critics also argue that although hedge funds may have used leverage excessively, the mortgage lenders and banks are the firms needing stringent regulations.

It is becoming clear that instead of heavily regulating the hedge fund industry, Congress will pass strict requirements for mortgage lenders and banks. Hedge funds will most likely be forced to register with regulators such as the SEC. Hedge funds will also have to provide an increased level of transparency, which most funds are doing (regardless of requirements) due to the Madoff scandal and the suspicion it cast on the alternative investment industry. So, it looks as if U.S. hedge fund managers are going to dodge a potentially crippling bullet.

Across the Atlantic, European regulators are ensconced in similar regulatory talks. However, the current climate in Europe appears slightly bleaker than here in the U.S. The proposed reforms to EU governance of hedge funds would limit the amounts of leverage permitted, require EU-domiciled funds to use onshore banks, and impose new reporting requirements for a fund. Opponents of these plans fear that an increase in EU regulation would cause a flight of demand to non-EU regulated countries such as Switzerland. Luckily for European-domiciled funds, opposition to these regulatory reforms is mounting by the day. U.K. officials have been strongly against such strict reforms for quite some time, but in recent weeks other European nations have joined the battle. Furthermore, the U.S. and the U.K. have agreed to collaborate on hedge fund reporting by sharing data in an effort to create a common approach to hedge fund reporting and regulatory requirements. It seems that the longer the regulatory debate rages, the more relaxed the requirements imposed by the European Parliament will be.

During these heated debates, BHA analysts have been collecting data and gauging the level of interest for funds focused on these geographic regions. One would think that strict regulatory reform may cause a drop in demand for hedge funds. On the other hand, lenient regulatory reform (like what is probable in the U.S.), would likely encourage more investors to consider alternative investments that were previously seen as risky, unpredictable, and volatile investments. Thus, in theory, it would be logical to see an increase, or at least no decrease, in demand for U.S.-focused hedge funds. On the same note, one might think that demand for European-focused funds would decrease as strict regulatory talks are considered. Furthermore, one might think that debates in these two areas would surely change aggregate demand for the EU and the U.S. combined, possibly shifting investor interest to Japan, continental Asia, or other emerging markets.

The data collected by BHA analysts show why economic theory is not economic law. In the second quarter, 35.16 percent of all mandates collected reflected a specific interest in the U.S. For the EU the number was 26.45 percent. Together, demand for a fund focused on Europe or the U.S. was expressed by 61.61 percent of investors actively looking to allocate capital during the second quarter. In the first two-and-a-half months of the third quarter, 32.89 percent of investors expressed interest in funds exposed to the U.S., while interest in European funds increased to 27.79 percent. Together, this is 60.68 percent of the total mandates collected. These numbers suggest, first, that there has been a slight decrease in demand for U.S.-focused funds, while the EU has seen a slight increase in demand.

A final and telling statistic is demand for European-focused hedge funds relative to U.S.-focused ones. In the second quarter, BHA found that the demand for EU hedge funds relative to the demand for U.S. hedge funds was 75.23 percent. In the third quarter, those numbers jumped to 83.33 percent. So, hedge funds in Europe have become 8.1 percent more popular relative to U.S. funds in just one quarter. This means that investors have not been swayed by the reform talks in Europe, and that these talks (or other underlying factors) have actually increased investors’ interest in the area.

It is important to recall that correlation does not imply causality, but these numbers will certainly allow hedge fund managers in the U.S. and Europe to breathe a sigh of relief. It is true that demand for funds outside these regions has increased, but this increase is slight (roughly .9 percent). The most shocking statistic here is the increase in relative demand for EU hedge funds from the second to the third quarter. However, all of these results have shown that regulatory talks are not drastically altering demand, and for that reason, the alternative investment industry can sleep easily tonight. It is probable that, given the current trajectory of the regulatory debates in both regions, there will be little to no hindrance to funds’ freedom to invest on their own terms. The best news for managers is that investors clearly understand the minimal effect regulation will have, and for this reason, they are not shying away from alternatives in either of these extremely influential world markets.