2009 saw investors raise the bar on hedge fund managers. After experiencing a rocky year in 2008, some investors waited months before beginning to research managers for new investments. When they did, they performed more due diligence than in the past and scrutinized managers’ operational and risk management practices.

Investors also dissected funds’ returns in deciding whether or not to hire managers, although some gave this more weight than others. BHA analysts always ask investors if they have strict return expectations for their searches. In 2009, analysts also probed to determine the importance of managers’ 2008 performance. The BHA team received responses across the spectrum.

Some investors refuse to consider a fund that had negative performance numbers in 2008. For this audience, a fund’s negative performance signaled an inability to react and adapt as markets moved against it. Such investors regularly cite a fund’s lack of effective risk management controls as a reason for disqualifying them from their search. An investment consultant based in the U.K. had such an outlook. This firm will consider only managers that have had positive years for the life of their funds. It believes that an occasional monthly drawdown over the years is acceptable, but that they should be relatively low and be outweighed by the positive months.

Other investors said that 2008 was an anomaly; a manager’s 2008 performance is not an accurate barometer of its ability to make money going forward. These investors believe that one year’s performance is not a good indication of a manager’s skill. A small family office in New York shares this viewpoint. The firm manages an in-house fund of hedge funds and takes an opportunistic approach when evaluating funds. It does not rule out managers based solely on their performance and understands that certain markets were hit harder than others over the past few years.

Finally, there were investors that fell somewhere in the middle of the two extremes. They were open to working with managers whose returns were down in 2008, but they established a maximum threshold. For example, they determined that managers could be down 15 to 20 percent but no more. For these investors, which made up the majority, returns seemed to reflect a mix of manager skill and market conditions.

Moving into 2010, investors will continue to weigh the significance of the past few years’ returns. 2009 was a great year for certain strategies, allowing managers to make up for their difficulties in 2008. But there will always be investors that want to invest in strategies providing consistent if modest positive returns year after year despite market fluctuations. Conversely, there will also be investors that don’t mind experiencing an occasional drawdown as long as the fund is able to hit its fair share of home-runs. It will be interesting to see if 2010 causes any shifts in investor sentiment.

Equity-based hedge funds have been in high demand this year, due to their typically high liquidity, combined with strong performance numbers throughout much of the year. Investors that maintain a heavy bias towards equity-based investments in their hedge fund portfolios often look to diversify their holdings through investments in certain sector-specific funds. BHA has spoken with many investors that find the healthcare and energy sectors attractive because government regulations could cause a lot of movement in these stocks. But BHA has also spoken with other investors that, for the same reason have purposefully minimized their exposure to these sectors, arguing that government intervention could adversely affect the potential for the specific sectors that many view so favorably.

The HFRI EH: Sector – Energy/Basic Materials Index is up more than 25 percent year to date after being down almost 19 percent last year. The HFRI EH: Sector – Technology/Healthcare Index is also up almost 15 percent this year. The more aggressive investors see tremendous opportunity for returns in these sectors to continue to climb during 2009, more than making up for losses in 2008. Hedge funds focusing on these sectors offer investors both long/short equity and event-driven investment strategies. Any changes in government policy with regards to health care or energy could cause significant price fluctuation in these sectors during the next several months. BHA has spoken with many funds of funds and wealth advisors that have an appetite for this type of volatility, because they believe the return potential is well worth the risk.

Analysts have also spoken with investors taking a much more conservative approach in this environment. Investors with long-term investment horizons, such as government pension funds and family offices, are choosing to avoid investing in sectors that are highly sensitive to government policy and regulation.

Funds focusing on retail and consumer goods or technology and media are more independent of government actions and, thus, the level of standard deviation will remain consistent with historical figures. These sectors are less correlated because changes in government regulation have little effect on the number of movies consumers see or the goods they purchase on a daily basis.

The current market provides investors with a range of opportunities to satisfy their risk/return appetites. Investments in hedge funds focused on health care and energy may require investors to take on additional volatility, but the returns these funds provide may justify the risk. For other investors, long-term performance and stability is the goal, in which case investment in uncorrelated sectors is a better fit.

Shifting from one of the worst performing strategies of 2008 to one of the best in 2009, convertible arbitrage is making waves in the hedge fund industry. The difficulties experienced by managers in 2008 left investors wary to even consider this strategy moving into the first quarter. However, it has bounced back significantly since. BHA has heard several investors mention that convertible arbitrage is an area they could invest in by the end of 2009.

Convertible arbitrage funds are appealing to investors for many of the same reasons as volatility arbitrage funds. Convertible arbitrage funds can provide a fair amount of liquidity in comparison with other credit-oriented strategies. Also, a significant number of investors have expressed more confidence in strategies taking a systematic rather than fundamental approach. A wealth advisor in Europe, for example, is currently focusing on evaluating opportunities in liquid and systematic strategies, and it’s including convertible arbitrage. The firm targets annual returns of at least 8 percent for convertible arbitrage funds, and many convertible managers surpassed that in the first two months of this year.

The current environment provides a great opportunity for convertible arbitrage managers to prove that they have the ability to bounce back from difficult markets. When convertible arbitrage managers find investors interested in their strategy, they will need to explain how they were able to minimize losses in 2008 and how they have been able to recover this year. Evaluating managers’ risk management procedures will be a critical part of investors’ due diligence over the next few months.

Convertible arbitrage managers can appeal not only to investors seeking that strategy specifically, but also to investors looking for event-driven or credit-related strategies in general. In addition, multi-strategy managers with exposure to the convertibles market can appeal to investors that want exposure to these assets, although not through a dedicated convertible arbitrage fund. BHA sees opportunities for managers to get in front of qualified investors before allocations take place at year’s end.

While investors continue to look for ways to create more liquidity with their hedge fund investments, the search for the same old high-frequency trading strategies, such as CTAs and global macro, carries on. However, since the beginning of the second quarter, the demand for volatility arbitrage managers has gradually increased. Investors are finding that volatility arbitrage funds can provide them with the liquidity they need while allowing them to capitalize on the market’s volatile price fluctuations.

Much of the recent interest in volatility arbitrage funds has come from funds of hedge funds. In one recent week alone, BHA saw the interest from these funds span three continents: North America, Europe, and Australia. What’s interesting is that all of these funds are actively searching for credit strategies. While the investors expect credit strategies to be less liquid, they expect volatility arbitrage funds to balance their portfolios. Because volatility arbitrage managers can make plays in several markets, including the equity and currency markets, the strategy can offer strong liquidity to investors. As has been the case for several months now, the more liquidity offered by the underlying assets in a fund, the more attractive the strategy is to the investor.

In addition to liquidity, investors have also been attracted to volatility arbitrage strategies because of their ability to hedge risk while maximizing potential return. Managers that take a nimble approach to employing the volatility arbitrage strategy can take advantage of both the long and short sides of the spectrum. A European fund of hedge funds is looking for a manager that demonstrates this concept. The firm is holding capital in reserve to allocate to such a manager in the short term. It believes that managers that hold only long volatility positions are not able to provide long-term value. The firm places heavy emphasis on the fund manager’s track record in the strategy, which is much more important than the asset size of the fund.

Volatility arbitrage funds serve as an attractive investment option for hedge fund investors due to the funds’ underlying liquidity and ability to maintain a strong risk/return ratio. Interest in this strategy is beginning to spread slowly from funds of funds to family offices, wealth advisors, and private banks, and should remain popular during the next several months.