Most investors have preferences when it comes to allocating to alternative products. Some take a fundamental approach, others prefer quantitative tools. But all look to buy low and sell high. An area that is providing this opportunity is emerging markets.

Although emerging markets can be volatile, they are priced at deep discounts. As a result, many investors feel emerging markets have a better chance of providing higher returns than developed markets. Last week, EPFR Global reported the second-largest net inflows to emerging market equity funds.1

The marketplace has been quite turbulent over the past month; however, many alternative investors have conveyed their interests in emerging market funds to BHA analysts. A family office in New York City, for example, stated that it is seeking region- and country-specific emerging market hedge funds focused on Asia or Latin America. The firm is also evaluating global macro, event-driven, or multi-strategy funds for these allocations.

Family offices aren’t the only investors looking to allocate to the emerging market space. During the past few weeks, BHA analysts have seen a mix of family offices, corporate pensions, wealth advisors, and many other investors looking to add capital to emerging market hedge funds. This could be a positive sign for fund managers in this space, as investor sentiment has been fairly pessimistic due to the volatility in these markets.

1 The Economic Times, “Emerging market funds get second-largest inflows in ’10,” June 19, 2010.

For many investors, one of the most important requirements during the past several months has been liquidity. It’s not surprising, then, that a significant number of European investors have expressed an interest in UCITS III funds. In fact, in conversations with BHA analysts, many European investors have stated that they require hedge funds to be UCITS III compliant.

UCITS III funds are investment vehicles that apply absolute return strategies to a number of asset classes. The appeal of these vehicles stems largely from the fact that they are monitored by the European Commission and must abide by regulations put in place to protect investors’ capital. For example, UCITS III funds must offer daily and weekly liquidity. Additionally, they are required to provide transparency; that is, a UCITS III fund must keep investors apprised of the asset classes in the fund and the exposure it has to each strategy. Finally, UCITS III funds must follow a known set of risk-management guidelines.

BHA recently spoke with a midsized fund of hedge funds in London, England. The firm just made an allocation to a UCITS manager and plans on adding several more such managers to its portfolio. It stated that one of its main concerns is liquidity, which is why UCITS funds will account for a major portion of its portfolio.

UCITS III funds are a regulated investment vehicle for institutional investors. The majority of investor leads from Europe are citing UCITS funds as their main search criteria. With governments from around the world increasingly pressuring funds to be more transparent, regulated investment vehicles like UCITS funds are a perfect fit for many investors.

A lack of liquidity has been a major issue for both fund managers and alternative fund investors during 2008 and 2009. Before the financial crisis, many investors overcommitted to funds that were extremely illiquid. As investors look to rebalance their portfolios and begin to re-allocate capital, many are looking at hedge funds that trade liquid assets and provide frequent redemption opportunities. Because many funds temporarily blocked redemption requests, investors today are looking for funds that not only offer frequent liquidity opportunities but also make explicit promises to not impose gates on future redemptions.

For example, endowments, which were hit hard by illiquidity problems, have increased their allocation pools. Many have large portions of their portfolios invested in hedge funds because of their liquid nature.

Similarly, advisory firms are taking a different path. The investment committee of a consulting firm based in Florida met recently regarding the liquidity of clients’ investment portfolios. In 2008, the firm had a large number of clients invested in the real estate sector, which performed very poorly. Now that the firm is beginning to see capital inflows from real estate fund redemptions, it has decided to change direction and is placing that capital with hedge funds. The firm has decided that managed futures and other short-term trading funds, which are highly liquid, are the best places for its clients’ capital.

BHA continues to see many investors move into liquid vehicles and predicts that even more will make the shift from private equity and real estate funds to liquid hedge funds. The unpredictability of the market during the past year is causing many investors to take a new direction.

When it comes to investing in alternatives, there are three key fund characteristics that all investors evaluate: liquidity, transparency, and risk management. BHA analysts find that investors continue to prioritize their analysis of these criteria when choosing funds.

It’s not surprising, then, that during the past few months a significant number of European investors have expressed an interest in UCITS III funds. In fact, in conversations with BHA analysts, many investors have stated that they require hedge funds to be UCITS III compliant.

UCITS III funds are investment vehicles that apply absolute return strategies to a number of asset classes. The appeal of these vehicles stems largely from the fact that they are regulated by the European Commission and must abide by regulations put in place to protect investors’ capital. For example, UCITS III funds must offer daily and weekly liquidity. Additionally, they are required to provide transparency; UCITS III funds keep investors apprised of the asset classes in the funds and the exposure funds have to each strategy. Finally, UCITS III funds must follow a known set of risk-management guidelines.
BHA recently spoke with a large pension plan in Norway. It stated that one of its main concerns going forward is proper risk management. However, the pension plan also will require funds to have high levels of liquidity and transparency. It sees UCITS III funds as a good fit for its requirements.

UCITS III funds offer a regulated investment vehicle for institutional investors. As long as investors continue to seek out low-risk, high-return investments, UCITS III funds will have a place in the hedge fund industry.

During the past two months, a large spectrum of institutional and private investors have been seeking funds trading public equities. While long/short equity funds are always popular, it appears that many investors think now is a time to seriously begin evaluating long/short equity funds for potential allocation.

Many investor firms, large and small, have expressed an interest in making allocations to equity funds by the end of 2009. The market has shown signs of stablizing and investors have been making a select list of managers to keep on their radar. According to BHA data, nine out of ten consultants surveyed have specific mandates for long/short equity managers. One consultant, for example, has a specific mandate for sector specialist equity managers. The firm wants to hear from U.S., European, and Asian managers that have global equity exposure; it plans to allocate to several managers by the end of 2009.

Morningstar recently reported that equity funds are among the top performers of all hedge fund strategies. Because of the strong results, investor firms have been actively researching, performing due diligence and allocating capital to long/short equity funds. Additionally, BHA finds that many firms are keeping an open mind as to the types of funds they

should research. For example, while some firms are expressing interest in emerging market equity funds, others are stating their interest in developed regions. Therefore, the significant rise in interest is not directed at certain segments only; rather, all types of equity funds are seeing greater attention from the investor community.

After much turmoil, equity markets seem to be recovering, which should translate to a healthier marketplace overall. And as we move closer to the end of 2009, it appears as though investors are beginning to show signs of deploying capital into the equity arena.

At the beginning of this year, many investors stated that they were going to wait until the markets settled before reviewing new hedge fund vehicles. As the months have gone by, however, the fear has somewhat receded, and many investors are evaluating and even allocating to new funds. A number of these investors believe that there is opportunity in this market and want to invest with managers capturing above average returns. A sticking point, however, are management fees.

Some investors have stated they do not want to return to hedge funds because of the high fees. Many more are making it clear to BHA that managers must demonstrate that they can generate the types of returns that merit high fees. Managers often cite positive past returns as a reason for high fees, but with a forecast of uncertain growth, investors are wary. High fees must produce consistently high returns, which many investors don’t think is possible.

Performance is not the only benchmark investors are considering, however. Competition is another. Managers need to be aware of the fees charged by their peers. If other funds are charging less, investors may consider them a more attractive investment.

Today, managers need to analyze and adjust their fee structure not only in terms of performance, but also in terms of their competition and investors’ expectations. Only by doing this will managers be able to position themselves when marketing their investment vehicles and gain the upper hand.