Liquidity and transparency have been the watch words of investors since the financial crisis. Recently, however, BHA analysts noted another trend in the hedge fund community. Investors are looking to fixed-income hedge fund strategies for consistent returns, and managers have indicated that they are seeing steady growth in this area.

Before the financial crisis in 2008, hedge funds were largely viewed as vehicles that offered investors an exciting opportunity to earn higher returns by being exposed to slightly higher risks. Since the crisis, investors have been cautious and, as a result, investments in hedge funds have decreased substantially.

However, inflows may be on the rise again. Between April 30, 2009, and April 30, 2010, there was an estimated 36 percent increase in trading volume among hedge funds, according to a survey by Greenwich Associates: “The total trading volume among the 245 hedge funds that responded to the 2010 survey jumped to $4.7 trillion from $2.8 trillion in the year ended April 30.”

One reason for the increase is investor interest in fixed-income securities. Prior to the financial crisis, many investors were not as captivated by vehicles such as Treasurys, government bonds, interest rate swaps, and agency securities. They were perceived as boring and had seemingly become out of date. However, in this postcrisis world, interest in many of these staid fixed-income strategies has rebounded among investors and managers alike, and riskier investing has dropped off. The same report noted, “From April 30, 2009 to April 30, 2010, a matched sample of hedge fund survey respondents revealed a 73% increase in Treasury’s trading volume. Hedge funds constituted 3% of trading volume in government bonds as of April 30, 2009. That share in trading volume jumped to about 20%, as of April 30, 2010, increasing 60% year-over-year.”

BHA data supports this trend. About 20 percent of the hedge fund investor mandates that BHA has received over the past month and a half have mentioned an interest in fixed-income and fixed-income arbitrage strategies. But have analysts seen any rise in fixed-income investor interest after April 30, 2010? Indeed, there has been a slight rise. Investors interested in fixed-income and fixed-income arbitrage hedge fund strategies rose 17 percent from May through July. A wealth advisor in London, as well as a family office in Illinois, explained to analysts that they are seeking exposure to sovereign and corporate debt rather than some of the more volatile strategies like global macro.

A sign that this trend may persist at least near term, some hedge fund managers are adding fixed-income funds and expertise to their offerings. A large wealth advisory firm in London is a prime example. It recently hired an experienced fixed-income manager to look over the firm’s UCITS III-compliant fixed-income funds. The chief investment officer said, “The asset class has always played an important role at the heart of our client portfolios, and has made a significant contribution to our long-term performance track record, delivering our clients an annualized return of some 10% per annum.”

Although some investors are still allocating to hedge funds in order to earn large returns by taking on slightly higher risk, many are looking to a variety of debt instruments that can produce more predictable and absolute returns. Although investor interest in this area is rising now, only time will tell if it will continue for the remainder of 2010.

Many wealth advisors have full discretion of their clients’ investment portfolios and can choose investment opportunities free of the many requirements that larger institutional investors must abide by. To select investments, these wealth advisors have often used a third party to help with the due diligence and selection processes.

That seems to be changing. Since the financial crisis, many advisors have commented to BHA analysts that they are taking full control of the investment process rather than relying on outsourced teams. By hiring one or two people, wealth advisors believe they will be able to add more hedge fund investments to their clients’ portfolios.

Some wealth advisors are also building in-house investment teams so they can start internal funds of funds. They plan to give clients access to certain opportunities at lower investment minimums. One such example is a wealth advisor based in Florida that has Dutch, South American, and U.S. clients. The firm runs an internal fund of managed accounts, and it is in the process of launching an emerging manager fund.

In Europe wealth advisors have been adding internal teams to manage their portfolios rather than using larger private banks to handle their hedge funds investments. A midsized firm based in Geneva explained to BHA analysts that it has recently started to invest directly in hedge funds.

Many managers target larger institutional investors because the size of their investments are larger and the time they’re willing to invest is longer. However, it seems smaller managers would do well to consider wealth advisors. As they increasingly handle investments directly, it is likely that they will need to build relationships with new managers.

Sovereign wealth funds (SWF) are government-backed investment vehicles. At the end of 2009, these funds had approximately $3.8 trillion under management.1 Although SWFs have been around for decades, their numbers have increased dramatically in recent years. Of the top 50 funds, 56 percent were launched between 2000 and 2009.2 As this asset pool continues to expand in size and number, so will its importance. According to International Financial Services London, “SWFs are likely to become more important participants in global financial markets over the coming years as inflows from trade surpluses and commodities’ exports continue.”3

Since 2009, SWFs have increased their investments into both private equity funds and hedge funds. The Korea Investment Corp. (KIC), a $35 billion fund, is one such example. According to Scott Kalb, chief investment officer, “The fund plans to double the portion of investments made through stake purchases, private equity deals, hedge funds and property acquisitions to 20 percent of its portfolio.”4 Kalb also stated, “Financial-market turmoil has created considerable opportunities to invest directly in companies, and sovereign wealth funds are ideally placed to inject capital and credibility into sound businesses whose value has fallen.”5

Another example of an SWF increasing its exposure to alternative investments is the Government of Singapore Investment Corp. This “manager of more than $100 billion of Singapore’s foreign exchange reserves, increased its allocation to alternative investments, including private equity, real estate and hedge funds, to 30 percent in the year ended March 31, 2009, from 23 percent a year earlier, according to its latest annual report released in September.”6

Conversations between BHA analysts and SWFs have indicated a similar trend. BHA research analysts have interviewed and obtained investment strategy information from 11 of the 47 largest (based on assets under management) SWFs worldwide. During these conversations, SWFs have expressed their interest in hedge fund and private equity investments. They have also voiced a willingness to invest in riskier and less liquid strategies. This could be due to their ability to invest in strategies that require longer lock-up periods but offer superior returns.

No matter what the reason is, however, if SWFs continue to grow in number and size, it is likely that they will have a noticeable impact on the alternative investments industry.

1,2,3 International Financial Services London, “Sovereign Wealth Funds 2010,” March 2010.

4,5,6 Bloomberg, “KIC to Shift Toward Direct Investments After ‘Flat’ Returns,” August 26, 2010.

In the aftermath of the recent financial crisis, financial regulation has become a top priority for countries around the world. Governments in North America and Europe, in particular, have pushed for increased transparency and accountability from firms they believe had a hand in the meltdown.

This quest to eliminate systemic risks in the global financial system recently manifested itself in the U.S. through the passage of President Obama’s financial reform bill. Similarly, in Europe, the pending Directive on Alternative Investment Fund Managers will seek to increase regulation and transparency of managers in the EU. The short-term and long-term consequences of these legislations will be varied, but already investors have begun to feel their impact.

In the U.S., large banking institutions are now limited to holding a maximum of 3 percent of their Tier 1 capital in alternative investment funds. For firms such as Goldman Sachs and Morgan Stanley, this means liquidating billions of dollars from their private equity, real estate, and hedge fund commitments. Over the next ten years, Goldman will have to redeem at least $13 billion from these funds, while Morgan Stanley will need to liquidate more than $2.5 billion.1 Funds themselves will also be affected. Firms with more than $150 million in assets under management are now required to register with the SEC and along with disclosing more information than previously, will be subject to SEC audits.2

In Europe, the European Parliament and the Council of Ministers are currently working to reconcile their two (sometimes conflicting) versions of the Directive on Alternative Investment Fund Managers.3 While the two bodies work to resolve their differing views on disclosure, scope, and the treatment of so called “third country” funds, European investors are left in a state of uncertainty.

In recent conversations with a BHA analyst, a large European insurance firm mentioned that although they’re still evaluating and meeting with new fund managers, actual allocations will be on hold until the effects of the pending legislation are clearer.

Similarly, a pension fund in Switzerland has decided to use this time of uncertainty to take a bird’s-eye view of the alternatives universe and do extensive research on new funds while it waits for the regulatory issues to clear up.

Both of these sweeping pieces of legislation will undoubtedly change the landscape of the alternative investment space. Although investors and fund managers alike are feeling the immediate effects of these policies, both can only speculate as to the true long-term impacts they will have.

1 FINalternatives, “Goldman, Morgan Stanley Will Liquidate Huge Alts. Portfolios, August 10, 2010, http://www.finalternatives.com/node/13499.

2 FINalternatives, “Obama Signs Financial Regulation Reform Bill,” July 22, 2010, http://www.finalternatives.com/node/13259.

3 Global Financial Market Watch Blog, “The EU’s proposed Alternative Investment Fund Managers Directive, May 26, 2010, http://www.globalfinancialmarketwatch.com/2010/05/articles/europe-uk/the-eus-proposed-alternative-investment-fund-managers-directive/.

The BHA research team comes in every morning with one goal in mind: to collect unbiased data on institutional investors alternative investment strategies. The responses vary significantly, but one factor remains consistent: the data reflects the real-time interests of investors from all categories. For some investors, their interests change as often as the seasons; for others, a proven approach that brings positive results will always be the firm’s mandate.

Since the start of the third quarter, the BHA research team has identified over 106 investors looking for hedge funds focused on emerging markets. This compares with 254 investors that looked for these funds in the second quarter, and 175 in the first quarter. Considering that there are still five weeks left in the quarter, investor interest in hedge funds focused on emerging markets seems on track to remain high.

Some investors in recent quarters took redemptions as emerging market currency volatility and global growth concerns caused them to reach their risk tolerance levels. But for others, there is still confidence in the space and they are closely watching trends in emerging-market stocks, sovereign debt, and commodities.

Many investors are allocating new capital to funds focused on Latin America and the Middle East. A London-base wealth advisor, which has $300 million under management, mentioned to analysts that it is interested in hearing from all funds devoted to emerging markets, including Latin America (and specifically Brazil), the Middle East, and emerging Europe and Asia.

In the second quarter, total inflows to hedge funds were roughly $9.6 billion.1 Despite outflows of $1.5 billion from emerging market funds during the quarter, managers can expect that there are still plenty of investors looking for these funds.

1 FINalternatives, “Emerging Markets Hedge Funds Suffer $1.5B Outflow,” August 20, 2010, http://www.finalternatives.com//node/13597?time=1282686684.

The summer months are notoriously slow for funds and investors alike. Managers take advantage of the opportunity to revamp while investors review their allocation strategies. Both spend time away from the office.

Despite this industry wide slowdown, analysts at BHA have spoken with and received mandates from more than 200 hedge fund investors over the past four weeks. That is a large number of mandates for a summer period, so the research team decided to take a closer look at this trend and see what was driving it.

After an abysmal May, hedge funds saw their performance improve in June and they had a positive return in July.1 This no doubt attracted some investors. Perhaps more significant, however, was the fact that investors were seeing new reasons to put money into hedge funds, since more managers have been using strategies that preserve capital.

Hedge funds have traditionally been a vehicle that provides investors with outsized returns. Although some investors may be in search of riskier strategies in attempts to recoup some of their losses from previous months or years, BHA analysts have noticed increased investor interest in safer strategies, such as fixed income and managed futures.

Over the past four weeks, more than 20 percent of the hedge fund investors analysts spoke with expressed an interest in fixed income or fixed-income arbitrage strategies. In what analysts perceive as a positive market indicator, many investors looked at the pricing inefficiencies of government and corporate debt with various credit ratings in hopes of catching decent yields. Other investors considered fixed-income arbitrage. No matter which they choose, it was clear that investors were focusing on capital preservation and steady returns instead of extreme volatility plays.

In additional to fixed-income strategies, investors sought out CTA/managed futures funds as well. During the past month, more than 35 percent of hedge fund investors expressed interest in managed futures. For the most part, these funds are inversely correlated with stocks and bonds. In market conditions where inflationary concerns exist, managed futures that track foreign exchange rates, gold prices, and the like provide an excellent hedge to the situational damage that theoretically could be done to equities and bonds. Many investors view managed futures as another way to mitigate risk in their portfolio instead of trying to achieve larger returns.

In short, hedge funds continue to attract an array of investors despite market conditions because of the funds’ ability to provide returns as well as hedge other portfolio positions. While strategies will vary depending on the investor’s appetite for risk, hedge funds continue to remain a popular investment vehicle.

1 Eurekahedge, Performance Tables, August 17, 2010, http://www.eurekahedge.com/indices/default.asp.

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.

Many investors tend to allocate to funds that are actively managed with a fundamental approach. They like the fact that managers review historical data, such as financial statements, competitive advantages, and the overall state of the economy when building a hedge fund portfolio.

Since the beginning of this year, however, investors have been opportunistic in their hedge fund allocations and willing to consider managers implementing a quantitative process. From the first to the second quarter, BHA’s research shows that there was a 25 percent increase in the number of quantitative hedge fund mandates. So far during this third quarter, that growth has been sustained.

Quantitative analysis is quite different from the traditional fundamental approach. In the former, managers construct trading models that analyze vast amounts of historical data, such as the prices of securities, the rates of returns, and the risk parameters. These models also consider the statistical analysis of such information from other sources. Some managers program the models to determine when trades are to be completed but have a trader executes the trade. Other managers program the model to complete all tasks.

Many managers are quite successful using this approach. For example, many CTA managers implement a systematic style for their funds. CTA models are traditionally constructed to be uncorrelated with the S&P 500 so they are less sensitive to daily market conditions, such as interest rate fluctuations and inflation concerns. Hence, CTA funds are popular hedging tools for traditional stock and bond portfolios.

The application of quantitative analysis to portfolio management has increased tremendously over the years thanks to the increase of technology. Managers now have access to more user-friendly software, numerous sources for data feeds, and powerful computers.1

From BHA research, it’s apparent that investors in 2010 understand that hedge funds implementing a quantitative style, or a mix of quantitative and fundamental analysis, are a way to broaden their opportunities for positive returns. A family office in New York recently expressed its interest in expanding its portfolio to include quantitative funds; it is specifically interested in systematic CTA funds. A corporate pension in the Netherlands is of the same mind. It mentioned investing in quantitative funds as a way to expand its investment objectives.

Hedge funds are instruments that allow qualified investors to access unique opportunities for positive returns. Adding quantitative funds to a their portfolios helps investors capture opportunities that they may have missed in the past. Many investors are searching for stable, niche funds with positive returns, and embracing a quantitative style is a way to accomplish that.

1 FINalternatives, “The Statistical Mystique,” July 30, 2010, http://www.finalternatives.com//node/13356?time=1282062326.

It’d be nice to be able to tell recently launched hedge funds that raising the first $100 million or $200 million will be easy. However, the current environment for raising funds is anything but. The due diligence ringer that investors put funds through is longer and more thorough than ever before. In addition, although BHA currently has over 600 active mandates for funds with less than $200 million in assets, only a very small percentage of those would consider funds with less than $20 million. The challenge facing emerging managers is enormous in the current fundraising atmosphere. Funds that are just starting the asset-raising process need to not only identify potential allocators but also decide whether to target anchor or seed investors.

A marketer at a fund with less $100 million recently commented to an analyst, “Compared with two to three years ago, it takes four times as much work today to get a ticket that is half the size.” In other words, the effort, time, and resources needed to grow a fund, especially as it attempts to eclipse the mythical $100 million barrier, is enormous.

Every emerging fund that is looking to raise capital and grow its asset base must first ascertain what types of accounts it wants to target. Investors interested in emerging funds can generally be grouped into one of two buckets. There are investors looking to provide seed capital to emerging funds and become GP’s. Then there are investors that prefer an LP commitment; they’re interested in making an anchor investment in the fund. If the marketer’s claim about the amount of time and resources necessary to raise the capital is true, then it would be wise for the fund to not only identify potential targets but also to identify the type [Do you mean size rather than type?]of investment the fund could potentially expect.

Most fund managers will prefer to target anchor investors that are not looking to make a seed commitment first. However, often times these investors look for preferential treatment with regards to management or performance fees, or liquidity through a separately managed account structure. Other funds will prefer to associate themselves with a well known institution that provides seed capital. This can be advantageous because it brings a level of calm and stability to the fund, and assurance of minimized business risk, after the larger institution comes on board.

Each type of investment has its pros and cons. However, for smaller funds looking to raise assets, they will undoubtedly have to turn to one or the other.

2008 is a year that will be forever etched in investor’s memories. Some of the major events included the bursting of the residential real estate bubble, the shoring up of major financial institutions with TARP funds, and the FDIC take-over of weak and failing institutions. Because these cataclysmic events continue to send aftershocks throughout the financial system two years later, 2008 is still very much on investors’ minds.

Given this, the few select funds that were able to successfully navigate the “black swans” of 2008 are on track to benefit, because fund manager performance in 2008 has become a benchmark for hedge fund investors. In terms of manager assessment and evaluation, 2008 has become an important year in a hedge fund’s life.

If a fund was positive in 2008, investors are quick to take notice. I’ve heard from a handful of institutional investors that today, they have three main criteria when evaluating funds: performance in 2008, strategy, and liquidity. This is in stark contrast to 2007 when investors required a specific pedigree and returns of 20 percent or more. Now, investors are more focused on risk management, downside protection, and capital protection. How a manager performed in 2008 is a quick way for investors to narrow their fund manager universe.

Considering that in 2008 the S&P 500 index returned –33.99 percent and the MSCI World Index returned –40.33 percent, if a fund manager’s returns were even half of those two commonly used benchmarks, then the fund manager will have much greater odds of landing on an investor watch list. If a fund had positive performance in 2008 and followed it with positive performance in 2009, the managers should expect increased conversations with investors for the remainder of 2010 and into 2011.