Ten years ago, investors worldwide were investing in Brazil, Russia, India, and China (BRIC) in order to catch the strong wave of growth and development being predicted for those markets, particularly Brazil. Many investors still are seeking such opportunities. However, there are also many investors that believe the “next Brazil” is the continent of Africa, and they are striving to find an appropriate investment plan for this complex and under-researched continent.

Recent economic data legitimizes the optimism investors are showing for Africa. As of April 2010, funds focused on both the Middle East and North Africa (MENA) gained 7.76 percent year to date.1 Even more impressive was the 9.3 percent gain during the month of March. This is the highest monthly gain for the index since the inception of Hedge Fund Research’s coverage of the region.2 Also as of March, this index had a 12-month return of 28.31 percent.

Many economists believe there are various aspects of the African economy that are under-estimated and under-researched. These include countries such as Nigeria which has a very undervalued banking sector. Additionally, economists continue to stress that there is a great deal of opportunity within the oil, gas, and telecommunications sectors of Nigeria – which is thought to be one of Africa’s economic leaders behind South Africa.3

There seems to be positive sentiment for countries other than Nigeria as well. The continent’s lack of overall infrastructure, specifically in Kenya and seven other African nations, points to opportunity for wireless providers. Such providers and businesses are either entering the region or expanding their operations. Campaigns such as “One Laptop Per Child” is also fueling the continent’s growth in technological development and awareness.4

Some investors have looked to the 20th century for lessons in sound investments that they can take into the 21st. In hindsight, it was a wise decision to invest in Japan after WW II, in Southeast Asia during the 1970’s and, during the past 15 to 20 years, in BRIC countries.5 These were all frontier markets at certain points in time. Investors who see this consider it a no-brainer to invest in what is expected to be the next profitable frontier market. Although there are many investors with this belief, there are still many who greatly underestimate the African continent or simply don’t see sustainable growth potential.

Within the last month and a half, on several occasions, BHA research analysts spoke with investors seeking African-focused hedge fund managers. They included an investment consultant in the U.K., a corporate pension in Latvia, and a fund of hedge funds in Switzerland.

When speaking with the Swiss-based fund of funds, the CIO had a perspective on African markets that was unique because it was a combination of both positive and negative sentiments. On the positive side, he believes that investment capital will trickle down from the BRIC countries to the frontier markets, specifically Africa. He noted that there have been inflows of capital to the region and he expects it will continue. There are the obvious growth signals as well. First-tier African nations such as South Africa have a growing hedge fund industry and a well-advancing economy. Again, there are nations such as Nigeria with banks that are “dirt cheap.”.And Nigeria along with countries such as Angloa and Zimbabwe have extremely young populations that are consuming massive amounts of domestic products, a trend that is expected to continue to grow.

What was also intriguing to this CIO is that in a large portion of Africa, it is extremely difficult for businesses to obtain financing from banks and other lenders, which means they must be self-sufficient, using their own cash flow to grow their businesses. He also anticipates that those investors that missed out on the emerging market boom of the last 15 to 20 years will want to get involved in the “next Brazil”.

On the negative side, the CIO does not believe the region has long-term growth potential, and he recognizes that the great weaknesses and flaws in the continent cannot be ignored. These include a lack of infrastructure, a lack of national identities in the majority of nations leading to civil unrest, a lack of leadership, poor or inconsistent governance, and “huge” structural and operational issues in the countries’ governments and economies.

Although the CIO believes in the negative long-term effects of these weaknesses, he is striving to be a front runner in the wave of investor interest and capital toward the region. The firm has a two- to four-year bullish outlook on Africa, and feels that because the market capitalization within these markets is extremely small that an investor could double or triple an investment in a very short time period. However, he believes it is extremely important that investors navigate this region and time period very tactically with liquid investments. Private equity, which is illiquid, is very susceptible to the instability and economic risks, such as hyper-inflation, that have plagued certain African nations at times. He will be trying to ride this wave by seeking strong directional long-biased managers in the short term.

The next five to ten years are somewhat unclear for Africa. Investors will learn whether or not Africa truly is the next emerging market. It is clear is that investor interest and capital is entering the region, but it is not clear for how long it will last and if it will be sustainable in the long term.

1 HFM Week, “BRIC and beyond,” April 21, 2010, http://www.hfmweek.com/features/527447/bric-and-beyond.thtml.

2 Hedge Funds Review, “Investors wary of high-performing emerging market hedge funds,” May 20, 2010.

3 HFM Week, “BRIC and beyond,” April 21, 2010, http://www.hfmweek.com/features/527447/bric-and-beyond.thtml.

4 Wealth Daily, “Investing in Africa with ETFs,” March 8, 2010, http://www.wealthdaily.com/articles/africa-economic-growth-beats-forecasts/2363.

5 Hedge Funds Review, “Insparo Africa and Middle East Fund: Insparo Asset Management,” May 27, 2010, http://www.hedgefundsreview.com/hedge-funds-review/profile/1648929/insparo-africa-middle-east-fund-insparo-asset-management

To spot worldwide investor trends, BHA analysts periodically step back from the day-to-day news and investor conversations and look at the big picture. They did this recently, evaluating BHA hedge fund investor mandates from April 1 through mid-July and comparing them with mandates from the same period a year ago. There was a noteworthy difference. In the 2010 time frame, 120 investor mandates specified the commodities sector as a major interest. Last year during this period, only 70 mandates included commodities. This represents a significant increase of 71 percent from 2009 to 2010.

Over the past month, BHA has interviewed a wide variety of investors around the globe. Whether they were family offices, corporate pensions, consultants, fund of funds, or wealth advisors, many of them expressed an interest in increasing their exposure to commodities. Despite the volatility and uncertainty in the marketplace this year, these alternative investors saw commodities as an opportunity to offset equity risk with potential growth and stability.

A family office in New York, for example, stated that it is specifically seeking funds focused on commodities. The firm mentioned that it is researching a variety of strategies including asset-based lending, credit, CTA/managed futures, distressed, and emerging markets.

A fund of funds investor based in Austria has also shifted its interest to the commodities area. Previously the firm was primarily focused on global macro hedge fund managers, but recently it told BHA analysts that it is seeking CTA managers for new investment opportunities in 2010.

There may be another explanation for rising commodity interest. Investing in commodities can be an effective hedge against rising interest rates. The Federal Reserve pushed up the discount rate to .75 percent in mid-February for the first time in over three and a half years, and this is likely to occur again.

“Portfolios that add commodities after the Federal Reserve tightens the discount rate, perform better than portfolios that don’t,” stated Wall Street Journal writer, Carolyn Cui.1 She came to her conclusion after analyzing data on a new study that will be published in the Journal of Investing. The authors of this study researched data from December 1970 through August 2007.

To explain the process, Cui stated, “The researchers added a basket of commodity futures tracking the S&P GSCI Commodity Index to five types of stock portfolios: value, small-cap, momentum, growth and large-cap. The commodities added to the returns of all five equity styles during periods when the Fed tightens the discount rate.”

Whether to offset equity risk or hedge rising interest rates, investors around the world are beginning to see positive investment opportunities with commodities-related funds. Confidence has truly grown and only time will tell if commodity interest will continue to rise in the future.

1 Dailymarkets.com “Investing In Commodities: A Hedge Against Rising Interest Rates” April 26, 2010, http://www.dailymarkets.com/forex/2010/04/26/investing-in-commodities-a-hedge-against-rising-interest-rates/.

In recent conversations with investors, research analysts at BHA have noticed an increasing interest in merger-risk arbitrage. This is after the strategy saw its worst years in 2008 and 2009. HedgeFund.net reports, “The strategy had a big year in 2006, gaining 12.93% on the HFN Merger-Risk Arbitrage Index. In 2007, when the Dow Jones Industrial Average peaked at 14,093 and deal volume hit $1.57 trillion, the strategy also performed well, returning 6.42% on the HFN Merger-Risk Arbitrage Index. But in 2008, the strategy tanked hard, losing 2.89% on the HFN Merger-Risk Arbitrage Index during the worst ever annual performance for the asset class, a 15.75% loss on the HFN Hedge Fund Aggregate Index. Deal flow was sluggish, and the global credit crisis tightened deal making.”1

Now that the credit market has seen some loosening, merger-risk arbitrage deals are on the rise again. Although merger-risk arbitrage is correlated to the overall credit market, investors are still attracted to the strategy since it is not affected by the equity market’s ups and downs.

A large wealth advisor based in Brazil with more than $200 million invested in hedge funds is interested in hearing from managers in the event-driven space, more specifically from funds that are focused on merger-risk arbitrage strategies. The firm is looking to place capital into three to six funds and it wants at least a couple of them to be in event-driven merger-risk arbitrage. The firm believes the strategy is going to provide good returns and have low correlation to the market.

After 2008, the merger and acquisition space has seen a tremendous increase in the number of deals being done. As a result, managers running merger-risk arbitrage funds have more deals to trade on and greater opportunities. Investors are realizing the potential that the strategy holds once again.

1 HedgeFund.net, “Merger-Risk Arbitrage Set for 2010 Surge,” March 22, 2010, http://www.hedgefund.net/publicnews/default.aspx?story=11076.

In these turbulent economic times, the power in the alternative investment marketplace has begun to shift. In the “good old days,” many large funds had no need to market themselves; investors were chomping at the bit to allocate capital to top performers. Today, that is no longer the case, and many managers are facing the reality that it is now the big allocators who have the power in the alternatives space. This shift recently manifested itself when the California Public Employees’ Retirement System (CALPERS) renegotiated the fee structures of its managers in its favor.1 Managers are now catering to investors in ways they previously were not.

Take, for example, the use of managed accounts. Managed accounts are by no means new, but recently they have become increasingly popular. Because of the financial crisis, investors are more scrupulous than ever in their search for alternative investments, and they value the liquidity and transparency that managed accounts can provide. In addition, with the shifting power in the marketplace, more investors are in a position to demand access to funds through managed accounts.

The investors that are most able to take advantage of the market’s changing landscape are large allocators, such as government pensions, endowments, and foundations. These institutional investors are able to use their size to force fund managers to take on the added back-office complexity of managed accounts. Indeed, some say that the approximately 4 percent of hedge fund assets that are currently in managed accounts could increase to as much as 20 percent.2

Data gathered by BHA analysts reinforces this idea. Almost 70 percent of government pension plans contacted by BHA expressed an interest in managed account investments, compared with 38 percent for family offices.

Other large investors such as foundations and endowments also expressed similarly strong preferences for managed accounts. Seventy-nine percent of foundations and 63 percent of endowments contacted by BHA would invest in managed accounts.

Of course, with increased privilege comes increased responsibility. Managed account investors receive significantly more data regarding their investments, but this information is worthless without the ability to interpret and act upon it. Thus we find that institutional investors are investing more through managed accounts not only because they now have the power to do so, but also because they have the ability to benefit most from this structure.

1 Bloomberg Businessweek, “Calpers Managers Relational, Ares Agrees to Cut Fees,” June 17, 2010, http://www.businessweek.com/news/2010-06-17/calpers-managers-relational-ares-agree-to-cut-fees-correct-.html.

2 Financial News, “Breaking free from hedge fund gates,” June 7, 2010, http://www.efinancialnews.com/story/2010-06-07/breaking-free-from-hedge-fund-gates.

Alternative investors are turning their attention towards macro funds. According to BarclayHedge, macro funds brought in $2.5 billion from January through April 2010. In all of 2009, macro funds generated inflows of $4 billion dollars.1

Why the sudden shift in strategy?

Lingering doubts about the global economic recovery coupled with Europe’s sovereign debt crisis and China’s shift in monetary policy, which allows the yuan to trade more freely, have caused investors to gravitate toward liquid funds. Macro managers are able to position their funds to take advantage of the ever changing economic climate.

At the recent GAIM conference, a fund manager noted, “the overall environment has been driven by macro events in 2010, and I believe it will continue to be the case because of economic imbalances in the largest markets. With markets highly volatile, macro managers benefited from their ability to take long or short positions in most markets, trade in very liquid products and change positioning nimbly if their view of the economic outlook changes.”2

CS/Tremont data showed that global macro strategies lost only 0.63 percent in May while most funds languished, losing 2 to 3 percent.2 However, some macro funds posted gains of 7 to 8 percent. According to an article in Bloomberg Businessweek, “Macro managers often post a broader range of returns than rivals because they trade in more markets. The range has been even wider this year because of volatile price swings and the diversity of bets on the direction of global economies.”3

Last week, BHA analysts spoke with 23 investors that were interested in managers focusing on macro strategies. For the month of June, more than 100 investors were interested in macro funds, and through the first two weeks of July an additional 40 expressed interest. Many of the investors BHA interviewed were actively researching managers in the hedge fund space. They indicated that they were evaluating macro funds because they were avoiding illiquid strategies. Liquidity was the dominant theme during our conversations with investors.

1 FINalternatives, “Macro Funds Lead As Hedge Funds Return To ‘08 Asset Levels,” June 24, 2010, http://www.finalternatives.com/node/12964?time=1277748490.

2 Reuters, “Macro hedge funds best despite May dip,” June 17, 2010, http://www.reuters.com/article/idUSL43649120100617.

3 Bloomberg Businessweek, “Macro Funds Add $2.5 Billion as Trades Proliferate,” June 24, 2010, http://www.businessweek.com/news/2010-06-24/macro-funds-add-2-5-billion-as-trades-proliferate.html.

From April 1 through June 9, 2009, BHA collected 135 mandates for funds of hedge funds. Remarkably, that is the same number we collected this year during the same time frame. Although the number of mandates have stayed the same, investors’ preferences have not.

The most significant change from this time last year is the increased demand for liquidity. Additionally, many investors are avoiding lock-ups. The pain of the financial crises is still being felt by many investors. Although the market has improved, they are reluctant to go back to the old ways. Needless to say, funds that don’t have at least quarterly redemption periods and rigidly impose hard lock-ups are finding themselves out of the running with an overwhelming majority of investors.

Perhaps most interesting, though, is a shift in investor preference for smaller funds. Last year, the majority of investors BHA spoke with required funds of hedge funds to have $200 million to $500 million in assets. This year, many investors are evaluating funds of funds with as little as $75 million to $100 million under management.

A wealth advisory firm in Geneva is an example of an investor that has changed its assets-under-management requirements. The firm recently began searching for a specialized fund of funds that invests only in long/short equity funds. It wanted funds that offer superior liquidity, however, it specifically requested that funds have only $100 million in assets. Prior to this, the firm required funds of hedge funds have a greater amount of assets under management in order to be seriously considered.

As the graphs below show, during the past year investors have become increasingly comfortable with smaller funds. In 2009, only 35 percent of investors with active mandates for funds of funds indicated a comfort level with less than $200 million in assets; that number has jumped to 48 percent in 2010.

Throughout the rest of the summer, BHA analysts will continue to monitor the trend to see if investors continue to be comfortable investing in smaller funds.

Investor interest in private equity funds has been concentrated on the developed markets of the United States and Europe. However, this year, there has been a spike in the number of investors researching Asia-focused funds—in particular, growth-capital and small- to middle-market-buyout funds.

During the past week, several investors, including a foundation in Denmark and an endowment in the United States, expressed interest in growth-capital and small- to middle-market-buyout funds focused on Asia (excluding Japan). Both of these investors were searching for U.S.-focused funds when BHA analysts last spoke with them.

The recent shift of investor interest to Asia is due to the clear prospect for sustained economic growth as China and other emerging countries in the region continue to prosper. That coupled with the diminished deal flow in the region is urging investors to capitalize on opportunities now while there are still deals to be done rather than hold off and potentially end up empty handed. As a Reuters’ article noted, “Private equity fund-raising flows are returning to Asia as finding and completing deals remains much harder than in the U.S. and Europe, because of local competition, foreign investment restrictions, and unpredictable governments.”1

Investor interest in small- to middle-market-buyout and growth-capital funds can be explained by these funds’ historical ability to perform during periods of economic recovery. “If equity-driven investments see challenges, then credit-related strategies, such as distressed, special situations and turnarounds, may benefit. That being said, as the economy recovers, exposure to equity remains a critical part of a well-diversified portfolio. In buyouts, we favor the mid-cap LBO space, as funds in this area tend to be more operationally focused and less reliant on financial leverage to drive returns.”2

Essentially, buyout and growth capital funds are in the best position to invest in more stable, mature companies in the region and generate operating cash flows, which will lead to higher rates of returns for their investors.

Asia has been getting much attention from private equity firms and investors that are looking to take advantage of the region’s many opportunities and diversify their portfolios away from more developed markets. It is a safe bet that despite concerns with deal flow and foreign investment restrictions, Asia will remain a hotbed of activity for the foreseeable future.

1 Reuters, “Asia private equity fundraising bounces back,” March 5, 2010.

2 Neuberger Berman, “2010 Private Equity Outlook,” January 2010.

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.

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.

Long/short equity is among the most popular investment strategies used by hedge fund managers, primarily because it is a straightforward and effective way to hedge market risk. Similar to stock picking, funds invest in equities that they believe will increase in value over time while simultaneously selling short positions they believe will decrease in value.

Traditionally, long/short equity funds average 35 to 40 percent net long, indicating a bullish outlook. Recently, however, we have seen that percentage dip well below the historical average due in large part to the guarded nature of today’s investors.1

However, many managers are doing more to protect themselves against downturns than rebalancing their portfolios. To fight against negative market trends, more and more hedge fund managers are pursuing fundamental strategies. Apparently, this is just what investors want.

In May, 45 percent of the investors we spoke to expressed a preference for fundamental mangers while 30 percent favored quantitative managers. This difference could be attributed to the fact that fundamental approaches have outperformed their quantitative counterparts during the past few years.

However, BHA’s conversations with investors point to other reasons. Many investors note that long/short strategies are easier to understand and fundamental managers provide more transparency. Investors are reluctant to invest in something they don’t understand and many feel quantitative strategies are too complicated.

Additionally, almost half of the investors we spoke to in May required at least quarterly liquidity, and an astonishing 99 percent required an experienced management team with a proven track record. Investors want access to their money and they want to work with teams they can trust. The plethora of Ponzi schemes and fund meltdowns over the past few years has diminished investor’s willingness to take risks.

Although most quantitative strategies may be difficult to understand, they can potentially provide better downside protection and characteristically have lower operational fees. Therefore, an argument can be made for combining a fundamental approach with a cheaper, more defensive model that employs sophisticated mathematical tools able to sift through copious amounts of data in seconds. The fact that there isn’t an uptick in quantitative interest during such volatile times, however, implies that current investors prefer fundamental reasoning and analysis when it comes to picking stocks.

As always, long/short equity strategies will remain a popular choice among hedge fund investors for the foreseeable future. However, BHA expects more management teams will combine both fundamental and quantitative models in order to maximize upside potential while mitigating risk.

1 Market Folly, “Long/Short Equity Hedge Funds: Net Long Exposure Below Average,” April 21, 2010.