BHA recently attended an industry conference devoted to family offices and their role in hedge fund investing in 2010. More than 200 single- and multifamily offices were in attendance as well as 250 alternative fund managers. Speaking to numerous family office investment teams and sitting in on a handful of panel discussions, analysts gained considerable insight into how family offices have evolved and how their focus has changed.

To start, the number of family offices in the U.S. and abroad has grown considerably over the past few years. The main reason for this a need for services. Large institutions are not offering affluent investors highly personalized financial services.

Services vary from office to office, however, most are providing investment and finance-related services, such as tax management and advisory services, political donation management, cash flow management and budgeting, and multigenerational wealth transfers. These services are not available in a private banking or traditional wealth-management setting, simply because they are affordable for only the most affluent individuals. During these uncertain and volatile economic times, the demand for highly sophisticated and personalized finance and investment services has increased significantly, and paved the way for teams to spin out and open shop.

Family offices have also increased their activity within the hedge fund space considerably over the past few years. After a disastrous 2008 and an extremely volatile 2009, the need for exposure uncorrelated to the market has become more and more apparent to single family and multifamily offices. Of the roughly 7,000 mandates published on the BHA platform, nearly 1,000 are family offices around the globe actively seeking new investment opportunities.

The three major themes discussed throughout the conference were better liquidity terms, typically at least quarterly; more transparency, including insight into how managers run their strategies and direct access to portfolio managers; and investing through managed accounts.

Although family offices are increasing their activity in the alternative space, they are becoming much more cautious in their approach to new investment opportunities. Furthermore, family offices are increasingly adopting institutional investment practices when conducting due diligence. Track records and performance are no longer enough to justify an allocation; it takes much more to earn the trust of these coveted investors. They are putting more emphasis on operational due diligence, including risk management analysis, administrator reviews, and even manager background checks. Funds with a stable infrastructure and a cohesive team are now the most eligible bachelors.

It is apparent that money is gradually flowing back into the alternative industry, specifically in the family office circle. However, with that also comes a change in perspective and process. Managers will find that they must be much more accommodating if they want to get on the radar screens of an ever-growing segment of the investor market.

Although the economic outlook for the United States is far from sublime, there have been numerous reports released in the past month that indicate things are moving in the right direction. The U.S. Bureau of Labor Statistics reported that unemployment decreased in June, both as a percentage of the total working population and in the total number of unemployed individuals.1 Furthermore, although predicted GDP growth for the second quarter was only 2.5 percent, the U.S. is still among the fastest growing economies in the developed world. Investors looking for secure investments are flocking to this market.

A recent study released by the Dutch Statistics Bureau revealed that world trade, measured in total import and export volumes, has nearly returned to the all-time highs of early 2008.2 In the U.S., capital goods orders increased, signaling an increase in business investments. In fact, business investment in the second quarter rose at a rate of 17 percent, the largest increase since the first quarter of 2006. All of these indicators provide a mildly promising outlook for the second half of 2010 in the United States.3

Furthermore, although the Federal Reserve has limited options to stoke economic growth due to near zero real interest rates, it still has a few silver bullets. One option is to increase the money supply by buying back U.S. Treasurys. With a cheaper dollar, exports are more competitive on the world market. As has been vividly displayed in China and India, export-oriented economies are far more sustainable than those that rely heavily on importing goods; an increase in U.S. exports will help neutralize the trade deficit, which, in the second quarter, singlehandedly took 2.78 percentage points off the U.S. GDP.

It seems that the imbalance between imports and exports was one of the only negative results of the second quarter in the U.S.; other indicators signaled a positive outlook for its economy. If the U.S. was a more export-oriented economy, economic growth could reach pre-recession levels. Investors, aware that the U.S. is on a slow but stable path to recovery, are regaining confidence in U.S.-focused investments in the alternative space.

Compared with the first month of the second quarter, the first month of the third quarter has shown a significant increase among private equity and hedge fund investors for U.S.-focused funds. In July, 116 investors specified an interest in U.S. funds. In April, only 90 investors specified the same interest. Not surprisingly, that number dropped in May (86 total mandates) because the flash crash on May 6 scared many investors from the region’s public markets.

Since then, investors have re-evaluated their interest in the world’s largest economy. Due to promising economic indicators released during the month of July as well as low inflation, which gives the Fed the ability to instate expansionary monetary policy, the outlook for the U.S. economy is slightly better than it has been in past months. This has caused more investors to refocus on investments in the United States.

1 The U.S. Bureau of Labor Statistics, “The Employment Situation – June 2010,” July 2, 2010, http://www.bls.gov/news.release/pdf/empsit.pdf.

2 City AM, “World trade is continuing to recover,” July 29, 2010, http://www.cityam.com/news-and-analysis/allister-heath/world-trade-continuing-recover.

3 Reuters, “Imports slow Q2 growth as business spending surges,” July 30, 2010, http://www.reuters.com/article/idUSTRE65M2WK20100730.

The months of July and August are known by many in the industry as a time when vacations and holidays are common—a time when it takes more calls and creative efforts to get in touch with investors. But it certainly can be worth it. BHA analysts compiled 137 investor mandates this past week. Although it is important to maintain a constant dialogue with new and existing investors, it is also critical to do the leg work required to maintain an organized marketing campaign. The slower months provide such an opportunity. They are the perfect time for marketers to do the “behind the scenes” work that will help them hit the ground running when September rolls around.

Updating investor contacts is a good use of time over the next few weeks. In an industry where individuals move frequently from firm to firm, it becomes easy to lose track of existing contacts within the span of just a few months. September is also a popular month for people to begin new jobs. By culling existing contact lists and finding fresh sources of data to supplement them, marketers will increase their hit rate when it comes time to reach out to prospects.

Fund marketers should also use this month to build a pipeline for the fall. They can identify those in their existing network that they need to reconnect with and mine their new sources of leads to find those that should be added to their prospect lists. At the same time, marketers should refine their investor introduction e-mails and fund documents, so everything is ready to begin targeting investors in their pipeline.

Depending on what their pipeline looks like and who they want to connect with, marketers can identify a few cities or regions that make the most sense to visit in the next few months. The sooner a travel schedule is compiled, the sooner they can begin to schedule meetings and look for additional prospects in the same areas.

Summer can mean a few weeks out of the office for one person and a head start on an action-packed autumn marketing campaign for another. It is important for marketers to use their time as efficiently as possible from September until early December. Some hard work over the remaining weeks will go a long way towards creating new investor relationships this fall.

The global financial crisis has caused many investors to change the way they allocate their capital. Prior to the downturn, many investors chased high returns; they considered the strategy of the portfolio or fund to be secondary. Since the crisis has subsided, however, many investors have taken a different approach. They are looking for ethical investment vehicles.

Many investors have come around to the thinking that environmental, social, and corporate governance (ESG) issues can affect fund performance. They believe that if they invest in companies focused on these issues, then they are selecting to invest in better-managed, more innovative companies that are better positioned than their less enlightened competitors to deliver long-term performance.

At the same time, they believe that companies focused on ESG issues are more ethical than companies focused solely on profitability. In fact, ESG funds are drawing investors’ attention to the downsides of greed and fraud that many funds might overlook.

The CIO of Australian super fund recently stated, “Good responsible investing, [that considers] additional non-financial issues (including ESG issues), mitigates against the risk of corporate scandals, fraud and potential litigation against a company. The community’s recognition of a genuine commitment to corporate governance can enhance the reputation of the company and raise general confidence.”1

A good example of a new ESG investor is a pension fund in the Netherlands. It has a portion of its assets dedicated to ESG funds. The pension fund wants to hear from equities funds that focus on ESG or socially responsible investing (SRI). It will look at funds that invest in developed areas as well as emerging market regions. However, it wants management teams that have substantial experience in ESG investing. [Okay to say "new ESG investor" in first sentence?]

ESG funds will be an area that BHA will monitor going forward. Ethical and responsible investing is in its infancy and has the potential to be a popular choice among alternative investors.

1 SuperReview, “Socially responsible investments earning their keep,” July 19, 2010, http://www.superreview.com.au/article/Socially-responsible-investments-earning-their-keep/520244.aspx.

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.