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Hedge Funds Combat Negativity

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BOSTON (–Hedge funds still are trucking down the path of profitability despite some noteworthy obstacles thrown in the way by investors and regulators this year.

New distribution channels are opening up to hedge funds, as they prepare to add regulatory compliance vernacular to their business models. At the same time the nagging fears over opaque portfolios and lack of performance have yet to subside.

Combining data from three separate surveys, Cerulli Associates found that the recent bear market bolstered hedge fund managers; that investors are still leery of high fees; and that the hedge fund industry is concerned about the Securities and Exchange Commission’s actions and the perception that hedge funds have performed poorly of late.

Bullish analysts at Cerulli said in a report titled “Hedge Funds: The Market for Absolute Return” that the hedge fund industry could more than quadruple in size by the end of the decade, shoving aside doomsday scenarios that predict capacity issues could burst the hedge fund bubble.

The idea that hedge funds are performing poorly is up for little debate. In October, each of the major hedge fund indexes reported losses that likely will be difficult for hedge funds to overcome by year end.

Roughly 36% of the hedge fund managers surveyed by Cerulli said they believed that future hedge fund growth rested on the industry’s ability to mitigate performance concerns. About the same number said the hedge fund business’s ability to prevent seismic collapses was important in maintaining investor interest. Managers also expressed worry over what the SEC plans to do next.

Cerulli collected its qualitative analysis through interviews with 100 “industry insiders,” including asset managers, distributors and administrators. Cerulli’s surveys looked at: hedge fund and long-only managers’ attitudes toward growth; funds of hedge funds’ and investment consultants’ mining of managers; and advisers’ views on hedge funds reaching the retail market.

Cerulli found that fees are a major hurdle for investors considering hedge funds, with 74% of non-investors saying they would pay no more than a 1.5% management fee. Clearly some of those investors are more comfortable with mutual fund fees, since half of them said they would rather invest in hedge fund strategies that are found within the mutual fund format.

Mutual funds with a hedge fund bent are becoming more widely available. Cerulli estimated that US$200 billion to US$300 billion in mutual fund assets are actually invested hedge fund-type strategies.

Distribution platforms for hedge funds also are changing, Cerulli analysts said. A small number of broker-dealers are creating “super-platforms” that run multiple strategies and have state-of-the-art trading systems. These systems allow them to reallocate capital rapidly, which may threaten funds of hedge funds, they said.

Funds of funds, like their underlying hedge funds in some cases, are facing downward pressure on fees. Competition from consultants and advisers may further drive down fees that funds of funds typically charge. For single-strategy hedge funds, Cerulli predicted that if they compete on price they may not be around in five years.

This all spells trouble for traditional asset managers as well. Institutional investors that accept high hedge fund fees generally insist on paying lower fees to their long-only managers.

These same institutions, though, have yet to put pressure on their hedge fund managers to outperform. Cerulli officials concluded that it will take more than one year of mediocre performance to change these investors’ minds on hedge funds.

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