Deutsche Bank 2010 Alternative Investment Survey

The hedge fund industry rebounds and confidence is back

Originally published in the April 2010 issue

The Industry is buoyant and confidence is back. Investors still have cash to allocate: 29% of investors have 10% and upwards. Furthermore, they are looking to reduce their cash levels over the next six months by an average of $3.09 billion. The Industry is now predicted to grow further and return to previous highs.

Key Points
• 68% of respondents invest in hedge funds to attain better risk adjusted returns. Reduced volatility and protection on the downside in these markets is what investors value most.
• Investors are increasing allocations to hedge funds: 72% of investment consultants said their clients were increasing their allocations to alternatives and 76% said this was to hedge funds in particular.
• Cash inflows: 73% of investors are predicting inflows into the industry of more than $100 billion in 2010. We estimate the inflow figure to be closer to $222 billion, taking the industry to $1.722 trillion this year.
• 80% of investors predict that fewer than 20% of managers will shut down in 2010. This estimate has fallen significantly from 2009 when 25% of investors predicted more than 30% of managers would fail, with a further 40% of investors predicting that 20-30% of managers would not survive.
• Most managers are no longer gated. Over 60% of investors indicated that fewer than 5% of their managers were still gated, with almost half of these investors noting that none of their existing managers were gated.

Good performance expected
• 34% of investors are predicting the S&P500 will return between 5-10%; 74% of investors are predicting positive performance for the MSCI World. 22% of investors are even predicting the MSCI Emerging Markets index will return 15-20%.
• Investors are convinced of their own ability to perform with 99% predicting they will end the year in positive territory. 45% of investors think they will return between 10 and 15% on their own portfolios.

Equities are back
• Investors are looking at increasing their allocations to equity long/short (51%), event driven (42%) and emerging markets (38%). Equity long/short is also predicted by 52% of investors to be one of the best performers for 2010.
• Beta is back. Market neutral is predicted to be one of the worst performers for 2010 and there is minimal demand for the strategy. Asia ex-Japan, Latin America and China are predicted to be the best performers in 2010.

Industry maturing: lessons learnt
• Increased barriers to entry: 42% of allocators are invested with managers that run on average over $1 billion in AUM. Investors’ reluctance to allocate to small start-up funds continues: 50% of investors require funds to have at least AUM of $100 million before investing.
• Investors unforgiving of mistreatment: freezing or suspending of assets and increasing side pockets by managers would prevent 80% of investors from making a new allocation to a manager. Freezing of assets was also overwhelmingly considered by investors to be the most damaging action to a fund’s reputation (38%). This dwarfed even bad performance (20%).
• Due diligence is becoming more rigorous: 15% of investors say they now use a consultant. Consultants are increasingly used to perform specialist operational due diligence as investors recognize its importance in the post-Madoff world. Investors are also taking slightly longer to complete their due diligence with 14% of investors taking seven months and upwards.
• Risk management remains the second most important consideration for investors when they assess a hedge fund manager. (Investment performance being first and investment philosophy the third.) Transparency, liquidity and regulation increasingly determine investor allocations.
• Regulation: 50% of investors felt that regulatory issues will be the greatest challenge for managers in 2010. Only 20% of investors expressed this as a concern in 2009.
• UCITS III: year on year we have seen a 50% increase in interest from investors. 34% indicated that they will have investments in the UCITS III space in the next 12 months. 33% of respondents said they would rather invest in a UCITS III version of the same hedge fund, as opposed to a Cayman vehicle.
• Managed accounts: appetite is not simply a knee jerk reaction to the events of 2008. 14% of investors use managed accounts and 26% of investors are likely to in the immediate future.
• Asset segregation: 62% of investors prefer a manager that segregates its assets and investors have a strong preference for the tri-party asset segregation model.


In 2009, the hedge fund industry was still struggling with the asset outflows seen at the end of 2008. However, Q3 2009 and Q4 2009 saw the trend reverse and flows were positive for both quarters. These marked the first positive inflows since Q2 2008. That said, cumulative figures for the year remained in negative territory and the industry still lost $131.2 billion, according to Hedge Fund Research. 41% of the investors we surveyed in 2009 predicted net asset outflows of over $150 billion from the hedge fund industry, with 30% of investors predicting as much as $200 billion. These estimates illustrate the pessimism of the investors we surveyed at the time. The fact that they considerably overestimated the true figures also shows what a rebound we have seen since then. The hedge fund industry is at $1.5 trillion as of 31 December 2009, how much do you think will flow into hedge funds in 2010? (see Fig.1). This year there has been a striking turnaround in investor sentiment with an overwhelming 73% of respondents predicting net asset inflows into the industry of more than $100 billion. Fewer than 2% of investors are expecting asset outflows in 2010. Performance in 2009 Hedge fund performance in 2009 was largely driven by three factors:

1) Opportunistic directional exposures to rising markets
2) A bounce back in the valuations of less liquid securities still held by hedge funds, that traded well below fair value in 2008
3) Skill-based returns (non-directional) from market inefficiencies that were abundant.

2009 overall was a positive year for hedge funds. Those managers that participated in the factors mentioned above generated strong performance, however; this was of course not without risk. A correction of the equity markets, a blow-out in credit markets or a worsening of liquidity was a possibility in 2009 and still remains a threat for 2010 (see Fig.2).

Very few hedge fund strategies have experienced performance difficulties in 2009.The only strategy that really struggled was equity short bias. This was a result of short bias funds not participating in the equity market rally of 2009. With good performance comes confidence and also a desire from investors to allocate more capital to the space (see Figs.3,4 & 5).


It seems from the graphs mentioned above, that appetite for beta is back. Market neutral is predicted to be one of worst performers and directional equity strategies some of the best performers. Cash, not surprisingly with interest rates at their current levels, is predicted to be the worst performer, however, many might be surprised to see CTAs and convertible arbitrage as so out of favour.In conclusion, as regards performance, investors are predicting a positive 2010. That said, one must remember that very few investors managed to get it right for 2009. Investor sentiment often seems to be based on their most recent experience.


Strategy Allocations
The graphs in this section show investor appetite for 19 different hedge fund strategies, as well as investors’ cash allocations. It seems that overall many more investors are looking to increase allocations than are planning to reduce their allocations. If we apply this to the general mood of investors, it seems fair to say that 2010 is tentatively expected to be a good year (see Figs.6 & 7).


Difficult Strategies to Source
This was the first year we have asked investors what strategies they find the most difficult to source. It comes as no surprise that 14% of investors cited global macro and volatility arbitrage as the most difficult strategies to source – particularly as demand for these strategies is high and the universe of managers is already well known. As a capital introduction team we are always asked for “good global macro manager suggestions” and we often find it very difficult to come up with new manager ideas (see Fig.8).

Changing Investors Landscape
In 2009, we saw the continued institutionalisation of the investor universe. Like hedge funds, investors saw rapid growth between 2003 and 2008. All markets expressed dramatic declines (or losses) with great impact on investors in 2008 and early 2009. No investors were exempt.

Furthermore, each country and region suffered in a different way. US based investors did not generally lose the percentage of assets their European counterparts did and they have definitely rebounded faster. European investors, who often have retail money invested through funds of funds, have suffered to such an extent we do not expect to see many of them reach their previous asset highs for some time to come, if at all. Last year we finally saw redemptions cease in all geographies.

Money has also started to flow back into the industry. Flows back into the industry, however, are not following the same path that they came out of. The larger investor groups are benefiting and there are still concerns as to whether many smaller investors will survive. We feel therefore, there is still a lot more consolidation to take place (see Fig.9).

Those investors that have limited mandates when it comes to hedge fund investing are almost all public and private pension plans, foundations and endowments and insurance companies. The majority of those we have surveyed, however, have no restrictions. This will come as no surprise since 42% of survey respondents were funds of funds (see Fig.10).

AUM in Hedge Funds
Of our respondents, over 50% still manage less than $1 billion in hedge fund assets. This gives us cause for concern. With the continual institutionalisation of the business, many feel that it is necessary to mange more than $1 billion to get the necessary economies of scale, have institutional infrastructure and perform vigorous due diligence.

The industry asset base is much improved since we took data figures in 2008. It seems we are increasingly losing those investors who have under $100 million invested in hedge funds. This could either be because they have raised more assets taking them up the scale since last year, (something we highly doubt unless they have merged with another entity), or because they have ceased to exist. Those managing over $1 billion continue to increase their asset base. This is because they will have the infrastructure and global footprint that allows pension fund and foundation and endowments to invest with them (see Fig.11).


New investors
Only 17% of investors have been investing in hedge funds for between one to five years. The remainder of our participants have track records that are much longer than this. Those investors who have been in the industry for 15 years and more are nearly all based in North America. The European and Asian investor base have been investing for shorter periods than their US counterparts.

The majority of respondents are invested with surprisingly few managers. 19% of the investors we surveyed only hold positions with 10-20 managers. The types of investors that have 30 investments and upwards are fund of funds and asset management companies. Pension plans in both the US and Europe account for the 7% of investors who have between one and 10 investments.

Our historical data shows that the number of managers investors have money with has been decreasing since 2008. It seems the events of the last two years have pushed investors to remain with only their high conviction managers. When there is turbulence in the market place, investors are not willing to have managers in their portfolios who could potentially produce any performance surprises or worse, fraud (see Fig.12).

Furthermore, investor sentiment has long turned against having portfolios that are too diversified. The level of due diligence that is now required is more costly and timely and fewer managers means allocators are able to monitor their investment in minute detail. It is possible that as investors have suffered redemptions they have had to redeem from managers, however, if this was the case, this should have been reflected in our data from 2009 (see Fig.13).

It is startling how investors have migrated to larger hedge funds over the five years we analysed this in our survey. 42% of those surveyed are invested with managers that have over $1 billion on average in assets under management. We saw a small drop off in 2009, however, this undoubtedly reflected the heavy redemptions we saw across the industry at that time.

Those investors that are happy to look at managers with smaller AUMs tend to be based in Asia or Europe. 45% of those allocating to managers with AUMs of under $100 million come from Asia, 28% from Europe, 24% from North America and 3% from Latin America. The 45% of investors from Asia, are fund of funds and family offices. Those putting money with hedge funds with AUMs of between $100-500 million tend to come from: 45% from Europe, 35% from North America, 19% from Asia and 1% from Latin America. American investors have a strong preference for larger managers (see Fig.14).


As a team, we were surprised that European investors in 2009 have been so active. We feel one way of explaining this data is that many Europeans disinvested in 2008, and they may have given back into the market place in 2009.

Furthermore, European institutional investors, (mainly pension schemes), have approximately $4 billion in outstanding mandates. While more than $1 billion in hedge fund and fund of funds mandates were completed in 2009, most of that activity ($800 million) was in fund of funds. This must have fed up the food chain and benefited single managers. In the US, there was $3 billion in awarded mandates but there was little in the way of search activity as only $587 billion in open mandates were reported in 2009. When you look at follow-on allocations, however, it is US based investors who have been the most active (see Fig.15).

Investors focus on risk management continues to be borne out in 2010. In spite of a significant rebound in the markets, investors still remained focused on risk management. The 3Ps: performance, philosophy and pedigree, use to be the reasons continually cited by investors as the most important considerations when reviewing a manager. 2008 changed this. Since the financial shake down, risk management and transparency have crept up the rankings.

Investors are rewarding prudent navigation of risk through a problematic period. Performance of course still holds the number one spot, however, long gone are the days when a manager’s previous experience alone (pedigree) could result in him/her being allocated capital. The increase in the number of investors who cited ‘Lock-up’ this year as an important consideration for them was a little surprising. We thought this would have been reflected in our 2009 survey. Investors arguably have moved away from wanting the least restrictive lock-up possible, to a lock-up that matches the underlying liquidity of the fund.

Evolution of terms and future pressures The buoyant performance of 2009 certainly served to assuage many investors’ concerns over the survival of the hedge fund industry; however, with the ugly spectre of 2008 still lingering in their minds, it was evident that there remain considerable pressures on managers and that the balance of power has certainly remained far more with the investor community than we had witnessed in previous years. Investors continue to demand liquidity where possible and their tolerance for locking up capital indefinitely remains severely affected by the events of 2008. The key beneficiaries of the changes in investors’ sentiment would appear to be the larger, more established funds with a continued reluctance amongst most allocators to consider funds of AUM <$100 million and with short track records.

However, investors appear to be ever more forgiving to those managers who were impacted by the severe market downturn and needed to restrict redemptions. Increasingly investors will consider managers who experienced a significant drop off in performance (one would suspect provided that they had demonstrated a significant rebound from these levels) and at least a third of investors would allocate again to a manager who had either invoked their gate or adjusted liquidity terms. Not all measures were viewed so compassionately though, with the majority of respondents refusing to consider an allocation to a manager who had frozen assets or increased sidepockets.

It was clear from the responses given that although there are managers who are still having difficulty, (an average of 31% of funds still had not reached their high water marks at the time of the survey), many managers will once again be collecting performance fees in 2010 and a majority have now worked through their gates. The pressures faced by managers would appear now to be more to do with the regulatory environment than with concerns over performance and redemptions. This would suggest a stronger industry, but one that still has issues to overcome.

Source for all graphs: 2010 Deutsche Bank Alternative Investment