Whatever analogy one chooses to describe the market decline of 2008 – tsunami, meteor strike, meltdown – it caused investors to question long-held assumptions about their investments, including their performance and liquidity expectations.

In the post-crisis landscape, transparency has become more than a sound bite for institutional investors. Trust in financial institutions has been severely shaken and investor priorities have seen a seismic shift with return of capital moving to the forefront of investors’ minds.

Against this backdrop, the SEI Knowledge Partnership conducted its 2009 global survey of institutional hedge fund investors. The 2008 survey, conducted in the midst of the crisis, found institutional investors staying the course. But how would investors view their hedge fund investments after having a year to reflect on their performance and liquidity (or lack thereof), not to mention the Madoff scandal?

Good news but call to action in new era
For the hedge fund industry, the results of the 2009 survey come as both good news and a call to action. Institutions, which have replaced high-net-worth individuals as the core investor base for hedge funds, are firmly committed to preserving the role hedge funds play in their portfolios. Indeed, a portion of the survey respondents plan to increase their hedge fund allocations, albeit incrementally.

That said, investors’ continued commitment comes with substantially increased expectations. Indeed, power has shifted and greater transparency is the price of institutional commitment. This expectation is emblematic of a key trend transforming the investment management industry. At SEI, we refer to this trend as the Era of the Investor. In the Era of the Investor, institutional investors and their representatives are increasingly asserting themselves, changing the rules of hedge fund investing as they push managers toward greater transparency, insisting on identifiable sources of alpha and intensifying their focus on operational effectiveness.

Transparency specifics
With respect to transparency, institutional investors expect far more information regarding their hedge fund investments. In fact, those surveyed named transparency as both the biggest worry and the single greatest challenge related to hedge fund investing. What’s more, a majority of investors have already acted on their transparency concerns. Over 70% reported requesting more detailed information from managers than they did a year earlier. While the type of information sought ranged from counterparty and leverage exposure data to sector and position-level detail, over 80% of the respondents reported a focus on funds’ valuation methodologies.

In their open-ended comments, survey participants described their transparency expectations in varying ways. For example, one defined the challenge as “obtaining adequate information to fully understand the fund’s strategy,” while another explained it as “having a deep understanding of the underlying positions to be sure that the risk profile is well in line with what we are looking for.” All in all, survey responses make it clear that institutions are concerned with transparency as it applies to a hedge fund’s investment process, as well as its portfolio.
Investors’ focus on transparency also related to the second greatest challenge they cited, “educating board members.” In their responses, survey participants spoke to the difficulties of “explaining why absolute return funds did not perform as expected,” “convincing trustees of the added value of investing in hedge funds,” and “educating the board on the use of hedge funds within a diversified portfolio.”

Focus on valuation
When asked what kind of new information they were seeking, investors overwhelmingly named valuation as the function on which they most want more information, followed by detail regarding leverage, sector exposure, portfolio positions, and counterparty exposure (see figure 2).

When asked what contributes to accurate valuation of hedge fund holdings, respondents emphasised the importance of independent auditing, which was named “very important” by 72% of those surveyed. Those surveyed also looked for independence in the form of third-party valuations and independent administration, which were named “very important” by 47% and 40% of respondents, respectively.

Where do we go from here?
SEI’s 2009 survey documents the enduring relevance for institutions operating in a long-term investment framework. While the fallout of last year’s financial crisis shocked hedge fund investors, who saw returns significantly lower and more correlated with unhedged indices than anticipated, they are maintaining and even strengthening their commitments to hedge fund investing. But by no means can hedge fund managers expect a resumption of “business as usual.”

The hedge fund investor base is empowered and proactive. To remain competitive, fund managers will need to be proactive in enhancing their transparency and investor communications and reporting. In fact, investors’ focus on the issue indicates they will not only push hard for greater transparency from current managers, but also will increasingly make it a prerequisite for hedge funds in which they invest as nearly 80% of respondents cited “portfolio transparency” as an important or very important factor in manager selection. In short, investors are rewriting the rules of engagement as they continue absorbing the lessons of the past 18 months.

Phil Masterson is Managing Director of SEI Investment Manager Services and is responsible for leading the division’s thought leadership program, the SEI Knowledge Partnership. SEI is a leading global provider of institutional and private client wealth management solutions, including asset management, investment processing, and investment operations.