US Hedge Funds to See Net Redemptions in 2007?

Based on a large scale survey of hedge fund investors, Deutsche Bank forecasts 8% redemptions in the US for the upcoming year, which would represent a substantial change from the large inflows of the recent past. Nevertheless, the bank claims it will not have much impact on domestic markets (but how could they say otherwise? They have a prime brokerage operation). The survey also found that investors are taking a dim view of hedge funds diversifying into unrealated stategies like private equity. Are investors finally wising up? From MarketWatch:

Hedge funds focused on U.S. markets will see net redemptions for the first time ever in 2007 as investors shift money to emerging-markets managers, especially traders specializing in China, according to an annual survey of the $1.4 trillion industry by Deutsche Bank AG.

U.S. focused funds are likely to see outflows of 8% this year, while managers specializing in China could experience a 39% jump, Deutsche Bank found in a poll of investors with more than $900 billion in hedge funds.

Other emerging-markets managers focused on other parts of Asia and Latin America could also see inflows of at least 13% in 2007, Deutsche Bank added. Emerging markets hedge funds were the best performers in 2006 as a global liquidity wave pushed many investors to search for higher returns. That pushed up stock and bond markets in developing markets much faster than in the U.S. See full story.

That’s encouraging more hedge fund investors to diversify away from the U.S., which has traditionally been the largest hedge fund market. “Investors are asking us about emerging markets and planning trips to the region much more than we’ve ever seen before,” John Dyment, head of Deutsche Bank’s Hedge Fund Capital Group, said during a conference call with reporters.

“They will have to sell something to go into those regions,” he added. “We’re seeing slightly diminished interest in the U.S.” Dyment said he thought U.S. hedge fund redemptions probably won’t have a big effect on U.S. markets.

In their search for talented managers focused on China, hedge fund investors “are having a real struggle,” Dyment noted. “These funds are much smaller [than typical US hedge funds] and are more spread out geographically, making it hard to visit managers,” he explained.

Many investors polled by Deutsche Bank took a dim view of hedge funds’ recent foray into private-equity. Almost 40% of those surveyed thought it was bad idea for hedge fund managers to add private-equity investments to their portfolios. Just 15% said it was a good idea to mix the two, Deutsche Bank noted.

However, many more investors have become comfortable with longer lock-ups, the bank said. Lock-ups prevent hedge fund investors from redeeming quickly. More than half of those polled by Deutsche Bank are comfortable with lock-ups of at least two years, despite the fact that they’re often used to help managers make longer-term, private-equity type investments.

Agreeing to longer lock-ups gives investors access to some of the industry’s top managers and allows hedge funds to invest in longer-term assets such as real estate, derivatives and debt financing, Dyment said. What investors don’t like is when hedge funds unexpectedly begin mixing their regular investments with private-equity holdings, he explained.

“Investors get nervous when managers who have historically not invested in private equity sudden get into it because it’s booming,” Dyment said. “They may not have same depth of expertise as dedicated private-equity firms.”

That may be why many hedge fund investors are comfortable with managers using so-called side pockets. These are typically off-shoots from a main hedge fund that have stricter redemption rules and allow managers to hold more illiquid assets. Two-thirds of investors surveyed by Deutsche Bank said they would consider investing in a hedge fund with a side pocket.

An article in the Financial Times, commenting on the same study, stresses that investors are disappointed in hedge fund returns and are having trouble finding managers that meet their performance objectives:

Hedge fund investors are becoming increasingly frustrated by their inability to find managers who can meet performance goals, which is making it harder for new funds to raise money.

Three-quarters of investors report difficulty in finding managers who live up to their performance expectations, according to an extensive survey by Deutsche Bank, to be released today.

John Dyment, the global head of Deutsche Bank’s hedge fund capital group, said: “I hear this complaint from investors more and more often. Hedge funds’ biggest challenge this year will be performance-related.”

Hedge funds last year returned an average of 13 per cent, which is in line with their historical average.

“But the expectation is that the funds will outperform the markets, and they haven’t been. You have to look at the competition. Private equity was huge last year,” said Mr Dyment.

The picture emerging from 200 investors interviewed – culled from the 1,000 polled – was that they were finding it increasingly difficult to find the right managers.

As a result, he said: “It is harder for funds to raise capital today than it was six months ago. There are a lot more hedge funds today than there were five years ago . . .

“People [managers] without track records are finding it hard to raise money. Investors are investing in businesses, they don’t just want a star trader any more.”

Investors are still expected to put a total of $110bn into hedge funds this year – slightly more than the estimated $100bn inflow for 2006.

The investors typically expected returns of 10 per cent this year, and believed that emerging markets, especially in Asia, would produce the highest returns.

The expectations about returns had proved accurate over the previous five years that the survey had been conducted, said Mr Dyment.

“The biggest thing we are seeing now is the shift to emerging markets,” he said.

Funds specialising in China were expected to lift their assets by close to 40 per cent this year as a result of the flow of new money.

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