Hedge fund managers face strict demands from investors

In light of the problems seen in the hedge fund industry last year, especially after the Madoff scandal, investors are increasingly re-evaluating their investment criteria and objectives but remain committed to investing in these funds.

However as the landscape changes, investors' demands from hedge fund managers are on the rise and now stress in on the quality of information on liquidity, fund reporting and lower fees.

According to a recent survey by Preqin, these are the key concerns amongst investors. In 2009 stricter demands will be placed upon fund managers and they will need to work hard to meet these requirements if they are to secure investor capital, the survey revealed.

"Whilst our findings revealed that there is no mass exodus from hedge funds, with some investors even increasing their allocations, for the majority of institutional investors the events of the past 12 months have changed their demands from hedge funds. Increased liquidity, lower fees, and transparency were common demands being made by investors we spoke to," said Preqin.

According to Dr Reza Hadizad, Managing Director of Asset Management at Arqaam, one important trend has been a continuous re-assessment and separation of the concept of alpha from mere market exposure.

"As an example, exchange-traded funds [ETFs], which provide a cheap method of gaining beta exposure, actually grew in Europe by 6.5 per cent last year. In itself, this may be construed as a tendency towards cheaper, directional (non-hedge fund, and therefore, market correlated) forms of exposure. Put in the context of massive outflows of capital from hedge funds it can demonstrate the emergence of a more demanding and discerning hedge fund investor who is inevitably putting pressure on the fees charged by fund managers," Hadizad told Emirates Business.

Transparency key concern

Preqin's survey shows that institutional investors will be scrutinising funds more closely now. Although the Madoff scandal has not seriously affected the types of funds that are being considered, it is having some notable effects on institutional investors with 38.5 per cent of them stating that going forward they would be carrying out more vigorous due diligence checks.

Transparency is a crucial concern amongst investors and there is a need for fund managers to communicate with investors on a more frequent and unambiguous basis.

Calls for hedge funds to be less opaque was a common request amongst investors surveyed by Preqin and a good 43 per cent of investors raised this issue.

In the aftermath of the Madoff scandal investors want to know what managers are doing on a more frequent basis and to have a better understanding of how their returns are being generated.

Hadizad said: "New investors are exercising their recent importance to demand more transparency and liquidity. In the GCC, the consistent adherence of the fund managers to their mandate, their lack of style drift, and infrastructural issues, such as ring fencing of client assets, have become watchwords. In addition, the quantitative aspects of due diligence are being supplemented and augmented with qualitative questions and demands."

In addition to the dissatisfaction shown over the level of information they receive over strategy, more than a third of the investors in the survey were not completely satisfied with the quality of information on liquidity and fund reporting generally.

Investors noted that the levels of communication between them and the fund manager can on occasion be rather poor and the amount of information they receive is an area that needs to be improved.

To increase the level of communication, the role of the investor will have to be inclusive. "This may range from meeting requests that go beyond the formal presentation phase to attending the workplace and wanting to observe the fund manager's decision-making process in real time and of course the old time favourites such as insisting that the entire team has their own money invested in the fund," Hadizad said.

In addition, investors have become more stringent about the use of independent administrators and custodians, again after the Madoff scandal, and insist on investing in funds that fulfill this criterion.

These developments come at a time when all kinds of funds are suffering from a marked drop in confidence due to turbulence in the financial markets.

"Undoubtedly all funds have suffered a crisis of confidence. This has been exacerbated by a number of high-profile Western hedge funds, which have resorted to a variety of measures, for example creation of 'side pockets', to prevent investors from redeeming investments," said Hadizad.

"Volatility in even the most liquid exposures of hedge funds, coupled with contraction of credit afforded these funds through their prime brokers, has led to substantial realised (as opposed to mark to market) losses. This in turn has led to a further loss of conviction in the very business model that these hedge funds operate in," he said.

Increase in investments

Despite the setbacks, investors seem to be in the mood to increase their investments in hedge funds. According to the Preqin survey, there is a significant level of optimism towards the market with a combined 76.9 per cent of investors stating that the turbulence of the past 12 months had not affected their confidence in the asset class and that they would continue to invest or even increase their allocation.

Approximately one-quarter of all investors polled by Preqin stated that they would be increasing their allocations over the next 12 months and believed that there were some exciting investment opportunities opening up on the market. Investors revealed that many remain committed to the asset class and are set to weather the storm and capitalise on a market upturn whenever this may occur. On the contrary, only seven per cent of investors polled stated that they would be decreasing their allocations citing poor returns and a lack of transparency as the key factors in this decision. "Quite a number of major fund managers are seeing some green shoots of investments and some are reporting net positive inflows of fund. Clearly these encouraging signs are small and at their embryonic stage, but are subject to lack of further catastrophic events that may further affect investor confidence. What I will corroborate from my standpoint is the general shift towards those investors who are taking a longer-term outlook," Hadizad said.

Another key finding of the survey is that investors will be looking to invest only with established firms in the future.

"The fallout from the Madoff affair does not appear to have drastically altered what investors look for in fund managers. A total of 15.4 per cent reported that from now on they would be changing their strategies to only invest with well-known or established managers with a proven investment strategy," said the Preqin survey.

"Generically speaking the larger, more established players have not been immune to large negative performance numbers. However, operationally and from a governance and regulatory compliance standpoint it may appear that these fund managers are offering more of a safety net. The events of recent months including that of Madoff and Stanford have highlighted the importance of due diligence measures that go beyond the mere superficial," said Hadizad. "Often the availability and the eagerness of smaller fund managers to provide a better service such as the continuous engagement of actual and potential clients have become more of a factor. This is coupled with the notion that so-called independent service providers such as external auditors and administrators may have a predilection to being influenced by larger more established players. The propensity of some of the larger players to be recalcitrant in addressing legacy issues such as high water marks, which are reset periodically, has further exacerbated the negative image of the more established players."

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