Institutional Hedge Fund Investing Comes of Age: A New Perspective On The Road Ahead

Institutional Hedge Fund Investing Comes of Age
A New Perspective on the Road Ahead

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0 1 I N T RO D U C T IO N
0 2 C ON T E XT
0 4 K E Y FIN D IN G S / TA K E AWAYS FOR HEDGE FUND M ANAGERS
07 S U RVE Y R E S U LTS
2 3 A BO U T T H E S U RV E Y
Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead
In the annals of hedge fund investing, 2010 will be
remembered as the time when investors began to
apply consistently the lessons learned during the
financial crisis. Meanwhile the hedge fund industry,
after being badly shaken by the upheavals of 2008 and
their aftermath, appears to be back on a growth track.
Investors who stayed the course were generally rewarded
with a strong rebound in 2009 and positive, if modest
returns in 2010. Confidence in hedge funds is returning.
Yet there is no doubt investor perceptions and practices

have been fundamentally altered by their recent
experiences, as revealed by this fourth SEI Knowledge
Partnership global study of institutional investors.
In the process, the practice of hedge fund investing

has leaped in maturity, as investors and fund managers
alike have learned they can take nothing for granted,
including liquidity and absolute returns. Having survived
the firestorm, investors still believe in the benefits of
hedge funds, but are seeking a better handle on the
complexities. For hedge fund managers this brings both
challenges and opportunities.
1
Context
SEI’s 2009 survey was conducted against the On the plus side, having experienced a 21.4%
backdrop of an industry in recovery mode after cumulative decline during the crisis, the HFRI Fund
reeling from the experiences of 2008—the worst Weighted Composite Index recovered all of those
year on record for average hedge fund performance, losses. In fact, the index was up 30% between its
and one in which expectations for non-correlated trough in March 2009 and the end of November
returns were challenged. By the third quarter of 2010. When 2010 is viewed on balance, the glass is
2009, with average performance on the upswing, the at least half full.
tide of net outflows had reversed on an industrywide
basis and fund launches were beginning to outpace MANY HEDGE FUNDS CONTINUE TO OUTPERFORM
liquidations, trends pointing toward stabilization and LONG-ONLY STRATEGIES. The HFRI Fund Weighted
possibly a new cycle of expansion. Composite Index posted a gain of 8.48% over the
12 months ending on November 30, 2010, placing
The record for 2010 has justified institutional hedge fund returns on par with domestic stock
investors’ ongoing commitment to hedge funds, but indices over the short term. During the past five
has underwhelmed those hoping for a vigorous if years, however, the index produced an annualized
not spectacular rebound. Market and economic return of 5.64%, well ahead of the 0.98% produced
conditions remain less improved than many hedge by the S&P 500 Total Return Index. Going back to
fund managers and investors had hoped. the beginning of the past decade reveals an even
more dramatic difference. While the S&P 500 Total
Return Index stayed flat, the HFRI Fund Weighted
Composite Index doubled in value [Figure 1].
Figure 1: Relative performance of HFRI Fund Weighted Composite Index since January 1, 2000 (Indexed to 1000)
HFRI Fund Weighted Composite Index S&P 500 Index (TR)

2,200
2,000
1,800
1,600
1,400
1,200
1,000
800
600
400
200
00 01 02 03 04 05 06 07 08 09 10
Sources: Hedge Fund Research, Standard & Poor’s
2
Figure 2: Estimated number of hedge funds launched and liquidated (2000 - Q3 2010)
Launches Liquidations
2000
1800
1600
1400
1200
Number of Funds
1000
800
600
400
200
0
-200
-400
-600
-800
-1000
-1200
-1400
-1600
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Thru Q3 2010
Source: Hedge Fund Research
STAR PERFORMERS WERE FEW AND FAR BETWEEN. INDUSTRY ASSETS ARE GROWING, IF MODESTLY. In
Last year, some hedge funds came roaring back from 2009, hedge funds bounced back with a respectable
the carnage of 2008 to post eye-popping returns. The 13.7% growth in assets for the year—regaining
average top decile return in the HFRI Fund Weighted a good share of the painful 24.7% contraction
Composite Index for 2009 was an astonishing 100%. in 2008. Asset growth in 2010 was substantially
In contrast, top decile returns averaged 15.2% in slower. Assets rose only 10.5% during the first three
Q1 of 2010 and 10% in Q2. Dispersion in 2010 was quarters of the year, reaching $1.77 trillion [Figure
relatively low: bottom decile returns averaged -8.6% 3]. At that point, the industry’s total assets under
and -16% in Q1 and Q2 respectively. management remained short of the peak of $1.93
trillion recorded in Q2 2008, as well as the annual
THE SHAKEOUT CONTINUES. Approximately 2500 peak of nearly $1.87 trillion at the end of 2007.
hedge funds were liquidated in 2008 and 2009,
far in excess of the 1443 launched during that Nonetheless, there is reason for cautious optimism,
period. While fund closures slowed, only 130 net in that the industry’s fortunes have improved over
new funds were introduced during the first three the course of 2010. The third quarter saw hedge
quarters of 2010 [Figure 2]. The upshot is that the funds gain a net $19 billion in new capital, the
number of funds is stabilizing, but is unlikely to grow largest quarterly inflow since late 2007.
quickly anytime soon. Many managers remain in
retrenchment mode, taking a wait-and-see approach
to new product launches. Meanwhile, start-up
managers face significant barriers to raising capital
and clearing higher regulatory hurdles.
3
Figure 3: Global hedge fund assets through Q3 2010 ($ billions)
Assets Under Management
2000
1800
1600
1400
1200
$ billions
1000
800
600
400
200
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Thru Q3 2010
Source: Hedge Fund Research
Key Findings
INSTITUTIONS ARE NOT ONLY MAINTAINING, BUT goal in hedge investing, up from 24% last year. The
STRENGTHENING, THEIR COMMITMENT TO HEDGE percentage that say they invest mainly with the
FUND INVESTING. That’s good news for hedge objective of lowering portfolio volatility also jumped,
funds, which have become increasingly reliant on rising from 8% in 2009 to 18% in this year’s survey.
institutional asset flows as their growth driver. More
than 54% of the investors surveyed said they plan INVESTORS ARE KEENLY AWARE OF PERFORMANCE
to increase target allocations to hedge funds in the CHALLENGES, AND HAVE MODIFIED THEIR
next 12 months—over three-and-a-half times the EXPECTATIONS ACCORDINGLY. In response to
percentage giving that response in 2009. an open-ended question, “meeting performance
expectations” tied with “transparency” as the
ACCESSING NON-CORRELATED STRATEGIES HAS greatest challenge in hedge fund investing. Still,
EMERGED AS THE TOP INSTITUTIONAL AIM IN 54% of participating institutions said they are
HEDGE FUND INVESTING. This reflects a shift in “satisfied” with the performance of their hedge fund
objectives since our 2009 survey, when institutions investments, and another 13% reported being “very
reported investing in hedge funds primarily with an satisfied.” Only 9% expressed dissatisfaction and
eye to diversification and absolute returns. Those just 3% pronounced themselves “very dissatisfied.”
objectives have dropped to the second and third,
respectively. This year, having been surprised TRANSPARENCY DEMANDS HAVE NOT ABATED. In
by higher-than-expected correlations among fact, concerns with hedge funds’ level of disclosure
asset classes and investment strategies during have intensified. Nearly 70% of investors name a
the financial crisis, 30% of respondents named lack of transparency as their biggest worry. While
exposure to non-correlated strategies as their #1 respondents to our 2009 survey were focused on
4
hedge fund valuation methods, more than three out restrictive lockups or gates, or favoring funds with
of four investors in this year’s survey said they also less restrictive terms.
want more detail on sector-level positions, use of
leverage, and risk analytics. HEDGE FUND SELECTION FACTORS HAVE SHIFTED
WITH INVESTOR PERCEPTIONS. In 2009,
SENSITIVITY TO LIQUIDITY RISKS AND TERMS investors placed the most weight on “the quality
PERSISTS. Fifty-eight percent of this year’s of management teams” in selecting hedge funds.
respondents cited liquidity risk as their biggest Among this year’s respondents, “clarity of investment
worry. “Liquidity terms,” which did not even appear philosophy” was named the #1 selection factor.
on the 2009 list of the top hedge fund selection “Risk management infrastructure,” which did
factors, cropped up this year as the fifth-ranked not even appear on last year’s list of the top 10
decision-making factor. Over 43% of respondents selection factors, jumped into second place in this
have had hedge fund investments subject to year’s survey results.
gates or suspension of redemptions. Among those
respondents, three out of four perceived those A MAJORITY OF INVESTORS AND CONSULTANTS
actions negatively while nearly one in four viewed EXPECT HEDGE FUNDS’ INSTITUTIONAL BUSINESS
them as a positive measure potentially mitigating TO GROW. Nearly nine out of ten respondents—and
damage from a rush to the exits by fellow investors. 100% of those representing large institutions with
A sizable share of investors reported taking steps to more than $5 billion in hedge fund investments—
enhance the liquidity of their investments, such as expressed a positive outlook for the industry over the
avoiding funds with side pockets, negotiating less foreseeable future.
ON A GROWTH CURVE:
INSTITUTIONAL
COMMITMENT TO HEDGE
FUND INVESTING
5
Takeaways for Hedge Fund Managers

Our 2010 survey findings show this to be a EMBRACE TRANSPARENCY. Last year we advised
time of significant opportunity for hedge funds managers to embrace transparency, and it warrants
to differentiate themselves from competitors in repeating. With investors’ transparency concerns
the eyes of institutional clients and prospective continuing to broaden and intensify, fund managers
investors. While more than half of the institutions need to:
we surveyed say they intend to increase their hedge • Understand that investors require a growing body of
fund allocations, their responses show that investors information to satisfy their range of constituencies
are operating with a shifting set of objectives and and gain comfort with a firm and its capabilities.
selection criteria.
• Institutionalize their transparency policies, so as to
create operating efficiencies and a consistent
Hedge fund managers can apply these insights
investor experience.
to reposition their funds and proactively address
primary areas of concern to investors. Specifically, • Be aware of possible conflicts of interest. While
managers should consider taking steps to: managers appropriately consider the needs of
individual clients, legal experts warn that hedge
ENSURE THEY CLEARLY ARTICULATE HOW THEIR funds may find themselves on shaky ground if
STRATEGIES ADD VALUE. Investors now put greater some clients are treated preferentially. Seek
emphasis on earning non-correlated returns than on counsel when in doubt.
absolute returns. Nonetheless, survey respondents
identified “meeting performance expectations” as CONTINUE INVESTING IN RISK MANAGEMENT
a top challenge and “failing to achieve the primary INFRASTRUCTURE. With institutions giving this factor
objective” as their second biggest worry regarding more weight in fund selection, the efforts that hedge
their hedge fund investments. Consequently, funds make to enhance their risk management
managers should have clear, succinct explanations measures and personnel will be time and money well
of how their strategies fit within a diversified spent. Strong risk management is essential not only
portfolio and are expected to perform under to mitigate financial losses and attract new capital,
varying scenarios. While the opaque and exotic but to protect a firm’s reputation—its ultimate asset.
may once have evoked visions of outsized returns,
an overly complex description of the investment INCREASE CLIENT SERVICE AND RETENTION EFFORTS.
process is an impediment to asset raising and Given the shifts occurring in investor perceptions and
retention. Institutions are increasingly focused on objectives, fund managers cannot take for granted
understandable strategies grounded in an investment their continued fit with the needs of existing clients.
philosophy with defined risk-return characteristics In this climate, timely, two-way communication and
and a readily identifiable source of alpha. consistent reporting are more important than ever.
Hedge funds should also redouble their efforts to
add value through ongoing improvements to client
service, especially investor reporting.
6
SU RV E Y R E S U LTS
Institutions are voting “yes” with their allocations

PO RT F OL I O A L L O C ATIO N S TO HEDGE FUNDS CONTI NUE TO RI SE
Institutional investors have maintained—indeed, Current hedge fund allocations are highest among
bolstered—their commitment to hedge funds. foundations and endowments, lowest among
More than 54% said they plan to increase target corporate plans, survey responses show [Figure 5].
allocations in the next 12 months, a much larger Allocations by foundations and endowments, early
vote of confidence than survey respondents gave adopters of alternative investing, have held steady
hedge funds last year, when only 14.6% anticipated since our 2009 survey, standing at 16.3% of total
a rise in allocation targets [Figure 4]. assets. Corporate allocations increased slightly
over the same period, rising from 9.7% to 10.2%.
Respondents reported that on average, hedge funds Meanwhile public funds participating in the survey,
represent nearly 14% of total portfolio allocations— beginning to catch up with other institutions, made
more than a 10% increase since our 2008 survey was a substantial leap in hedge fund allocations, which
completed in the early stages of the financial crisis. rose from 6.4% in 2009 to 11.5% this year.
Another way of viewing the trend: two years ago, 39%
of investors had more than 10% of their portfolios in
hedge funds; this year, that figure rose to 59%.
Figure 4: Planned changes to target allocation over coming 12 months (% of investors)
2009 2010
No Change, 78.1% Increase, 54.1%
Decrease, 10.6%
Increase, 14.6%
Decrease, 7.3% No Change, 35.3%
Source: SEI Knowledge Partnership
INTERPRETING THE DATA This year our sample of 97 senior professionals representing institutional
investors was augmented by 14 respondents from consulting firms (see p. 23). Figures are labeled to show
percentages for all respondents, investors alone, or consultants alone, as appropriate.
7
Figure 5: Actual and target allocations to hedge funds by investor type (% of portfolio)
25%
20%
Percentage of total portfolio
15% 16.3 17.4 Legend
25th Percentile
13.1
10% 11.5 Average
10.2 11.6 x.x%
Median
75th Percentile
5%
0%
Actual Target Actual Target Actual Target
Foundation / Endowment Corporate Public / Government
RU MO R S O F T H E H E D G E FUNDS OF FUNDS’ DEM I SE HAVE BEE N

GR E AT LY E XA G G E R AT E D
It is true that single-manager funds have grown corporate plans (71%), lowest among foundations
more popular in the last two years. Almost 24% and endowments (57%).
of respondents say they invest in single-manager
funds exclusively, up from 19% in 2008. Still, while Not surprisingly, larger firms show a greater
the percentage investing exclusively in hedge funds propensity to use single-manager funds, while
of funds has declined from the 56% recorded in smaller ones are more likely to invest via funds of
our 2008 survey, nearly half of 2010 respondents hedge funds. Only 40% of the smallest investors
said they invest exclusively in funds of hedge with less than $500 million in assets use single-
funds [Figure 6]. manager hedge funds on their own or alongside
funds of hedge funds, compared to 81% of large
Moreover, among institutions who invest in both investors with $5 billion or more in assets. Similarly,
single-manager funds and funds of funds, 60% of 81% of small investors use funds of hedge funds
assets are directed to funds of funds. The share on their own or alongside single-manager funds,
of assets going to funds of funds is highest among compared to only 50% of large investors.
Figure 6: Use of single-manager hedge funds vs. funds of hedge funds (% of investors)
Funds of hedge
funds, 48.5%
Both, 27.8%
Single manager
funds, 23.7%
8
Hedge funds play an important, but
evolving role in institutional portfolios
T H E F OC U S N O W IS O N A C C E S SI NG NON- CORRELATED STRATEGI ES
In 2009, diversification and absolute return were This shift in goals comes as no surprise. During
the top objectives for institutions investing in hedge the financial crisis, investors certainly encountered
funds, named by 31% and 30% respectively. This challenges in achieving their diversification
year those objectives dropped to the #2 and #3 objectives, although hedge funds on average did
rankings. Investors now name as their primary continue to provide diversification benefits relative
objective, “gaining exposure to non-correlated to long-only indices. Investors also learned not to
investment strategies.” That was named a primary assume hedge funds will deliver absolute returns
goal by 30% of 2010 respondents as compared to under all conditions.
24% in 2009 [Figure 7].
Figure 7: Primary objective when investing in hedge funds (% of investors)
2009 2010
40%
Percentage of investors
30%
20%
10%
0%
Ability to Decreased Absolute Diversification Non-correlated
exploit market volatility return investment
opportunities strategies
9
Figure 8: Satisfaction with overall hedge fund portfolio return (% of respondents)
Very Satisfied
Satisfied
Neither Satisfied Nor Dissatisfied
Dissatisfied
Very Dissatisfied
0% 10% 20% 30% 40% 50% 60%
Percentage of respondents
I N S T ITU TIO N S A R E R E ALI STI C AND M EASURED I N THEI R VI EWS ON

H E D G E F U N D P E R F O R MANCE
Interestingly, despite the precipitous drop in hedge response suggests that investors are reserving
fund indices during the financial crisis and uneven judgment on performance of their hedge fund
rebound since, 54% of respondents said they investments. Nonetheless, when survey participants
are “satisfied” with performance of their hedge were asked to name the single most important
fund investments and another 13% pronounce challenge they face as hedge fund investors,
themselves “very satisfied.” Only 12% express “meeting performance expectations” tied with
any level of dissatisfaction. More than one in five, “transparency” as the most frequent answer [Figure
however, describe themselves as neither satisfied 10]. This reinforces the point that managers should
nor dissatisfied [Figure 8]. strive to clearly convey how their strategies fit within
a diversified portfolio and are expected to perform
Seen in the context of other survey results and under varying circumstances.
the generally uncertain investment climate, this
TOP CHALLENGES
TRANSPARENCY
MEETING PERFORMANCE
EXPECTATIONS
10
F E E P RE S S UR E S A R E R E A L, B UT RATHER THAN REDUCI NG FEES
F U N D S A RE N E G O TIATIN G O T HER TERM S
Institutions appear increasingly aware of the costs Research (HFR) pegs the median management fee
they pay for hedge fund performance. “Receiving for single-manager funds as 1.5% across all major
value for money” was named the top challenge by strategies. According to HFR, 40% of all funds (and
13% of respondents this year as compared to 4% a all of those in the Macro category) still have a 2%
year ago, ranking third among all challenges cited management fee. Performance fees, meanwhile,
[Figure 10]. Large institutions were much more likely remain unchanged at 20% for all major strategies.
to give this response, due perhaps to awareness of
their greater bargaining power. Nonetheless, many investors have succeeded in
negotiating other terms related to fees. This is
With returns now generally harder to come by, hedge particularly true of larger institutions. For example,
funds’ customary 2/20 fee structure (1/10 for funds 88% of those with more than $5 billion in assets
of funds) has come under growing scrutiny. Yet the report having negotiated fee arrangements including
evidence indicates that overall, management fees hurdle rates—more than double the percentage of
have been lowered only modestly and performance those with less than $500 million in assets [Figure 9].
fees have remained largely intact. Hedge Fund
Figure 9: Negotiated fee arrangements including this feature (% of respondents, by AUM)
<$500m $500m-$1B $1B-$5B $5B+
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Hurdle rates Benchmarks Clawbacks Performance fees Ex post beta fee
based on realized adjustments
gains
11
Investors’ list of concerns has grown, with

a particular focus on risk management
T R A N S PA R E N C Y E X P E C TAT I O N S C O N T I N U E T O R I S E
The drumbeat of institutional demands for greater This finding suggests that while hedge funds may
transparency, already being heard before the have generally increased their level of disclosure in
financial crisis, has grown steadily stronger since response to investor demands, their responses have
then as investors seek to identify and understand not necessarily assuaged investor concerns. It may
the multiple facets of their exposure to risk. As be that, after the experiences of the past two years,
noted above, transparency tied for first place as the the more institutions know, the more they feel they
greatest challenge in hedge fund investing [Figure need to know.
10]. Moreover, nearly 70% of respondents name
transparency as their top worry, up from 56% a
year ago [Figure 11].
Figure 10: Single most important challenge faced (% of respondents)
Transparency
Meeting performance expectations
Fees / Value for money
Liquidity
Earning non-correlated returns
Understanding risk
Manager selection
Headline risk / Bad press
Educating board
0% 5% 10% 15% 20% 25%
Percentage of respondents Source: SEI Knowledge Partnership
O N VIRTU A L LY E VE RY ISSUE, I NVESTORS EXPRESS SUBSTANTI A LLY

H E I GH TE N E D C O N C E R N
One of the most notable findings of the survey [Figures 11 and 12]. Strikingly, concern with the
is the sharp rise in the level of anxiety reported failure to achieve the primary objective tripled since
by respondents. While the most frequently cited 2008, underscoring the need for managers to do a
worries have remained consistent, the percentage better job of clarifying their investment process and
of respondents naming them has jumped markedly, setting realistic expectations for performance results
at least doubling since last year’s survey in the case under varying scenarios.
of headline risk and poor performance, for example
12
A CONSULTING PERSPECTIVE
Consultants are important

influencers concerning hedge fund
allocations, and their influence
Figure 11: Biggest worries about hedge fund investing
keeps growing. Accordingly, SEI
(% of respondents)
interviewed several consultants as
part of this survey. Here’s their take
on the single greatest challenge in
hedge fund investing:
Lack of transparency
”Separating the winners from the
Failing to achieve primary objective losers relative to performance
and costs”
Liquidity risk
Headline risk “Ability to protect on the downside”
Leverage “Communicating realistic

Poor performance
expectations and reminding
stakeholders of long-term objectives
Limited regulation
when hedge funds lag targets
0% 10% 20% 30% 40% 50% 60% 70% during strong equity bull markets”
“Poor management of tail risk”
(i.e., dealing with high correlations
in down markets)
“Generating a return that is truly

independent of the market”
Figure 12: Trends in worries cited regarding hedge fund
“Underestimating the tails of return
investing (% of respondents)
distribution”
“Understanding the risk associated

Aug. 2008 Nov. 2008 Sep. 2010 with the strategies; sometimes
90% the managers do not seem to
80% fully comprehend where their risk
70% exposures truly lie”
Percent of respondents
60%
“Understanding what you are buying”
50%
“Establishing realistic benchmarks
40%
and time horizons for measuring
30%
performance”
20%
“Paying a fair fee for equity-like
10%
returns with lower volatility”
0%
Failing to achieve Poor
Liquidity risk Headline risk
primary objective performance
13
D E M A N D S F O R MO R E D I SCLOSURE ARE RI SI NG ACROSS THE BOA RD,

W I T H PA RT IC U LA R E MP HASI S ON RI SK ANALYTI CS
In our 2009 survey, in which transparency emerged use of leverage, counterparty exposure, geographic
strongly as a top concern, investor demands exposure, and hedging positions [Figure 13].
for more detailed information were focused
overwhelmingly on valuation methodology. While that More than three out of four want more information
concern persists in this year’s survey, the percentage on hedge funds’ use of risk analytics, a factor that
of investors wanting more detail has increased didn’t even appear on last year’s list of top requests.
substantially (by 20 percentage points or more) Just under half of 2010 investors want more
when it comes to hedge funds’ sector exposure, position-level detail, consistent with 2009 results.
Figure 13: Types of information sought from hedge fund managers (% of investors)
Sector level detail
Valuation
Leverage detail
Risk analytics
Counterparty exposure
Geographic exposure
Hedging positions
Position level detail
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Percentage of investors
I N V E S TO R S A R E IN C R E ASI NGLY FOCUSED ON HEDGE FUND

M A N A G E R S WH O S E S T R ATEGI ES AND RI SKS THEY CAN UNDERSTA N D
“Clarity of investment philosophy” has come to “Risk management infrastructure,” which did not
the fore as the #1 factor in selection of hedge even appear among the top 10 hedge fund selection
fund managers [Figure 14]. The percentage of criteria named in 2009, emerged this year as the
investors naming it “very important” rose to 79% second-ranked criterion. It was deemed “very
from 61% in 2009. important” by three out of four investors.
14
IN V E S T O R S C O N TIN U E T O B R O ADEN THEI R HEDGE FUND SELECTI ON
C RI T E R I A WH ILE IN TE N S IF Y IN G THEI R LEVEL OF SCRUTI NY
Our survey shows that institutions have not only Comparison of year-to-year survey results also
expanded the criteria they apply to manager reveals shifting investor priorities concerning fund
selection decisions, but are also putting more selection. Factors such as “having an identifiable
emphasis on many of those factors. In our 2009 source of alpha” and “separation of investment
survey, 11 factors were named by at least 50% of and operations management” now loom larger than
respondents as “very important” or “important” before. Among the new selection factors cropping up
in fund selection. A year later, 16 factors are so on this year’s list, the highest ranking were “liquidity
described by a majority of respondents [Figure 14]. terms” and “restrictions imposed by managers
during the crisis,” which were ranked #5 and #8 in
importance, respectively.
Figure 14: ‘Important’ or ‘very important’ factors in the selection of hedge fund managers (% of respondents)
Very Important Important
Clarity of investment philosophy
Risk management infrastructure
Quality of firm's investment team
Identifiable source of alpha (excess returns)
Liquidity terms
Portfolio transparency
Fees
Suspended redemptions or used gates during crisis
Separation of investment and operations mgmt.
Quality of reporting and communications
Past investment performance (2 - 3 years)
Overall client service
Firm(s) that serve as prime brokers
Assets under management (size)
Willingness to accept managed accounts
Use of multiple prime brokers
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
15
I N V E S TO R S D O N O T S E E REGULATI ON AS THE SOLUTI ON

T O T HE IR C O N C E R N S
At a time of keen competition among hedge funds, registered products in addition to their current
SEC registration may increasingly become a basic hedge fund allocation. Even fewer say they plan
qualifying factor for funds seeking institutional to replace existing hedge fund investments
mandates. Still, survey results make it clear with allocations to registered funds [Figure 15].
that institutional investors are not waiting for or Nonetheless, these numbers may grow in the future,
relying upon bureaucrats to improve hedge fund given that more than one in three of the consultants
disclosure, liquidity, or risk management. While we interviewed say they plan to recommend
30% of respondents cite “limited regulation” as investing in registered products.
one of their biggest worries regarding hedge fund
investing, that issue is eclipsed by concerns with Among those investors who do plan to invest in
transparency, liquidity, headline risk, leverage, and registered products, the primary reasons for doing
poor performance [Figure 11]. so are liquidity and transparency (named by 81%
and 65% of that sample subset, respectively). Only
Moreover, despite the growing number of mutual half name the desire for regulatory oversight as their
funds and UCITs utilizing hedge-like strategies, less primary reason.
than 22% of investors say they plan to invest in such
Figure 15: Plans to invest in registered products in addition to current hedge fund holdings (% of investors)
Investors Consultants
Yes
Yes
21.6%
35.7%
No No
78.4% 64.3%
16
HEDGE FUND
SELECTION
FACTORS ARE
SHIFTING
T H E A DV I C E O F C O N S U LTA N TS I S RELI ED UPON BY M OST

IN S T I T U T I O N S , A N D N E A R LY A LL PUBLI C PLANS SURVEYED
Institutional investors are generally not inclined to in alternative asset classes. Reliance on consultants
navigate the world of hedge funds on their own. is highest among public funds (91%) and lowest
More than three out of four respondents said they among foundations and endowments (69%).
work closely with consultants when selecting funds
17
Liquidity remains a top-of-mind issue

for investors
L I QU ID IT Y T E R MS H AV E EM ERGED AS AN I M PORTANT FUND
S E L E C T IO N FA C TO R
In our 2009 survey, liquidity was not even named is confirmed by the share of respondents naming
among the top 10 selection factors. Just a year later, liquidity risk as their biggest worry in hedge fund
“liquidity terms” ranks #5 on the list, named “very investing. That percentage rose from 46% in 2008 to
important” by 36% of respondents and “important” 58% in our 2010 survey.
by another 45%. Investors’ growing focus on liquidity
I M P OS ITIO N O F G AT E S OR SUSPENSI ON OF REDEM PTI ONS I S V I E W E D

N E GAT IVE LY B Y MO S T —BUT NOT ALL—I NSTI TUTI ONS
Slightly over 43% of investors say they have had This negative view is not universal, however. Of
first-hand experience with gates or suspension of those investors who have been affected by gates or
redemptions. Within that group, 76% saw gates or suspensions, nearly one in four saw that experience
suspensions as detrimental. As one participant put as a way of protecting their investments from a
it, “It’s always negative if you’re looking to liquidate potential tidal wave of outflows at an inopportune time.
and cannot.” Others cited concerns that liquidity
restrictions expose their board members to criticism
and point to poor risk management on the part of
fund managers.
ALERT:
LIQUIDITY
RISK
18
A SIGNIFICANT SHARE OF INVESTORS AND CONSULTANTS HAVE TAKEN
STEPS TO ENHANCE THE LIQUIDITY OF HEDGE FUND INVESTMENTS
More than 40% of investors say they have either either negotiated less restrictive gate provisions
avoided investing in funds with side pockets or or allocated to funds with less restrictive gate
have allocated to funds that make side pockets provisions. Survey results indicate that overall,
optional. More than a third report having negotiated foundations, endowments and corporate investors
shorter lockups or allocated to funds with shorter have been more active in this regard than public
lockups. Approximately one in four say they have funds [Figure 16].
Figure 16: Steps taken in past two years to ensure greater liquidity (% of investors)
All Investors Foundation & Endowment Corporate Public
50%
40%
30%
20%
10%
0%
Avoiding side pockets Shorter lockups Less restrictive gates
19
Institutions foresee continued growth of

hedge fund investing among their peers
L A R G E R IN S TITU TIO N S ARE ESPECI ALLY POSI TI VE
Nearly nine out of ten respondents expect institutional investors (those with less than $500 million in assets).
use of hedge funds to either grow or hold steady for In fact, one in five small investors say they expect a
the foreseeable future. Perceptions do, however, vary decline in institutional hedge fund investing; not one
by investor type and size. Among investors with more of the investors in the $5 billion-and-up segment
than $5 billion in assets, nearly 70% expect hedge shared that view [Figure 17].
fund investing to grow, compared with 37% of small
Figure 17: Perception of future hedge fund use by other institutional investors (% of respondents)
Growing Holding steady Declining
70%
60%
50%
40%
30%
20%
10%
0%
Less than $500m $500m-$1B $1B-$5B More than $5B
20
MORE
GROWTH,
NEW
CHALLENGES
AHEAD
RE S OU R C E S F O C U S E D O N H E DGE FUNDS ARE EXPECTED TO HOLD

S T E A D Y O R G R O W MO D E S TLY
Nearly all investors (96%) anticipate either no their part, were more inclined than investors to
change or modest growth in the resources their anticipate growth in the organizational resources
organizations devote to evaluating, monitoring, and they devote to hedge funds, with 71% expecting
selecting hedge fund investments [Figure 18]. This some growth, compared with 37% of investors.
points to both the need and the opportunity for In fact, another 7% of consultants expect
managers to differentiate themselves through client “significant” growth.
service, reporting, and education. Consultants, for
Figure 18: Expected changes to resources for managing hedge fund investments (% of respondents)
All Investors Consultants
80%
70%
60%
50%
40%
30%
20%
10%
0%
Significant growth Modest growth No change Modest decline Significant decline
21
Conclusion
Hedge fund investors and managers alike have of investment philosophy” emerging as the top
endured a tumultuous period characterized selection criterion and investors naming the “lack of
by unexpectedly high degrees of correlation, transparency” as their number-one worry in hedge
unanticipated illiquidity, and widespread failure fund investing, performance also remains a key
to achieve absolute return objectives. Against that concern. Investors clearly recognize the difficulties
backdrop, this year’s survey results provide some posed by an uncertain, volatile climate.
especially welcome news for hedge fund managers.
As they did in last year’s survey, institutional The hedge fund managers best equipped to compete
investors voiced a strong, continuing commitment to in this new phase will be those able to demonstrate
hedge fund investing. certain characteristics:
• An ability to clearly articulate their value proposition
Even so, it would be a mistake for hedge fund within an investor’s diversified portfolio.
managers to take too much comfort from these
• Sufficient scale to support institutional-quality
findings. Through the financial crisis, institutional
operations and risk management infrastructure.
hedge fund investing has entered a new phase
of maturity—one in which investors have not only • Understandable investment strategies with readily
modified their performance expectations, but also identifiable sources of alpha.
dialed up their transparency demands, intensified
their due diligence, and heightened their focus on Those managers who understand and respond to
risk management. investors’ rising expectations and level of vigilance
will be the ones to benefit from their continuing
As survey findings show, investors’ concerns have commitment to hedge fund investing.
evolved and investors have rethought their selection
criteria, signaling the challenges and opportunities
ahead for hedge fund managers. With “clarity
22
About the Survey
SEI’s fourth annual global survey of institutional • Foundations and endowments represent nearly half
hedge fund investors was conducted in October, the participating organizations, with public pension
2010 by the SEI Knowledge Partnership in plans (21%), corporate funds (14%) and
collaboration with Greenwich Associates. Online consultants (13%) accounting for most of the
questionnaires were completed by senior investment remaining institutions.
professionals at 111 institutions, including 97
• Participating organizations range in size from less
institutional investors and 14 consultants. Telephone
than $500 million to more than $20 billion in assets
interviews were also conducted with the consultants.
[Figure 19].
Consultant responses were broken out where
appropriate. Characteristics of the survey universe • Approximately 85% of respondents are based in
were as follows: the United States with the rest based in the United
Kingdom, Canada, and Scandinavia.
Figure 19: Survey universe by asset size (% of respondents)
$1B to $5B, 24.7%
$500M to $1B, 15.5%

$5B+, 16.5%
<$500M, 43.3%
23
About SEI
SEI (NASDAQ:SEIC) is a leading global provider funds, collective trusts, separately managed
of outsourced asset management, investment accounts and institutional and private client services.
processing and investment operations solutions. The division applies operating services, technologies,
The company’s innovative solutions help and business and regulatory knowledge to each
corporations, financial institutions, financial advisors, client’s business objectives. Its resources enable
and affluent families create and manage wealth. As clients to meet the demands of the marketplace
of September 30, 2010, through its subsidiaries and and sharpen business strategies by focusing on
partnerships in which the company has a significant their core competencies.
interest, SEI administers $402 billion in mutual fund
and pooled assets. SEI serves clients, conducts or The SEI Knowledge Partnership is an ongoing source
is registered to conduct business and/or operations, of action-oriented business intelligence and guidance
from numerous offices worldwide. For more for SEI’s investment manager clients. It helps clients
information, visit www.seic.com. understand the issues that will shape future business
conditions, keep abreast of changing best practices,
SEI’s Investment Manager Services division provides and develop more competitive business strategies.
total operations outsourcing solutions to global The Partnership is an initiative of SEI’s Investment
investment managers focused on mutual funds, Manager Services division.
hedge and private equity funds, exchange traded
About Greenwich Associates

Greenwich Associates provides research-based Based in Stamford, Connecticut, with additional
strategy management services for financial offices in London, Toronto, Tokyo, and Singapore,
professionals. Greenwich Associates’ studies provide the firm offers over 100 research-based consulting
benefits to the buyers and sellers of financial services programs to more than 250 global financial services
in the form of benchmark information on best companies. For more information on Greenwich
practices and market intelligence on overall trends. Associates, please visit www.greenwich.com.
24
1 Freedom Valley Drive Oaks, PA 19456 610 676 1270
www.seic.com/ims | managerservices@seic.com
The Investment Manager Services division is an internal business unit of SEI Investments Company. This information is provided for educational purposes only and is not intended
to provide legal or investment advice. SEI does not claim responsibility for the accuracy or reliability of the data provided. Information provided by SEI Global Services, Inc.
©2011 SEI 101895 (1/11)

Institutional Hedge Fund Investing Comes of Age: A New Perspective On The Road Ahead

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Institutional Hedge Fund Investing Comes of Age: A New Perspective On The Road Ahead

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Institutional Hedge Fund Investing Comes of Age

A New Perspective on the Road Ahead

Yet there is no doubt investor perceptions and practices

In the process, the practice of hedge fund investing

HFRI Fund Weighted Composite Index S&P 500 Index (TR)

Sources: Hedge Fund Research, Standard & Poor’s

Source: Hedge Fund Research

Figure 3: Global hedge fund assets through Q3 2010 ($ billions)

Assets Under Management

Source: Hedge Fund Research

Takeaways for Hedge Fund Managers

Institutions are voting “yes” with their allocations

Figure 4: Planned changes to target allocation over coming 12 months (% of investors)

No Change, 78.1% Increase, 54.1%

Decrease, 7.3% No Change, 35.3%

Source: SEI Knowledge Partnership

15% 16.3 17.4 Legend

Source: SEI Knowledge Partnership

RU MO R S O F T H E H E D G E FUNDS OF FUNDS’ DEM I SE HAVE BEE N

Figure 7: Primary objective when investing in hedge funds (% of investors)

Source: SEI Knowledge Partnership

Figure 8: Satisfaction with overall hedge fund portfolio return (% of respondents)

Neither Satisfied Nor Dissatisfied

0% 10% 20% 30% 40% 50% 60%

I N S T ITU TIO N S A R E R E ALI STI C AND M EASURED I N THEI R VI EWS ON

Figure 9: Negotiated fee arrangements including this feature (% of respondents, by AUM)

<$500m $500m-$1B $1B-$5B $5B+

Source: SEI Knowledge Partnership

Investors’ list of concerns has grown, with

Figure 10: Single most important challenge faced (% of respondents)

Meeting performance expectations

Fees / Value for money

Earning non-correlated returns

Headline risk / Bad press

0% 5% 10% 15% 20% 25%

Percentage of respondents Source: SEI Knowledge Partnership

O N VIRTU A L LY E VE RY ISSUE, I NVESTORS EXPRESS SUBSTANTI A LLY

Consultants are important

Headline risk “Ability to protect on the downside”

Leverage “Communicating realistic

“Generating a return that is truly

“Understanding the risk associated

Source: SEI Knowledge Partnership

D E M A N D S F O R MO R E D I SCLOSURE ARE RI SI NG ACROSS THE BOA RD,

Sector level detail

Position level detail

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Source: SEI Knowledge Partnership

I N V E S TO R S A R E IN C R E ASI NGLY FOCUSED ON HEDGE FUND

Very Important Important

Clarity of investment philosophy

Risk management infrastructure

Quality of firm's investment team

Identifiable source of alpha (excess returns)

Suspended redemptions or used gates during crisis

Separation of investment and operations mgmt.

Quality of reporting and communications

Past investment performance (2 - 3 years)

Overall client service

Firm(s) that serve as prime brokers

Assets under management (size)

Willingness to accept managed accounts