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Investor Demand for Hedge Funds Rebounds Following Terrible Third Quarter

Although hedge funds just endured one of their worst quarters ever, steadfast institutional investors aren't racing to cash out.

Although the near-term outlook for the hedge fund industry remains murky in light of the European debt crisis and ongoing weak U.S. economic growth, the picture is brighter for the sector over the long haul. Even as the industry continues its long slog back from its worst quarter since the 2008 global market crash, data shows that investor redemptions remain near historical lows.

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Institutional investors -- which now comprise a significant portion of the hedge fund industry's client base -- are a big reason for the relative stability, experts say, since a bad month or quarter is unlikely to deter their long-term strategies. Unlike 10 or 15 years ago, when hedge funds primarily took investments from private wealth and private equity, a large portion of the money they now manage comes from pension funds and endowments as those traditional investment vehicles increasingly seek greater returns.

And unlike retail investors, institutional clients are more apt to ride out stormy periods, explains Hans Hufschmid, chief executive of GlobeOp Financial Services, which offers mid- and back-office support to hedge funds. "Their investment positions are much more long-term," he says. "When a pension fund decides it's going to increase its investments into alternatives over the next five years, it's not going to change its mind because hedge funds had a few bad months."

Although the third quarter ending Sept. 28 was among the worst ever for hedge funds, investor redemptions in October fell to 2.51 percent from 3.11 percent a month earlier, according to GlobeOp data. On an annual basis, October redemptions were up slightly from the year-earlier period -- the first year-over-year increase since 2009. Nevertheless, that's a long way off from November 2008, when redemptions soared to a high of 19.27 percent.

"The absence of significant outflows given what happened over the past three or four months is a very positive sign for hedge funds," Hufschmid insists. "Investors are definitely still sticking to their strategies."

Not Out of the Woods Yet

Outflows in October even slowed down at Man Group, the world's largest publicly traded hedge fund, which announced 400 layoffs in September after watching clients pull out $2.6 billion during the third quarter. But in an ominous signal to the industry, Luke Ellis, head of Man Group's multimanager business, warned in October that investors are still likely to yank their money out of hedge funds during the fourth quarter as the prospect of another recession and the European debt crisis haunt the global markets.

Steve Hotovec, the overseer of proprietary investing at Alchemy Ventures, agrees. "The redemptions on hedge funds are going to go up," asserts Hotovec, whose firm allocates money to hedge fund managers through its risk managed account platform. "They're always going to go up when people are scared and want to get at their cash."

But investor demand for alternative investments such as hedge funds will continue to be robust, Hotovec adds. Investors simply are leery of long lockup periods and are looking for a greater measure of capital control once they park money in a hedge fund, he explains. "The appetite for the investor has not waned," Hotovec says. "The appetite for manager-controlled structures and multilayered products like fund of funds has. You're going to see a decline in that."

Looking ahead, the outlook is strongest for hedge funds that aren't too exposed to the global equity markets, industry sources say. That primarily includes relative value arbitrage funds and macro funds. In fact, of the $70 billion that's flowed into hedge funds through the first three quarters of 2011, an overwhelming majority has gone either into relative value arbitrage funds or macro funds, Hedge Fund Research reports.

According to the firm, $30 billion went into relative value arbitrage funds, which look to make money off the price differential between related financial instruments, such as stocks and bondsand $20 billion flowed into macro funds, which invest in a range of assets, including interest rates, commodities and foreign exchange. Hedge Fund Research president Kenneth Heinz says relative value arbitrage funds tend to do well in choppy conditions. They're also more insulated from event-driven weakness in the marketplace, he adds.

"Typically you see the strongest performance after a period of financial market volatility," Heinz contends. "They've seen less impact than the equity-sensitive funds in the first three quarters."

As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio

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