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Like sticking your hand under scalding hot water, it is human nature to very much steer clear of getting burned twice, especially when it really hurts. But it is equally human nature to quickly forget how bad the pain was and be tempted to test the water again.

Apparently pension funds are no different, judging from the results of Citi Prime Finance’s debut research paper, “The Liquidity Crisis & Its Impact on the Hedge Fund Industry” (click here to download the full report; click here for the press release).

The report, which was culled from one-on-one interviews with hedge funds, investors, intermediaries and service providers, seems to imply that while still smarting from the worst financial crisis in history that the investing world is slowing testing the hot waters of alternative investments again.

The evidence comes from the report’s findings from surveying both hedge funds and fund of hedge funds (FoHFs), who in their own respects highlight some significant trends they are following to convince investors that they aren’t going to get smoked the second time around.

From the hedge fund side of things, the survey highlights the general de-levering of portfolios that occurred during the crisis, implications of that move on funds’ prime brokerage relationships and the industry-wide drive to secure a more stable and institutional mix of investors subsequent to the crisis. The chart below shows the change in investor flows by strategy from the final quarter of 2008 to the first quarter of 2009.

Specifically, the report explores the infrastructure investments, the increased transparency, expanded liquidity options and expanded level of investor communications that leading hedge funds are offering today to attract and retain direct institutional allocations.

In other words, the diversification hedge funds are now exploring in an attempt to better fit the revised mandates that investors are now looking for.

On the FoHF front, the survey highlights the mismatch between the terms they offered investors on their portfolios and the liquidity they were able to realize on their hedge fund investments during the crisis. The report also explores how portfolio construction has evolved in response, with FoHFs now aligning investment strategies across a “liquidity spectrum” and grouping strategies with similar liquidity profiles.

Again, changes to better fit the revised mandates investors, particularly institutions, are looking for.

And from the investors’ perspective? Apparently all the changes and lessons learned have made the water seem a little more bearable to test again. According to the report, the addition of liquidity as a third dimension to consider in addition to style and leverage is moving the hedge fund industry toward a set of “segments” which in turn is helping to blur distinctions between the long-only, alternatives and private equity (see illustration below showing the projected convergence between regulated funds and alternatives).

Translation: Hedge funds, now looked upon as viable substitutes to active long-only managers, are poised to attract hundreds of billions in capital inflows as investors begin to consider alternative investments as mainstream investing tools.

“As the definition of active management expands, that’s where the hedge fund industry is really well poised to pick up a lot of capital in coming years,” Sandy Kaul, Citigroup’s U.S. head of business advisory, prime finance, said of non-hedge-fund managers, told Dow Jones (see chart below showing diversification of allocations to different kinds of investment pools).

And with liquidity the dominant concern for most institutional investors, hedge funds with an institutional bend are likely on equal or even better footing to compete with other kinds of investments such as long-only funds, exchange-traded funds and private-equity funds.

So once burned, but not twice shy, especially considering the hedge fund industry has collectively cooled the waters by ensuring liquidity and transparency. We just hope the water stays a consistent temperature for a while.

Source: Hedge Fund Investors: Once Burned, But Not Necessarily Twice Shy