Most Hedge Investors Dissatisfied with Funds

by: Christopher Holt

We are fans of Investment News, but take issue with this characterization of the Deutsche Bank hedge fund survey released yesterday. Here’s the survey itself and here’s why you need to read it before forming your own opinion:

First and foremost, approximately half of survey respondents were funds of hedge funds. So when the report says, “73% of investors worldwide report that they have had difficulty finding managers that live up to their expectations”, it may very well be referring to disgruntled fund of funds managers who lost out on their own 10% performance fee due to the modest, but not spectacular performance of their managers. (We don’t know because the data is not broken down by investor type).

Average initial allocation to hedge funds rose 50% over 2005. This is indeed a surprise since, according to Investment News, most investors “were dissatisfied with (their) funds”.

In addition, the proportion of investors willing to lock-in their investment for 2 years or more was also up 50% over 2005. Again, a somewhat surprising result given the negative headlines.

So hedge fund investors increased their allocations and fell over each other to lock it in. But how do these ”dissatisfied” investors feel about 2007? Surely, they must be negative on 2007. Says the report:

Investors have an optimistic outlook on the hedge fund industry, with median return expectations of 10% for 2007.

Investors are still bullish on the hedge fund industry in 2007. Based on their responses, we project inflows to hedge funds to be in the range of $110 billion in 2007, an estimated 10% increase over 2006.

With 50% of respondents being funds of funds, this optimism (warranted or not) is no surprise to us. After all would you expect the funds of funds to say they were pessimistic and didn’t expect their own underlying hedge funds to perform well this year? In any case, investors certainly aren’t that dissatisfied after all.

The report (and Investment News’ coverage of it) suggest that 39% of “investors” don’t want hedge funds to invest in private equity. But once again, without any further breakdown in which group is saying this (funds of funds or end investors), it is impossible to draw any conclusions. For example, the following excerpt seems to suggest that it must be the funds of funds that don’t want their managers skiing off-piste:

61% of Pensions, Government Organizations, Endowments and Foundations will try to increase their private equity hedge fund exposure.

The survey goes on to conclude that ”only 15% take a positive stance on private equity investments commingled with other strategies in a hedge fund.” But note the use of the word “commingled”. Illiquid investments kept in side pockets are actually favoured by a majority of respondents according to this very same survey.

While we obviously take issue with several of the survey’s conclusions (and those of Investment News), the report does contain some interesting tidbits worth mentioning here. Specifically, according to respondents, 2007 will be the year of the merger arb, “credit opportunities” and market neutral fund. However, “credit Arb”, “credit long/short” and currency strategies will experience a drop in assets this year according to the survey.

A Hedge Fund Investor Discussing 2007It is also interesting to note that half of respondents were open to investing in exchange-traded hedge funds (a relatively new offering). Again, we are curious about the breakdown between prototypical “hedge fund investors” and funds of funds. And finally, respondents said that assets in hedge funds focused on China would jump nearly 40% in 2007 (at the expense of assets invested with US-focused hedge funds).

Still, after reading both the survey report itself and this article in Investment News, we are left wondering why the most negative line in the entire report made it all the way to the headline of the story. It’s not like trashing hedge funds sells papers or anything…