In an interview with Thomson Investment Management News, Max Ferri, a senior analyst at Laven Partners, points out that because the big funds tend to attract more money, they are also more tempted to find lucrative ways of spending their cash load that may not be in line with their business plan. “Some funds set themselves reasonable targets when they start off,” Ferri says.
“However, with growth also comes greed and when people start knocking at the door like crazy, funds can start to overexpand.”

He says funds that experience exponential growth may find their capacity point is 100 times more than when they started and at that new level, “the strategy can no longer be run without carrying some sort of major risk, or is simply too big to be profitable.” That’s when such funds may suffer from style drift, and suddenly the fund becomes more correlated to the markets and less of a hedge fund.

Ferri, who is also in charge of hedge fund selection at Laven, says his firm sticks to early-stage managers, since “best returns are found within the first three years of a manager’s strategies,” while the assets are still manageable. And he says the “sweet spot” in terms of HF size is between $50-$100 million and $300-$400 million.

-emii.com-

So to avoid making costly and painful staff errors, SpencerStuart recommends "clearly defining the role and agreeing on a set of shared expectations." Both the potential employee and the heads of the HF should consider whether the person represents "a good culture and personality fit."

To begin with, hedge funds are structured differently.
"The resources available in a startup or small hedge funds are going to be less than what many successful executives are used to. A senior leader in a hedge fund won’t have a v.p., an associate and analyst working for him or her. They need to be willing to roll up their sleeves." one HF leader told SpencerStuart.
Best, he adds, is to "recruit people who have proven ability to do this and who will not complain about it."

There are also differences between hedge funds themselves. One firm may have an open investment committee with a lot of "honest, back and forth dialogue," reports SS, quoting a HF manager. "Some people can’t handle that." And it’s hard to tell from just a few meetings.
As one hedgie put it: "When considering whether to bring on talent, we constantly balance internal talent development with the need to bring in outside perspectives." He said they have had trouble with people who "bring the big firm personality with them - they are too political, too rigid or don’t work out well with peers."

U.S. pension funds investing in hedge funds increased by 51 percent in 2007 from a year earlier, while in Japan their number rose by a third, said Masashi Toshino, a senior researcher on the industry at Daiwa Fund Consulting Co. in Tokyo, citing data from Pension & Investments, a New York-based provider of financial industry data, and Japan's Pension Fund Association.

``We're continuing to see strong needs from investors seeking to invest in hedge funds,'' Yanagisawa, 30, who heads Merrill Lynch Japan Securities Co.'s Financing Sales division, which provides brokerage services to hedge funds, said in an interview in Tokyo. ``The investor base is clearly changing and long-term money is starting to flow into hedge funds.''

Faced with increased pressure to boost returns as U.S. subprime loan problems rattle global financial markets, institutional investors, including pension funds and colleges, are putting more money into hedge funds because they take bigger bets and aim to make money in rising and falling markets.

Global Industry

The capital going into hedge funds from global institutional investors is expected to reach $1 trillion in 2010 from about $360 billion, the latest study published by the Bank of New York Mellon Corp. and Casey, Quirk & Associates in October 2006 shows.

Hedge funds are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether the price of assets will rise or fall.

The number of non-traditional hedge fund investors, such as pension funds and university foundations, increased this year at Merrill's sixth Global Hedge Fund Conference in West Palm Beach, Florida, Yanagisawa said, declining to specify the numbers.

Merrill's Financing Sales division provides hedge funds with prime brokerage services such as clearing, custody, securities lending, financing for assets and introducing fund managers to potential investors.

California Public Employees Retirement System, the largest U.S. public pension fund, last June announced plans to double its allocation to activist and hedge funds to more than $10 billion each. The top 200 U.S. pension funds invested a total of $76.3 billion in hedge funds as of the end of September, compared with $50.5 billion the year before, Daiwa Consulting's Toshino said.

Pension and Colleges

Meanwhile, Pension Fund Association, Japan's largest private- sector pension fund manager, allocated 4 trillion yen ($39 billion) to hedge funds as of the end of March 2007, compared with 3 trillion yen a year earlier, according to Toshino.

The best-performing U.S. college and university endowment funds in the year ended June 30, 2007, had more than half of their assets in so-called alternative investments, such as private equity and hedge funds, a Jan. 17 survey by the Commonfund Institute in Wilton, Connecticut, showed. The Commonfund is an investment manager for non-profit organizations in the U.S.

Even so, not all hedge funds are completely shielded from subprime problems and investors must be aware of taking risks, said Toyomi Kusano at Kusano Global Frontier in Tokyo.

`Headwinds'

``Hedge funds are facing one of the strongest headwinds in a decade now,'' said Kusano, president of the research firm that specializes in hedge funds. ``Financial firms are getting tighter with their loans amid the subprime problem and that's inevitably affecting hedge funds.''

Since Feb. 15, at least six hedge funds, with more than $5.4 billion in assets, have been forced to liquidate or sell holdings because their lenders -- staggered by almost $190 billion of asset writedowns and credit losses caused by the collapse of the subprime-mortgage market -- raised borrowing rates by as much as 10-fold with new claims for extra collateral.

Hedge funds ``sell themselves on the idea that they can do well in both up and down markets, but this has not been true in many cases,'' said Edwin Merner, who oversees $2 billion as president of Atlantis Investment Research Corp. in Tokyo.

Still, an increase in demand for hedge funds is heightening competition and consolidation among existing funds globally, Yanagisawa said.

Citadel Investment Group LLC, the Chicago-based investment firm founded by Kenneth Griffin, hired Kaveh Alamouti from Moore Capital Management LLC to run a hedge fund portfolio that will trade stocks, bonds, currencies and commodities.

New York-based Millennium Capital Management, the hedge-fund firm run by Israel Englander, bought the assets of London-based Castlegrove Capital to add more investors in Europe. An undisclosed number of Castlegrove's fund managers and employees will join Millennium's affiliate in London.

``We're starting to see bigger hedge funds buying out talents at smaller funds as consolidation accelerates within the industry,'' Yanagisawa said.

-Bloomberg-

"The amount of research that the buy-side purchases from investment banks has absolutely decreased in the past 12 months and is likely to fall further in the future," Michael Mayhew, chairman of Integrity Research Associates, told Financial News.

This is painful news for hedge funds represent 40% investment-banking clients (with traditional fund managers making up the rest), but account for 70% of the total fees. Then there are the fringe benefits the banks lose out on: fees from prime services. The prediction seems to jibe with research conducted last year by Greenwich Associates, which found that 30% of hedge funds polled said they expect to rely less on sell-side research by the beginning of this year.

Mayhew says the trend doesn’t necessarily spell doom for investment banks as they still offer a wider range of research coverage than hedge funds, and self-research may not be an option for every HF. He says only the biggest HFs with the most resources can afford to create their own in-house research teams and absorb the associated expenses.

-emii.com-

Prime brokers, which finance hedge fund trades, demand a downpayment, also known as a "haircut," to cushion their losses if the fund's portfolio declines in value.

The downpayment required to buy certain types of structured credit on a leveraged basis started to rise last summer following the collapse of two hedge funds managed by Bear Stearns in August.

Since then, downpayments on almost all asset classes have increased, according to data from Citigroup.

For leveraged investors buying AA-rated corporate bonds, the average downpayment demanded by prime brokers, has increased from 0% to 3% of the value of the leveraged portfolio in March last year to 8% to 12% this month, according to Citigroup data, based on the bank's best estimates.

That means the maximum leverage has fallen from over 30 times last March to 8.3 times this month.

Similarly, the haircut on high-yield bonds rated BB has increased from between 10% and 15% to between 25% and 40%, reducing leverage from 6.7 times to 2.5 times.

On equities, the haircut has increased from 15% to 20%, which means leverage has fallen from 6.7 times last year to five times.

Some hedge funds have come under pressure to secure financing from prime brokers.

Last week, UK hedge fund Peloton Partners liquidated its $2bn (€1.3bn) fund that was invested in asset-backed securities. Banks were unwilling to continue extending credit in the face of losses accumulated by the fund.

Hans Peter Lorenzen, senior credit strategist at Citigroup in London said: "If banks face constraints because they have lots of assets coming back onto their balance sheets, it becomes harder for them to provide funding for leveraged transactions.”

He said there was also an issue for banks that have become more risk averse.

Banks will require higher haircuts to protect them against potential losses in a climate of increased volatility, but in so doing they are also making it more difficult for hedge funds to buy assets from them because the higher haircuts constrain the volume hedge funds can buy, compared to 12 months ago.

-Financial News-

In Preqin Hedge’s latest survey of 50 hedge fund managers, 55% said that the number of institutional investors in their hedge funds has increased over the last three years. And it is not just new investors that account for the increasing institutional client base of hedge funds: Existing investors, buoyed by the success of their existing hedge fund investments, are also increasing their allocation to the asset class to boost returns and add further diversity to their portfolio.

On the contrary, just 14% of hedge fund managers reported that their institutional investor client base had decreased over the same time period.

“With over half of managers reporting that their institutional client base has grown over the past three years, we predict that this trend will continue and that within a hedge fund the average proportion of investors coming from an institutional background will only increase in the forthcoming years,” Prequin wrote.

The study also found that institutional investors now make up 75% of funds with $25 billion or more in assets. Hedge funds established before 1995 have between 67% and 75% institutional clients while, on average, 60% of fund of hedge funds capital comes from institutional coffers. Global macro (58% institutional), long/short equity (57%) and multi-strategy (49%) funds are also popular with institutional investors.

“It is clear that fund of funds are a common choice for institutional investors with no less than 60% of fund of funds capital, on average, coming from institutional means,” said the firm. “Funds of funds are seen as an excellent route to gain knowledge about hedge funds whilst reducing an investors overall exposure to risky strategies.”

-FIN alternatives-

Everybody's heard of mattresses stuffed with cash, or coins lodged beneath the cushions of a couch. But one venerable Virgina company seems genuinely confused about whether it's in the furniture business or the money business.

Bassett Furniture Industries (BSET), a 106-year-old furniture company founded by a traveling lumber salesman, has seen better days in the furniture business. It lost $19.9 million from continuing operations last year. Its revenues dropped 10% year-over-year - and three of the last four years. So how can it afford to pay any dividend, let alone an impressive 80 cents per share?

A quick peek at Bassett's 10-K however reveals the answer: The company has $51.7 million invested across a spectrum of hedge funds, which kicked in just over $5.92 million in loss-defraying cash last year. With an additional $25.1 million invested in marketable securities (80% equities), just under 25 percent of Bassett's $310.7 million balance sheet is now at work in the capital markets.

Having shut almost 60% of its U.S. manufacturing facilities in the past five years, management told Fortune that the investment portfolio is helping Bassett's balance sheet "stay flexible" without having to borrow money.

There's nothing wrong, of course, or even inappropriate about Bassett's surprisingly large hedge fund and real-estate investments, and they've no doubt helped keep the firm afloat. Without the annual $10 million-$12 million in returns thrown off from these investments, the profits of 2006 and 2005 would have gone up in smoke.

Bassett has come to rely on the returns generated by its investment portfolio because the U.S. furniture industry is in something of a collapse. Asian imports are now not only much cheaper, but of increasingly high quality. The effects of this competition have been devastating: tens of thousands of furniture-making jobs have been lost and a sharp decline in the fortunes of many publicly-held furniture makers.

So why not dump the furniture business and concentrate on the parts of Bassett that make money? Bassett's chief executive Robert Spilman told Fortune that his company is determined to stay in the furniture game. It has launched a series of initiatives designed to improve the performance of its retail stores, including rolling out a new store prototype and offering a series of do-it-yourself interior design options, which appear to be bearing some fruit. He predicted that revenues will likely stabilize, putting them on a $290-$300 million run-rate for this year.

The hedge fund stake isn't the only non-furniture lifeline the Basset, Va.-based company has, however. Last year, Bassett's 46.9% stake in High Point, N.C.'s International Home Furnishings Center - long home to the world's premier furniture trade shows, but which is seeing increasing competition from Las Vegas - provided $6.3 million in earnings and almost $6.1 million in dividends.

For 2006, a year when it reported a $5.4 million profit, over $11.7 million in income was recognized from the IHFC and hedge fund investments, keeping Bassett solidly in the black.

There is at least one high-profile dissenter from Bassett's strategy: activist shareholder Seth Hamot of Boston-based hedge fund Roark, Reardon and Hamot, who owns 5.1% of the company and is seeking to replace current board members with a hand-picked list of his own nominees. In an interview, Hamot told Fortune that neither the hedge funds nor the IHFC should be supporting the Bassett business anymore.

"This subsidy business should end and without any chance of continuance in the future," said Hamot. "Without the [hedge fund investments], management would have to face tough decisions to rationalize the business. The hedge funds and IHFC have no supported no job preservation for employees and have only served to delay decision making." Hamot argued that a management that did not have this hedge fund cushion would have sought a merger partner, and that regardless of the [hedge fund/IHFC] short-term performance, the investments are taking up valuable capital. "Investors who want to own furniture companies should own furniture companies; investors who want to invest in hedge funds should invest in hedge funds," Hamot said.

A Bassett spokesman asked to comment on Hamot's charges told Fortune: "The Company obviously disagrees with Hamot's position. These assets have been very important in supporting our retail transition, and in allowing us to pay out more than $48 million in dividends over the past five years. They have also allowed us to keep our debt relatively low and incur lease commitments and contingencies key to our retail growth strategies."

Who handles Bassett's money? Private Advisors LLC, a Richmond, Va.-based investment advisor, has overseen Bassett's investments in hedge funds since 1998, according to chief financial officer Barry Safrit. He told Fortune that the board picked the firm based on the recommendations of a former board member - he declined to specify which one - who had what Safrit described as "a relationship" with Private Advisors at the time. Safrit said that the hedge fund strategy is geared toward capital preservation. The hedge fund investments have been solid performers in the past three years, clocking in just below 11% each year, and beating the Standard & Poor's 500 index return last year and in 2005.

But Bassett faces a possible future headache: its $5.7 million investment in the D.B. Zwirn Special Opportunity Fund L.P. As Fortune.com reported last week, the fund is shutting this $4 billion portfolio down amidst a wave of investor redemptions. Further complicating matters is the fact that the Zwirn fund has a number of investments in private investments and loans, which are illiquid and difficult to value. The fund has stated that it might take up to two years to return client capital.

-Fortune-

The biggest losers were managers who buy and bet against stocks, known as long-short funds, which fell 4.1 percent, according to preliminary returns compiled by Chicago-based Hedge Fund Research Inc. Event funds, which focus on companies going through corporate changes like mergers or spinoffs, declined 1.8 percent.

The average fund still beat worldwide stock indexes. U.S. shares, as measured by the Standard & Poor's 500 Index, fell 6.1 percent last month and global shares, as measured by the MSCI World Index, tumbled 7.7 percent.

``On a relative basis it's been OK,'' said Brett Barth, a partner at New York-based BBR Partners, which invests money in hedge funds for clients.

Some large stock funds that lagged behind the industry average include New York-based Goldman Sachs Group Inc.'s $7 billion Goldman Sachs Investment Partners, which fell 6 percent in its first month of trading. San Francisco-based Farallon Capital Management LLC dropped 3.6 percent. Oslo-based Concentric Capital ASA's $740 million Concentric European Fund lost 22 percent.

Farallon, which oversees $36 billion, invests in real estate and companies facing cash shortfalls or going through mergers or other changes. A similar strategy is used by Third Point LLC, the New York hedge-fund firm run by Daniel Loeb overseeing $6 billion, which fell 3.6 percent last month.

SocGen's `Massive Unwind'

Quantitative Investment Management, the Charlottesville, Virginia-based manager with $3 billion in assets, declined 7.8 percent in its QIM Global Program last month, following a 2007 gain of 28.4 percent, according to a monthly client letter.

``The sharp, sudden increase in volatility in the markets, exacerbated by the massive unwind of a fraudulently constructed portfolio of stock indices at SocGen, increased our volatility dramatically,'' according to the letter.

Societe Generale SA, France's third-largest bank, said Jan. 24 that unauthorized bets by 31-year-old trader Jerome Kerviel led to about 4.9 billion euros of losses.

Concentric Capital, run by Peter Jebsen, had wagers on about a dozen companies to increase in value, including financials, according to an investor. Jebsen, a former stock trader for billionaire investor George Soros, started Concentric in 2002.

Investors in the funds asked not to be identified because the returns are private. Officials for the managers declined to comment.

Hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any assets and participate substantially in profits from money invested.

-Bloomberg-

Often viewed as a high-risk gamble or an investment for the super-rich, advisers say that the best hedge funds are one of the surest ways to make money if the stock market uncertainty continues. And you no longer need huge sums before they will open their doors to your cash.

Mark Dampier at Hargreaves Lansdown, a financial adviser, said: “Some hedge funds are extremely high risk but others are designed to preserve your capital and grind out positive returns whatever the market conditions.

“I’m increasingly coming round to the idea that they should be a core holding in everyone’s portfolio - I’m thinking of investing myself.”

The UK stock market was calmer last week as the FTSE 100 index of leading shares rose 3% to 6,029. However, the market is still 7% lower than on January 1 - the rockiest start to the year since the 1930s - and 10% lower than its peak of 6,732 in June.

Record numbers cashed in their stock-market investments in December, pulling £377m more out of unit trusts than they put in - the second negative month in a row, according to the Investment Management Association. In November, £330m more was pulled out than invested.

Net Isa sales were just £17m, compared with £107m in December 2006. Equity-fund sales were particularly bleak with outflows of £844m, of which £242m came out of commercial property funds.

Despite the unnerving climate, advisers are warning investors not to miss out on this year’s Isa allowance by sitting on their hands.

Everyone can invest up to £7,000 in an Isa and the returns will be sheltered from the tax-man - but you must use your allowance before the end of the tax year, April 5.

There are two options: invest your entire allowance in an equity Isa, or put up to £3,000 in a cash Isa and the remaining £4,000 in stocks and shares.

This year the market setback has unnerved people who were planning to put the maximum into equities, but advisers say there are several ways to invest in equities and still make money when markets fall.

Hedge funds

Individual hedge funds - which use a range of strategies to make money whether markets rise or fall - cannot be held in an Isa. Funds of hedge funds, however, can, and advisers are recommending them for the first time.

Tim Cockerill of Rowan, an investment manager, recommends Dexion Absolute, Alternative Investment Strategies or HSBC Global Absolute, up 7%, 1% and 7% respectively since the market peak in June, while the FTSE All-Share has fallen 12%. They all invest in a range of hedge funds and strategies to reduce risk.

He also likes Thames River Hedge+ which has returned 17%, though it uses a more risky investment strategy so may not be suited to nervous investors.

It has benefited from owning Paulson Advantage, run by New York hedge-fund Paulson, which bet correctly that the sub-prime mortgage market would collapse when everyone else was positive. Exposure to GLG, which invests in emerging markets, has also helped its performance.

Close AllBlue, another fund of hedge funds, is the choice of Mick Gilligan at Killik, a stockbroker. Listed on both the Alternative Investment Market and the Guernsey stock exchange, it has returned 7% since June.

Dampier prefers Blackrock UK Absolute Alpha, which does not invest in hedge funds but is run using hedge-fund techniques. Since the credit crunch began it has been the best performing UK fund rising 7%. Since its launch in April 2005 it is up 29%.

Dampier said: “Most fund of hedge funds are trading at a premium because they are in demand, which means the share price is higher than the underlying funds are worth. Blackrock’s fund is better value and easier to understand.”

Run by Mark Lyttleton, UK Absolute Alpha is one of the few schemes taking advantage of a change to investment rules that enables managers to use derivatives.

Lyttleton uses a strategy known as “going short”. If he thinks a company’s share price is going to fall, he can buy a derivative that will rise in value as the share price drops.

Lyttleton said: “I have done well out of shorting some of the retailers, housebuilders and pub stocks which are vulnerable to a consumer slowdown.”

Advisers warn that the funds will get left behind when the market recovers, but many think they should be a core holding in a balanced portfolio.

Gold funds

Investors in the Merrill Lynch Gold & General fund, which invests in gold-mining shares, have benefited from a stunning 39% gain since June last year, making it far and away the best performer. Investec Global Gold came in second at 31% after the gold price shot up to more than $900 (£457) a troy ounce.

Opinion is divided about whether investors should be buying into gold now. Ross Norman of The Bullion Desk, the top forecaster for the London Bullion Market Association for the past four years, predicts that gold could reach $1,170 this year.

However, Cockerill said: “Over the long term it still looks a good investment, but short-term I don’t think it is time to buy. When confidence returns to the stock markets I can see speculative money being pulled out of gold which could cause the price to drop.”

Bond funds

After years in the doldrums, bond funds have bounced back: Baring Directional Global Bond, which invests in government bonds worldwide, is up 16% since June - a stunning return for normally boring bonds.

Brian Dennehy at Dennehy Weller, an adviser, said: “Fund managers are genuinely excited about the prospects for bonds over the next few years as high quality corporate bonds are yielding 7% or more.”

He recommends Artemis Strategic Bond, which invests in a combination of high quality and higher risk bonds, or New Star Sterling Bond, which focuses on blue chip bonds.

Cautious managed funds

You would expect these multi-asset funds, which invest in a blend of equities, bonds, cash and occasionally property to have held up. But investors have discovered too late they are not protected against downturns.

The average fund is down 5% since June while the worst performers are BGI Global Income Plan down 17% and New Star Tri-Star, which has fallen 15%. But CF Ruffer Total Return, with 42% in equities, 50% in bonds and 3% in gold bullion, has risen 6% since June.

FOLLOWING THE HEDGE FUND ROUTE

HEATHER and Lawrence Mitchell, with their son Samson, have invested this year’s Isa allowance in Blackrock UK Absolute Alpha, a fund that uses hedge-fund methods to try to make money even when markets are falling.

The couple, from Esher in Surrey, were looking for a fund that could provide steady but positive returns whether the stock market was rising or falling.

In the past, property funds had served the purpose, but as returns have taken a slide they decided to plump for the Blackrock fund instead.

Heather, a freelance market researcher, said: ‘We wanted a fund that wouldn’t crash when shares plunge.

‘We’re pleased with how it has held up while stock markets have fallen.’

-The Times-

According to Financial Times, Morgan Stanley lost more money in write downs and bad trades than Long Term Capital Management and Amaranth Advisors, the two highest profile HF disasters, combined.
“If you are handing out report cards for 2007,” John Coyle of JPMorgan told FT, “the hedge funds are looking like some of the smartest kids in the class at the moment.”

HF managers point out this difference between hedge funds and banks, says FT: Banks and brokerage firms take risks with other people’s money; “incentives are skewed toward uncontrolled risk-taking on the theory that heads, the traders win, and tails the shareholder lose, but the bonuses when they bet successfully are all theirs.”

Hedge funds look at things differently.
“Because it is our capital, we move more quickly to reduce risk,” an unnamed HF manager told FT. The paper cites as an example the moves by Jeff Larson of Sowood Capital Management, who closed the fund after it lost 55% of its investor money from wrong way debt bets.
“If it had been a Wall Street firm, everyone would have gotten zero back.”

FT further notes that many hedge funds have strict loss limits, even writing in their offer documents. Banks don’t - and some, like Morgan Stanley, and their customers, may have paid for it dearly.

For a start, the hedge fund industry now comprises more than 7,500 funds and 2,400 funds of funds, but it is still the small number of failures that grab most media attention. 'The problems suffered in the summer by some credit funds were well-publicised. Less well-documented is that a handful of funds were short sub-prime mortgages and were part of a group of funds that at the end of October were up more than 100 per cent for the year,' says Ken Heinz, president of Hedge Fund Research (HFR), the alternative investment database and index provider.

The most recent performance data from HFR paints a relatively upbeat picture. The hedge fund industry attracted a record USD194.5bn in new investor capital in 2007, bringing total assets under management to USD1.87trn.

Inflows for 2007 outpaced the previous year's USD126.5bn and represent a 54 per cent year-on-year increase. However, the fourth quarter inflow of USD30.4bn was well below the pace set in the first three quarters of the year, making 2007 the third consecutive year to end with a fourth quarter drop in the rate of new capital coming into the industry.

The HFRI Fund Weighted Composite Index returned 1.37 per cent in the fourth quarter and 10.24 per cent for the year. For the third year running, the HFRI Emerging Markets Index was the top performer on an annual basis, adding 3.89 per cent in the fourth quarter, and returning 25.03 per cent for the year. Short selling led all strategies for the quarter, returning 5.94 per cent, but was up just 3.98 per cent for all of 2007.

Relative value arbitrage and event-driven attracted the most new assets in the fourth quarter, bringing in USD9.9bn and USD5.3bn respectively. For the year, relative value arbitrage brought in the most new assets, totaling USD45.9bn. Equity hedge was next with USD41.5bn, although the strategy attracted just USD14m in inflows in the fourth quarter.

Funds of funds saw net new inflows of USD11.3bn in the fourth quarter and USD59.2bn for the year, compared with USD49.7bn in net new assets in 2006 and USD9.5bn in 2005. Globally, USD798.6bn is invested in funds of funds, according to HFR, with total assets invested in the category increasing by almost 22 per cent in the past year. Fund of funds performance was up 1.85 per cent in the fourth quarter of 2007, and 10.12 per cent for the year, according to the HFRI Fund of Funds Composite Index.

'It was another record year for hedge funds when it came to attracting new assets in spite of the slower pace in the fourth quarter,' says HFR's Heinz, who confirms that there are now more than 10,000 hedge funds in the industry. 'The trend in strategy allocations suggests investors are not chasing the best performers, and are anticipating continued opportunities in arbitrage and event-driven.'

Looking ahead, any outflows appear likely to be more than offset by continuing strategic inflows. 'If market conditions remain difficult in 2008, which we think they will, then inflows will remain strong,' says Thomas della Casa, head of research, analysis and strategy at Man Group.

Barry O'Brien, director of business development at fund administrator LaSalle Global Fund Services Europe, also noted an optimistic outlook among hedge fund providers. 'It is very much business as usual,' he says. 'Of course some individual funds have lost their shirts, but that is a cyclical phenomenon. In the late 1990s emerging market funds suffered in the Asian crisis, which was followed by the technology crisis. Certain discrete areas have been severely affected this year, but others are expanding.'

In 2007, market volatility has resulted in a greater variance in the performance of both managers and strategies than in recent years, which for an industry that promotes itself on its ability to generate alpha is a good thing. 'The hedge fund industry fee model has attracted a lot of mediocrity, but the fees are set at levels that are not synonymous with mediocrity,' says Robin Bowie, chairman of Dexion Capital. 'It is now an ideal environment for hedge fund managers to exploit opportunities and show their worth.'

With this greater variation in performance, manager and strategy selection will be even more important than usual in 2008, and there is a renewed belief in the benefits of diversification. 'Achieving a return of Libor plus 500 basis points with a fund of funds is a much better bet than investing in credit at the same level,' says Bowie.

Both Man Group and LaSalle Global have noted a trend towards a greater relative focus on fund of funds rather than hedge funds. 'In 2008, we will see a revival of the diversified fund of hedge funds. In recent years investors wanted high returns, more leverage and specialised exposure. Now they are starting to value diversification more highly again,' says della Casa.

The strategy mix is also shifting to reflect a less benign macroeconomic outlook for 2008. Distressed asset trading, for example, is definitely on managers' radar. Parts of the credit market, such as the industrial segments of the corporate credit market have come under pressure from long liquidation, despite company fundamentals - such as interest cover and cash flow - remaining sound. This creates opportunities for hedge funds to exploit the difference between intrinsic value and oversold market valuations.

Andrew Lodge, managing director of Nedgroup Investments, a fund of hedge funds, aims for a wide distribution of assets across different strategies, but says, 'we do make some tactical asset allocations and we are expecting distressed debt trading to do well in 2008. We are also optimistic about the prospects for funds getting involved in providing mezzanine financing: the banks have pulled back and so the deal flow and value opportunities are improving.'

As well as taking the place of traditional financial intermediaries, hedge funds look set to benefit from greater economic uncertainty. For example, the continuing stress in money markets is a possible threat to strategies in fixed income relative value, but also creates opportunities. 'There are currently very varied opinions about the macroeconomic outlook, which means that price action after central bank policy changes is quite marked,' says Man's della Casa. 'This movement in yield curves creates opportunities to both take profits and enter new trades. Twelve months ago yield curves just weren't moving.'

There has also been a shift of emphasis within specific strategies, such as credit. 'There are three launches that we are aware of in December from managers looking to exploit opportunities in the credit market,' says O'Brien. 'Some areas, such as CDOs have diminished, but other credit-focused strategies have expanded significantly.'

Opinions are more divided on the prospects for quantitative funds, after the very poor performance of several high-profile funds in the first half of August. 'There's an inherent inflexibility in those funds,' says Andrew Lodge. 'There is very little human intervention in the models and they may have had their time.' In November, however, when many hedge fund strategies recorded losses, equity market neutral - in which there is the highest concentration of quantitative funds - recorded a modest gain for the month.

One new area of quantitative investment, however, gained traction in 2007: hedge fund replication. Just as passive index tracking has become an important part of the mutual fund industry, as the hedge fund sector matures interest is growing in low-cost index-based products, which use proprietary algorithms to replicate the performance of hedge funds. Goldman Sachs, JPMorgan and Merrill Lynch have already launched hedge fund 'clones' and the market has also attracted new entrants such as New York-based Index IQ. By definition a passive investment strategy can only replicate beta not alpha. But gaining access at a lower cost to the alternative betas offered by hedge funds - the risk premia earned by isolating asset characteristics that are rewarded - has obvious appeal.

'Passive indexing accounts for about 17 per cent of the mutual fund industry,' says Adam Patti, chief executive of IndexIQ. 'We won't get to an equivalent level in the hedge fund industry next year, but that is the kind of future market growth we are thinking about.' If hedge fund replication does gain widespread popularity, it could lead to downward pressure on fee structures at those hedge funds whose performance is not exceptional.

While it is clear that fund providers are relishing the prospect of more turbulent markets, there are also indications that investor demand remains buoyant - at least for the right kind of hedge fund investment. At the start of December Dexion Absolute, the biggest UK listed fund of hedge funds, raised GBP 460m from investors, which was more than double its original target. 'There is strong demand for good quality funds, which are large and liquid,' says Dexion's Robin Bowie. Some smaller funds, however, have struggled to raise as much capital as they had hoped and there is definitely an element of 'size begetting size' in the current fundraising environment.

It is perhaps unsurprising that in a year during which illiquidity - the inability to sell an asset at the expected price - was the main cause of market distress, investors should show a preference for large vehicles offering ease of entry and exit. However, given the greater variation in performance in 2007, the best managers are finding themselves able to demand tighter, not easier redemption terms. Indeed, some have put forward the argument that very short notice periods added to the summer's volatility by allowing panic withdrawals.

Increased volatility has also prompted a demand from some institutional investors for greater transparency from hedge funds. O'Brien, for example, notes an emerging trend towards managed accounts rather than funds with a unit trust structure. For hedge fund managers there is a fine balance to be struck between meeting clients' requirements and protecting the proprietary nature of trading strategies. It is, after all, difficult to create alpha if everyone knows the exact details of the strategy being followed. In the aftermath of the August turmoil there has also been a greater demand for evidence of sound risk management and valuation processes.

Interest in risk management and transparency was also apparent among policymakers in 2007. Germany used its presidency of the G7 in the first half of the year to press for increased transparency at hedge funds and proposed a global database of hedge fund investments. Recommendations from the Financial Stability Forum, an international grouping of central banks and financial regulators, however, stopped short of calling for tighter regulation.

Germany and others pushing for action, such as the ECB, were mollified by efforts instead to establish a voluntary code of best practice.

The Hedge Fund Working Group, established by 14 leading hedge fund managers based mainly in the UK, this month published best practice standards for hedge fund managers following consultation with the industry and other interested parties.

The publication of the standards has been welcomed by the Alternative Investment Management Association (Aima), which will be involved in implementing them, and follows the issuing of a consultation document by the group last October.

The body of voluntary standards includes recommendations for managers to adopt an independent process for valuing portfolios and to put in hand robust governance of funds, in order to handle conflicts of interest between managers and investors.

The report also recommends enhanced disclosure to investors and urges managers to create a comprehensive risk management framework, an important consideration in the context of financial stability.

The Hedge Fund Working Group was set up last year in response to concerns about both the growing impact of hedge funds and financial stability. The standards aim to address these and other issues through increased disclosure to investors and other counterparties.

'Our final report is the result of extensive consultation within the financial industry, which has helped us to refine the standards and in some important respects make them more rigorous,' says the group's chairman, Sir Andrew Large

'Now it is up to investors to help take this forward. This is a voluntary, market-led initiative based on disclosure. It is the investors who can provide the market discipline to ensure these standards are widely adopted.' Compliance with the standards will be voluntary and will operate on a comply or explain basis.

A Hedge Fund Standards Board is being set up to act as custodian of the standards. The board's trustees will be responsible for updating the standards in the future and for encouraging convergence with the similar initiative currently being taken by the President's Working Group in the US.

Members of the group will initially act as interim trustees of the new Hedge Fund Standards Board and Sir Andrew Large will be interim chairman until permanent trustees are appointed. Aima chairman Christopher Fawcett will become a trustee.

According to the working group, Aima will also have a key role in developing aspects of the recommendations included in the report and in acting as a channel for guidance for the industry as well as consultations on future changes.

The association has welcomed the publication of the report, describing it as 'a substantial undertaking by leading hedge fund managers [that] offers high-level thought leadership on key issues surrounding the industry.

Aima notes that the report endorses its own work in defining and promoting best practice standards for the hedge fund industry and says it will work with the Hedge Fund Standards Board to mesh the standards with its own recommendations.

The association shares the working group's desire to see convergence of the various sets of standards drawn up for the hedge fund standards and has expressed its commitment to leading these efforts, while not underestimating the challenges inherent in doing so. It will consult with its members on the development of the standards by the board and may develop guidance on them if called upon to do so by its members and investors.

'This report is a substantial achievement by this group of leading managers, particularly given the time frame and the market conditions,'' says Aima deputy chief executive Andrew Baker. We believe this initiative is the right approach for the hedge fund industry.

'The working group's endorsement of Aima's leadership and its substantial body of work in industry practices is welcomed, and we are very much looking forward to working with the board and the rest of the industry to oversee convergence of standards.'

The working group was set up last July to address issues raised about financial stability by the G8 and the Financial Stability Forum as well as other concerns about the hedge fund industry. Its terms of reference were to explore a range of issues covering in particular valuation, disclosure of financial information and risk management.

The working group received more than 75 written submissions from interested parties in the industry, its investors and suppliers during the two-month consultation period and held 26 face-to-face discussion sessions.

The members of the group are Nagi Kawkabani, co-chief executive, Brevan Howard; Klaus Jäntti, chief executive, Brummer & Partners; Bernard Oppetit, chief executive, Centaurus Capital; Stuart Fiertz, president, Cheyne Capital; Michael Hintze, chief executive, CQS; Jeffrey Meyer, chief executive, Gartmore; Manny Roman, co-chief executive, GLG; Paul Ruddock, chief executive, Lansdowne Partners; Rob Standing, founding partner, London Diversified; Stanley Fink, deputy chairman, Man Group; Paul Marshall, chairman, Marshall Wace; Michael Cohen, managing partner and chief investment officer for Europe, Och-Ziff Capital Management; Michael Alen-Buckley, chairman, RAB Capital; and George Robinson, founding partner, Sloane Robinson.

The London-centric nature of the working group reflects the city's dominant role for hedge fund management in Europe. According to EuroHedge, UK-based hedge fund managers had USD415 billion of assets under management at the end of June last year, some 80 per cent of the USD539bn in total assets managed or invested in Europe.

The FSF noted in October that, 'The issuance of draft best practice standards…is a notable step towards improved transparency and discipline and a recognition by the sector of its responsibilities as a significant force in the financial system'

Importantly, the FSF has also recognized that this 'significant force' has not been the prime cause of financial market instability in 2007. At the request of the US government the FSF is now studying regulated financial institutions' liquidity, market and credit risk practices.

At the end of a year in which a long expected return of market volatility has tested the resilience of most financial institutions, London's hedge fund industry, with its focus on setting pragmatic best practice standards, is well placed to meet clients' needs in a more challenging investment environment.

-Hedgeweek.com-

"We are in a recession. It's not a question of whether it's a hard or soft landing, but how long it will continue," said Thomas Della Casa, head of research at British-listed Man Investments.

But he said it would most likely be a short recession, "like the one in 2001", which would be over by the US election in November.

Speaking from his base in Taipei, Mr Della Casa said he believed the equities bear market dated back to November - but it had been overdone given the relative strength of the non-US dollar denominated world economy.

"I would say that the market is as oversold as it was 10 years ago when we entered the Asian crisis," Mr Della Casa said.

"The panic was out there."

Man is one of the top three hedge funds in the world and manages $US70 billion ($80.5 billion).

It operates as a fund of hedge funds as well as running its own quantitative and other hedge funds.

But Mr Della Casa said recent lows could be tested within a few months if more bad news emerged from credit card providers and car loan groups in the US.

He said there were two things hanging over the US economy.

"Consumption will decline by the debt-ridden public (in the US) and a lot of people are scared it will spill over into Asia and China," he said.

Mr Della Casa predicted that growth in China could drop from as high as 12 per cent to 10 per cent or even 8 per cent, depending on how long the recession in the US lasted.

He said the market always looked about six months ahead of economic fundamentals.

But he said the debt crisis was still not over.

In the past week billions of dollars had been written down by major investment banks with more to announce losses in coming weeks.

"I am shocked that the banks do still not have a total look-through in their debt problems," Mr Della Casa said.

"There is still potential that more will come from credit card providers and car loan providers."

He said hedge funds would be wary of current conditions in recent weeks but would start moving into the market now.

"Since the beginning of the year the markets have been extremely difficult - they have been so emotional," Mr Della Casa said.

It had been the worst start to the year for global equity markets since 1932.

"Most of our funds have been holding cash in a neutral position," Mr Della Casa said.

"But they will benefit when the market calms down. You will have seen some activity today but I don't think they have been extremely active over the past few weeks." Mr Della Casa said equity markets tended to start rebounding around the middle of a recession.

"It will be in the second or third quarter and will be before the US election. The US Federal Reserve is supporting that."

He said that last year was the best year for hedge funds since 2003, handing investors returns of 10 per cent or more compared with 3.7 per cent for the MCSI global equities index and 5.3 per cent for bonds. He predicted that with bond markets shot and equities markets in turmoil, hedge funds could again generate double digit returns this year.

-The Australian News-

-Hedge Fund Daily-

Greenwich Alternative Investments notes that the S&P 500 declined by 0.69 in December and gained 5.50 per cent during 2007, while the MSCI World Equity Index fell by 1.37 per cent over the month but rose 6.49 per cent over the year, and the FTSE 100 returned 0.38 per cent and 3.80 per cent respectively. The Lehman Aggregate Bond Index posted a December return of 0.28 per cent and gained 6.96 per cent for the full year.

'Hedge funds have demonstrated their resilience to downward moves in the equity markets,' says Greenwich senior vice-president Ben Rossman. 'Hedge funds outperformed the S&P 500 by more than 5.5 per cent in 2007 through a combination of capturing market upside and protecting against downside.

'This is hedge funds' highest level of outperformance since 2002, when the S&P 500 was down more than 22 per cent and hedge declined less than 1 per cent. Over the last three years, hedge funds have outperformed the S&P 500 by roughly 2 per cent on an annualised basis, despite the S&P having roughly 50 per cent more risk associated with its returns.'

The Greenwich Composite Investable Index returned 0.27 per cent in December and was up 3.61 per cent for the full year. The Investable Index, comprising 49 constituent funds, adds investibility, active management and liquidity to the diversification and performance benefits of the broad Greenwich Global Hedge Fund Index. It references actual hedge fund vehicles as opposed to separately managed accounts or other methods used to replicate industry returns.

Oliver Schupp, president of Credit Suisse Index, notes that the December industry performance came amid global market weakness and signed of stress in the US economy. 'Global market indices were relatively flat for December,' he says. 'The US continued to show weakness in many sectors as the credit crunch of 2007 continued to affect financial markets worldwide - US manufacturing indicators were at their lowest since April 2003.

'At the December 11 Federal Open Market Committee meeting, the Federal Reserve cut rates for the third straight time and also lowered the discount rate. In the UK, a slowdown in manufacturing growth pushed the Bank of England to cut the benchmark interest rate for the first time in two years.

'Crude oil ended the year at USD95.98 per barrel, a 57 per cent surge over the 2006 year-end figure, and had flirted with the USD100 mark over the prior two months. Overall, this market environment has resulted in eight out of 10 hedge fund sectors ending December on a positive note.'

The Credit Suisse/Tremont Hedge Fund Index comprised 481 funds as of December 31. It is constructed using the Credit Suisse/Tremont database of more than 5,000 hedge funds and includes both open and closed funds located in the US and offshore, but not funds of funds.

To qualify for inclusion in the index selection universe, a fund must have a minimum of US50m under management, a 12-month track record, and audited financial statements. Funds are selected using a formula based on assets under management, ensuring that the Index represents at least 85 per cent of total assets in each of 10 strategy-based sectors in the selection universe.

As well as the Hedge Fund Index, the Credit Suisse/Tremont family of indices includes the AllHedge Index, an investible index comprising all 10 Credit Suisse/Tremont Sector Invest indices weighted according to the sector weights of the broad index, and the Blue Chip Index, an investible index consisting of 60 largest funds across the 10 style-based sectors.

The AllHedge Index was up an estimated net 0.31 per cent in December, while the confirmed performance for November was a decline of 1.18 per cent, leaving the index up 8.82 per cent in 2007. The Blue Chip Index was up an estimated 0.15 per cent net for December, and after a confirmed decline of 1.08 per cent in November, the index gained 7.36 per cent for the year.

-Hedge Fund News-

The firm’s HFRI Fund Weighted Composite Index returned 10.36% for 2007 after a 0.68% rise in December. Funds of funds trailed, but not by much, adding 9.94% last year following a 0.1% return last month.

As far as individual strategies go, there are emerging market funds, and then there’s everybody else. E.M. blew all other comers out of the water, returning 24.91% on the year (1.75% in December). Funds focused on Asia, in particular, had a stellar 2007, soaring 35.88%. The strategy’s 2.82% December return was also tops among those tracked by HFR.

Energy hedge funds also enjoyed a successful 2007, returning 16.47% (1.95% in December). Technology funds also posted strong returns, adding 15.68% on year, though the strategy fell 0.46% last month.

Speaking of losing, just three of the myriad strategies and sub-strategies tracked by the HFRI indices finished last year in negative territory. Hedge funds focusing on the financial sector suffered the most, as financial firms were battered by the credit crisis and roiling stock markets. The strategy lost 5.88% in 2007, dropping 1.62% in December alone. Real estate hedge funds were pushed into the red by a 2.41% decline last month, leaving the strategy down 1.33% on the year. And high-yield funds finished marginally down, losing 0.14% in 2007 (down 0.05% in December).

Among other major hedge fund strategies, macro funds posted a 12.2% return in 2007 (1.33% in December), while equity hedge funds returned 10.71% (0.68% last month). Relative value funds added 9.35% (0.99% last month), event-driven 7.38% (0.13%), merger arbitrage 6.73% (down 0.67% last month) and distressed securities 6.29% (0.55%).

Equity-market neutral funds were up 5.78% last year (0.78% last month), convertible arbitrage 4.9% (down 0.83% last month) and fixed-income 2.68% (0.23%).

Investable hedge funds did proportionally worse, according the HFR’s HFRX indices. Overall, investable funds returned 4.23% in 2007, declining 0.14% in December. While only one of the HFRX subindices found itself in the red last year—convertible arbitrage, which lost 0.95% for the year after a 2.17% drop in December—just one bettered the Standard & Poor’s 500 Index, which returned 4.9% in 2007. That was relative value arbitrage, which topped all other investable strategies with a 5.8% return, though like most of the HFRX strategy indices, it found itself in the red last month, dropping 0.42% in December.

-FIN alternatives-