Infovest21 White Paper: Institutions search for structural efficiency....funds of funds take a more solutions-based approach

Three major trends continue to impact the hedge fund/funds of funds community - institutionalization, regulation and a challenging asset raising environment.

Infovest21's just-released annual white paper on trends and outlook, looks at each of these trends in detail.

Institutionalization

Pension underfunding, a major concern worldwide, is leading to increased institutional interest in hedge funds/funds of funds as a possible solution in pensions' search for alpha.

More institutions are becoming comfortable thinking about sources of alpha as opposed to traditional buckets. For example, long/short equity is now becoming part of the equity traditional allocation. Instead of a 5% allocation to alternatives now, 20-30% of traditional equity allocation may be put into long/short equities.

Pension plans are increasingly using hedge fund allocations for both fixed income and equity replacements whereas in the past, hedge funds were usually used as absolute return.

Another related trend is the search for structural efficiency. To achieve this, some pensions are allocating directly to hedge funds, accessing fund managers at a reduced fee and/or combining replication strategies. Other institutional investors are combining long-only managers with hedge fund managers as long-only managers generally can generate alpha at a lower fee level.

Regulation and its implications

A number of regulations are affecting the hedge fund community and having numerous repercussions. For example:

A number of compliance experts expect to see more enforcement actions against advisers for a full host of issues but particularly insider trading. The SEC is becoming more educated to what the risks are, how managers manage their book of business and what some of the conflicts are.

As a result, hedge funds are taking a closer look at their insider trading policies. They are putting together compliance policies on expert networks which they hadn't done before. Lawyers advise managers to have documentation showing what caused them to trade in a particular stock.

The SEC is currently investigating hedge funds, and other financial institutions' dealings with sovereign wealth funds. The SEC is scrutinizing these transactions to see if Foreign Corrupt Practice Act violations have occurred i.e. whether improper practices have been used to influence investment decisions outside the US. There haven't been any cases yet on this but the issue is expected to increase in importance.

In July, US hedge fund managers with more than $150 million in assets will have to register with the SEC. The increased cost of registration and the cost to implement compliance programs will significantly affect smaller hedge funds which are already particularly vulnerable, especially if they are not yet above their high water mark.

Due to the Volcker rule in the Dodd-Frank Wall Street Reform and Consumer Protection Act, proprietary traders continue to spin out of investment banks. The result is more hedge fund launches or talented traders joining hedge funds.

Improved but challenging asset raising environment

While improving, asset raising remains challenging and more difficult than most managers expected. While launches are increasing from the past few years' doldrums, new launches tend to be relatively small in size.

Consequently, seeders are in big demand which has resulted in more seeding platforms being set up and more specialization occurring. Institutions are starting to show more interest in emerging managers and seeding funds.

Momentum is growing in Asia as investors and seeders search for new managers and higher rates of return.

Inflows generally are going toward high transparency, liquid products such as managed accounts/funds of one and Ucits. Retail products such as mutual funds using hedge fund strategies are gaining in popularity.

The asset raising environment is also impacting the evolution of funds of funds. The medium-to-larger sized funds of funds increasingly find themselves competing against consultants, wealth managers, multi-strategy funds and specialist consultants. Some funds of funds are developing advisory businesses.Some are also moving into the subadvisory business as some pensions are looking for a fund of funds that can facilitate knowledge transfer so they may ultimately become more active in the internal management of its hedge fund program.

The above are excerpts fromInfovest21's white paper: Major Trends Occurring in 2011 - Implications for Hedge Funds/Funds of Funds.