Fledgling hedge funds struggle to raise assets

Morgan StanleyÆs survey of institutional investors finds they are pickier about hedge fund managers - and keener on Asia and Japan strategies.
Growing up is never easy. A Morgan Stanley survey of global hedge fund trends, based on interviews with 40 large US institutional investors, suggests that starting a new hedge fund is more difficult now, even as the overall industry continues to expand.

The report projects hedge fund assets growing to $3 trillion by 2010, having passed the trillion mark in 2005, assuming the pace of growth continues as it has since 1999, when the industry was $456 billion.

For start-up funds, the miracle of birth is getting even tougher. Unlike 2003 and 2004, when launches exceeded their day-one target fundraising to the tune of 25%, in 2005 there were shortfalls of about half the envisaged amounts to be raised for both multi-arbitrage funds of all sizes and long/short equity funds of less than $100 million. Long/short equity funds greater than $100 million barely hit their targets.

Traders or fund managers with a hotshot reputation can still attract money with relative ease, but the majority of newcomers cannot survive without a good capital-introductions programme, or so concludes Morgan Stanley, which thrives off of such connections.

ôInvestors are becoming more institutionalized in their process and the demands placed on prospective managers,ö says Kurt Baker, managing director at Morgan Stanley and head of its regional prime brokerage unit. ôSome question the quantifiable effect of the capital introductions process. We think it is critical to the success of a manager seeking to raise a meaningful amount of assets, particularly in the early stage of their life cycle. Managers need help in thinking about the issues that investors will raise in due diligence meetings.ö

Investors are looking for specialisation. According to the Morgan Stanley survey of US institutions, they say they are cutting back on convertibles, distressed, fixed income and multi-strategy. They plan to invest more in niche-focused sector hedge funds investing in energy, healthcare, technology, utilities and real estate. (ThatÆs clearly a hint for equity research analysts and traders who feel like pursuing an alternative lifestyle.)

The maturing industry increasingly favours larger participants. The top 50 funds hog 40% of the market, and the top 100 make up for 57%. That compares to 49% cumulatively in 2003.

ôInvestors remain interested in both new and established managers,ö says Baker. ôInfrastructural support and the risk management process, in addition to performance, are key to a manager's success in raising assets. The good are surviving and thriving. Poor performers are being weeded out more quickly.ö

The investor poll found 72% US institutions intend to increase allocations to Japan strategies, and 58% will increase exposure to Asia ex-Japan strategies this year. The biggest outflow will come from North America-oriented strategies: 30% of institutions intend to reduce these exposures.

Looking back to 2005, returns for hedge funds employing emerging-markets strategies yielded 20.9%. None of the 11 other measured strategies came close, with only US equities at 10.7% achieving even half the levels of emerging-market returns. The 2005 average hedge-fund return was 9.4%, with fund of funds averaging 7.3%.
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