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Innovations in Wealth Management Technology Awards 2014

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Friday, January 6, 2012

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Investors could favour smaller funds in 2012

by Nathan Collins

With hedge fund redemptions on the rise, Euromoney takes a look at whether investors will be placing their confidence in smaller start-ups rather than larger hedge funds


Investor confidence in larger hedge funds has seemingly waned over the years, with reports of lack of returns and big investment scandals leading to a slew of hedge fund redemptions.

With most industry participants expecting repeat volatility and downward trends from last year, it seems that the outlook for substantial and stable returns in 2012 would be unlikely

However, one area that might be promising for the coming year is for smaller start-up hedge funds, despite the last few years being difficult for such fledglings.

The turmoil of the financial crisis persuaded many investors that they were safer investing their money in more established funds – perceived islands of stability in the disorder.

Faith in larger funds was not unwarranted at the time – more than 15% of hedge funds closed in 2008 yet only one of these, Madoff feeder fund Fairfield Sentry, managed assets of more than $5 billion.

Yet of course confidence waned further in hedge funds after the Bernard Madoff investment scandal broke in December 2008, when it was revealed that it was a Ponzi scheme.

The third quarter of 2011 saw an increase in the rate of redemptions year-on-year and quarter-on-quarter. Man Group, the world’s largest hedge-fund manager, reported that $2.6 billion was pulled from funds it owns in the third quarter of 2011. However, research from data-vendor BarclayHedge, released on Tuesday, indicates that November saw an increase in industry assets – the first such increase in five months.

Start-up funds can be bolstered by the assistance of seeding funds: funds that contribute capital to smaller hedge funds allowing them to expand.

Jeroen Tielman, CEO of seeding fund IMQubator, is convinced that 2012 will be a strong year for these smaller funds, particularly those bolstered with the assistance of a seeding fund – and we may see a reversal of the trend towards investment in larger funds.

“During the crisis, investors flocked to the big funds as a safe haven,” says Tielman. "They’ve now realised this isn’t really the case."

Part of the attractiveness of these newer funds for investors is that fund managers need to perform strongly and consistently. Unlike more established funds, start-ups might not have the accrued goodwill of investors necessary to weather a bad patch; underperformance early on runs the risk of establishing a negative reputation that will be hard to shake.

“Start-ups tend to offer a healthy premium that’s attractive to investors,” says Tielman. "And after all, you only get one chance to set up a brand so there’s a real incentive to deliver results."

Start-ups of any kind are often seen as risky, and this is just as true in the context of hedge funds – the lack of a proven record can, rightly, make investors cautious. However, Tielman contends that the risks seen in start-ups are often illusory. Individuals starting up their own hedge funds tend to be experienced fund managers who have decided to strike out from another fund, rather than newcomers to the field.

“Start-ups are no more risky on the investment and risk-management side; they tend to be experienced investors," says Tielman. "The lack of experience is only on the operational side. Most emerging fund failures stem from operations problems, or failures in sales and marketing. We provide funds with support on these fronts, protecting them from failure."

Indeed, aside from mitigating the problems that may be experienced specifically by start-ups, Tielman believes the structure given to a start-up in the seeding process can help it avoid criticisms that are levelled at hedge funds of all sizes.

Specifically, Tielman feels that the structure imposed by his fund will create hedge funds that are more investor friendly. Hedge funds suffer criticism for being opaque to investors but since start-ups don’t have the ingrained habits found in larger funds, these concerns can be dealt with more easily.

Tielman is hopeful that the next generation of hedge funds will represent a correction of the balance between manager and investor.

“We demand transparency from the outset," says Tielman. "Since we work with new funds, we can put in place the proper structures for transparent operation, without having to remove a pre-existing system. We can make sure that the proper balance between managers and investors is there from the beginning.”

Marketing firm and consultancy Agecroft Partners released a report on Tuesday indicating that it expects 2012 to be a strong year for hedge funds, predicting $100 billion in net inflows for the coming year. This would mark the highest inflows since 2007. In particular, Agecroft targets small- and medium-sized firms as potential beneficiaries of these inflows, indicating investor concern over diluted alpha and investor risk in larger funds.

Tielman’s views are coloured with the opinion that all hedge funds – big and small – are not being paid the attention they deserve from investors. While some may be concerned about the ability of fund managers to deliver added value to investors, it is possible that skilled fund managers could take advantage of the volatile conditions projected for 2012.

“Hedge funds are under-represented in most investor’s portfolios," says Tielman. "They deserve a 20% to 25% allocation but are rarely given this. As a skill-based asset class, hedge funds are particularly well suited for investors in turbulent times like now.”