As hedge funds suffered their worst ever year in 2008, many private clients voted with their feet. Investors withdrew $154 billion last year and the exodus looks set to continue. More than two-thirds of respondents to Deutsche Bank’s annual Alternative Investment Survey said they expect outflows to total over $170 billion in 2009.

However, in a case of survival of the fittest, market volatility, combined with the ability to buy distressed assets, means now is arguably one of the best times for hedge funds in recent history, figures in the wealth industry suggest.

“For those that do survive, the medium and long term prospects are good, with a large set of opportunities and less competition,” said Barbara Vannotti-Holzrichter, head of fund research, Rothschild Private Banking & Trust.

Hedge fund managers will hope that strategies clock up a stronger year after losing an average of about 19 per cent last year, according to Chicago-based Hedge Fund Research. Even so, last year’s loss – the worst on record – was not as bad as the 40 per cent plunge in the MSCI World Index benchmark of developed countries’ shares. And some hedge fund strategies, such as macro and short-biased, made money.

Graham Wainer, group head of private clients at GAM, the investment firm, recently told WealthBriefing: “The rewards rise for those who remain. The survivors that know what they are doing will see a tremendous improvement in their results as there is a higher amount of alpha available across fewer managers.”

One issue that the hedge fund industry needs to address is ensuring that these vehicles genuinely enable investors to get uncorrelated returns instead of merely tracking a market with an additional booster from leverage.

"Should private wealth managers use hedge funds? Absolutely. The problem in 2008 was that everyone lost money in part by investing in equity long/short and market neutral strategies which were not providing decorrelated returns. Managers did not really review in enough detail what they were buying and so they were not effectively taking clients out of equities," said Jérôme de Lavenére Lussan, founder of investment management consultancy firm, Laven Partners.

Short-biased strategies, for example, can provide negative correlation to equity holdings, but too few managers have used them. "70 per cent of hedge funds are in long/short strategies and long/short gives 70 per cent correlation to beta. You do the math. They were correlated to equity indices, so they failed to provide alternative returns," he said.

PSigma Investment Management is a firm that has used hedge funds in the past to deliver a different performance schedule to traditional asset classes for investors and reduce overall portfolio volatility, yet it started to completely eliminate its hedge fund exposure last year and is making no fresh investments in the space.

The firm believes that the opportunity set available for hedge funds was severely curtailed as leverage became more difficult to obtain, making returns hard to achieve without taking unsatisfactory levels of risk. “In addition, our tolerance of investments where we had issues over liquidity had diminished,” said Thomas Becket, head of global strategy.

PSigma’s decision to exit hedge funds was supported by UCITS III regulation which provided retail fund managers with new powers which allow them to replicate some of the strategies that were previously exclusive to hedge funds such as derivatives, shorting and the use of leverage.

According to GAM’s Mr Wainer, one effect of the credit crisis is that whereas previously, a manager might have been able to say “trust us”, now if a client doesn’t understand, they won’t invest and they are not embarrassed to say so. “There are certain hedge funds that they are more comfortable with,” he continued. “They want to understand the principles and some hedge fund strategies are easier to explain than others, such as discretionary global macro, compared with say convertible arbitrage, which is much less so.”

Yoshiki Ohmura, head of structured investments at GAM, says a multi-strategy approach was presumed to cut risk; however, when the market fell, diversification brought few benefits.

“Clients are now looking to specific strategies such as managed futures and macro and concentrating on underlyings with a deeper market,” he said.

Liquidity

An overriding theme for those considering hedge funds at all is a desire for increased liquidity and, post-Madoff, investors are also hyper-sensitive with regard to transparency.

“Liquidity is a big issue and one which was not really perceived by investors until they lost it,” Mr Ohmura continued. He said the desire for liquidity and transparency has driven demand for managed accounts, where, rather than investors’ funds being shared or co-mingled in a hedge fund, they own the account which is specifically managed on their behalf and so have perfect transparency and control.

The evidence points to an improving outlook for hedge funds. Performance has rebounded: Eureka Hedge calculates that 96 per cent of the hedge funds that make up its indices outperformed the MSCI World Index in the first quarter of 2009.

Fund of hedge funds also posted positive performance of 1 per cent in the first quarter of 2009 and outperformed global equities which fell by 12 per cent in the same period, according to S&P fund services. S&P predicts that money will flow back into FOHFs, if the positive absolute returns achieved in the first quarter of 2009 are sustained over the rest of the year.

HSBC Private Bank said in a recent note that it is much more optimistic for the future performance of hedge funds, across most strategies. “The end of the mass redemption cycles of Q4 2008 is nearing,” said Fredrik Nerbrand, head of global strategy. “In addition, the quality of managers who are currently open is amongst the best we have seen and this provides access to these previously closed funds.”

Rothschild Private Banking & Trust notes substantial cash levels among managers ready to be deployed when client redemptions subside and that there is now less competition for profitable trades as investment banks have scaled back their proprietary trading activities.

Specifically, the firm sees opportunities for directional and global macro funds to benefit from high levels of volatility, a steepening of the yield curve and sharp foreign exchange movements.

“Specialist credit managers will be faced with rich pickings as the economic slowdown intensifies,” said Rothschild’s Ms Vannotti-Holzrichter. “The same is true for managers focusing on distressed areas however, timing is crucial and we are waiting for the economy to deteriorate further before taking positions. Value-oriented equity long/short managers should also be well positioned for when the focus on company fundamentals eventually returns.”

In Mr Wainer of GAM’s view, while the market remains vulnerable and volatile, it is hard to pick a strategy that is “good for all seasons”. However, managers that employ trading strategies are relishing this environment on the long side by picking opportunities amongst strong companies as well as shorting opportunities for their weaker counterparts.

“Credit-based strategies are incredibly well positioned now as we are seeing a stabilisation and the environment is set fair for the majority of managers in this space,” he said.

By contrast, PSigma believes that while macro and trading funds will do well in the current market, long/short funds will find it hard due to lack of leverage, as will fixed-income funds.

The consensus is that this year is critical for hedge funds, but there are significant rewards available for those that weather the storm and have good processes and due diligence procedures in place.

“Managers will need to demonstrate that they are able to deliver positive performance to recoup losses and, at the same time, to focus on operational issues and grapple with the overhang of investor redemptions,” said Ms Vannotti-Holzrichter.

As a result, Laven Partners, has seen its corporate finance based due diligence approach, which combines operational risk with risk management and compliance, boom. According to the firm, it turned down funds which have famously blown up since. "The industry is crying out for independent processes to reaffirm what is a good investment," said Mr de Lavenére Lussan.

Whilst the pace of hedge fund redemptions is starting to slow as average performance improves, investors are demonstrating increased scrutiny of providers and discrimination about the strategies they pick. Fund size is becoming increasingly important with investors focusing on higher quality managers with strong track-records and avoiding those with low levels of assets. Transparency and sound operational procedures are also now a prerequisite in regaining investors’ confidence.