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After sluggish performance over the past several years, investors in equity hedge funds are certainly hoping for better results in the year ahead. According to Barron’s, over the last three years, equity hedge funds have averaged a return of only 3.42 percent. This is less than half the return investors in fixed income funds experienced, yet equity investors were also faced with higher volatility.

It’s not only investors that are looking forward to a brighter 2013, but fund managers as well. Many equity hedge funds are seeing investors head to the exits and exchange their low performing, high fee assets for those in fixed income or other strategies. In fact, in the first nine months of 2012, investors withdrew a net $9.5 billion from equity hedge funds while placing an additional net $34.9 billion in investment with fixed income hedge fund managers.

Fixed Income Funds May Struggle to Keep Up With Equities in 2013

While investors fled equity funds in 2012, fixed income may be the next asset class to feel some pressure as the last remaining yield is squeezed out of nearly every possible investment class. Over the past several years, investors have seen yields drop in nearly every segment. First were government bonds, then high quality corporate issuers, followed by a decline in mortgage backed securities and even high yield issuers. While the decline in yields and the corresponding increase in fixed income asset prices has been great for investors, this trend will eventually need to reverse or at least slow down. Yields are now at the point where significant returns can only be made through price appreciation, and betting on further large scale shifts in the yield curve certainly carries some risk.

While attractive fixed income yields can still be found in a handful of foreign markets, currency exposure is becoming a concern as well, making these investments far from low risk. While it would be premature to call an end to fixed income hedge fund returns at this point, fund managers will need to be more creative in 2013 to generate attractive returns.

Investors May Be Encouraged Back to Equities By Lower Volatility

On the equity front, investors may begin to be encouraged back towards equity investment not only by higher possible returns, but also through lower volatility. Volatility indexes reached five year lows towards the end of December, even in the face of possible economic trouble surrounding the fiscal cliff. This marks a significant change in underlying tone and outlook towards equity markets in the United States. As investors begin to gain confidence in equities again, this should have positive impacts not only on flows towards equity hedge funds, but also in underlying stock prices.

After a Difficult Year, Some Optimism for the Year Ahead

After what was a difficult year for equity hedge fund managers, some encouraging signs are beginning to create some optimism in the segment once again. While there is certainly significant risk still on the horizon for global equities, improved confidence and lower volatility may encourage some investors back into equity. Declining fixed income returns should only help push investors from bond-focused funds back towards equities. While this would be welcome news for equity hedge funds, the outlook in far from certain and equity fund managers will need to be both creative and opportunistic in order to offer a winning value proposition to their investor clients.

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In 2012, large deals in the funds-of-funds segment of the hedge fund industry became a regular occurrence as fund managers sought out bigger partners in order to maintain their position in a difficult economy. According to Pensions and Investments, five of the top twenty-five hedge funds-of-funds managers have changed their ownership structure this year. This includes big names such as Prisma Capital Partners, FRM Holdings and the Rock Creek Group. As fund outflows continue to put pressure on the industry, all players are finding the need to step up their game in terms of securing reliable streams of future contributions.

Fee Pressures Continue to Weigh on Industry, Drive Transactions

One of the many pressures currently weighing on the hedge fund industry is the demand for lower fees from institutional clients. This is none more applicable than in the funds-of-funds segment. In the current environment of low investment returns, clients are struggling to justify the value of funds-of-funds management fees in comparison to do-it-yourself approaches to hedge fund investing. When it comes to sophisticated institutional investors, many portfolio managers are leaving this segment of the hedge fund industry and investing directly in smaller funds themselves, bypassing the middleman.

In response, hedge funds have actively begun cost reduction strategies in an attempt to make a lower fee environment still viable for their own margins. While in many cases this has meant a reduction in staffing levels, transactions can offer some advantages as well in terms of reducing costs. According to Pensions and Investments, access to Well Fargo’s distribution network was a key reason why Rock Creek sold a 35 percent to Wells Fargo. This sort of opportunistic transaction is becoming necessary for hedge funds to survive in this environment.

Low Fixed Income Yields Offer Opportunity for Hedge Funds

Large scale money managers have been an important and increasingly rare source of support for the fund-of-funds segment over the past year. With fixed income yields currently sitting at historical lows, portfolio managers are struggling to meet hurdle rates without taking excessive equity market risk.

Franklin H. Kettle, Managing Director of Colchester Partners LLC, suggested that traditional money managers need to consider funds-of-funds in order to retain clients in a time where low yields and high equity volatility are common place. “With low-yielding bond portfolios and wildly volatile equity strategies, companies like Franklin Templeton and others absolutely have to be able to offer hedge funds or be prepared to watch an awful lot of money walk out the door.”

Transaction Trend May Continue in 2013

While 2012 certainly saw a lot of new ownership arrangements in the funds-of-funds space, none of the underlying causes of these transactions are going away any time soon. Fee pressure is expected to continue in 2013 and fund managers will need to be creative in finding ways to lower costs while not sacrificing their investment management capabilities. Look for many of these creative solutions to come in the form of partnerships and strategic arrangements as the year continues.

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Hedge Funds Become a Leading Asset Class for Institutional Investors

December 17, 2012

While hedge funds have suffered publicly in terms of reputation since the financial crisis, portfolio managers have a different view of the asset class. Over the past several years, institutional investors have been feeling the pain of historically low fixed income yields. Pension funds, trusts and endowments are struggling to earn minimum hurdle rates in order to […]

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Hedge Funds see a Return of the Institutional Investor

November 5, 2012

Hedge funds have seen a significant change in their investor base in the last year as wealthy individual investors exit the asset class, according to a recent Reuters article, no longer seeing the same return potential in the lower risk strategies being executed by hedge funds today. The industry is beginning a transition back to its roots […]

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