Performance only the start for hedge funds

Until recently, impressive performance was all a hedge fund needed to attract assets. But that is no longer a ready formula for success. For one thing, delivering stellar returns is more easily said than done in difficult markets. Hedge funds also face growing ranks of direct competitors plus a growing challenge from traditional and private equity managers.

The influx of institutional assets accounts for the majority of recent flows to hedge funds. Beyond having vast sums to allocate, big pension funds and endowments represent "patient assets" invested over relatively long time horizons.

But in the current climate and with so much at stake, hedge fund managers cannot assume institutional capital will continue to roll in. Besides needing new ways to generate alpha and differentiate themselves in a crowded field, hedge funds must make sure offerings and methods are in keeping with the institutional mindset. After all, institutional objectives and concerns are quite different to those of hedge funds' traditional high net worth clientele. Moreover, investor preferences continue to evolve as institutions become more comfortable and experienced with alternative investing.

Hedge funds made a name for themselves by being innovators and iconoclasts. To continue prospering, they must now adapt to high expectations and often conservative attitudes that characterise institutional investors. The trick, of course, will be to fit that mould while preserving the investment attributes institutions found appealing in the first place.

As a start, hedge funds must recognise that strong performance is only one item on investors' checklists. Surveys show that institutions look to alternative investments more for stable returns and exposure to non-correlated strategies than for high absolute returns.

In addition to relying on returns, hedge funds need to focus on the broader spectrum of characteristics required to meet institutional comfort levels. As confirmed by a 2007 SEI-sponsored survey of more than 100 large pension funds, foundations and endowments, institutions prefer to invest with stable, well-run organisations - in short, ones that look and act much like institutions themselves. Based on the results of SEI's survey, institutions want hedge funds that have:

*A strong management team with a full range of skill sets and reasonable continuity. From the institutional perspective, having one or two investment superstars is no substitute for a well-staffed organisation, be it an up-and-coming boutique or a long-established fund with billions under management.

*Solid infrastructure incorporating third-party administration and valuation. In fact, the institutions in the SEI survey ranked infrastructure as their number-one criterion in manager selection, reasoning that "better managed funds produce better returns".

*A verifiable track record for their current people and products. Many institutional investors say they would favour a fund with a well-documented, three- to five-year history of consistently good results over one with a briefer record of outstanding performance.

*A transparent investment strategy and process. More than 85 per cent of institutions surveyed said they would not invest in a strategy they did not understand. While few wanted portfolio transparency at the position level, more than half said they seek it at the sector or industry level.

*Demonstrated adherence to the highest standards for compliance and business practices. With a growing body of regulations and "best practices" guidelines now emerging from working groups in the UK, Europe and the US, the bar is certain to be raised higher than in the past around these issues.

The principle message is that hedge funds should bank less on performance and more on capabilities. If their pragmatism outweighs their pride, they will take a cue from traditional institutional account managers who have long emphasised people and process.

This advice still holds when considering what keeps investors up at night. What is the biggest worry for the institutions investing in hedge funds? In the SEI survey, 67 per cent of pension funds and 37 per cent of all institutions said "headline risk" was the number-one fear factor. Transparency was second, underperformance only a distant third.

So it is no surprise if institutions take a dim view of hedge funds with a shoot-from-the-hip strategy or seat-of-the-pants operating style, no matter how many Nobel laureates are on the letterhead.

Many hedge fund managers are understandably preoccupied with today's economic and market turmoil as they search for new opportunities and novel variations on formerly winning strategies. But they must not forget to update their competitive mindset at the same time. The industry must recognise that for institutional prospects and clients, performance is only the beginning.

Paul Schaeffer is managing director of strategy & innovation for SEI's Investment Manager Services division.