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Why Hedge Funds’ Biggest Fear Is Their Investors

Date: Wednesday, March 25, 2009
Author: Wall Street Journal

The biggest peril hedge-fund investors see in the months ahead isn’t the credit-market paralysis that has spawned a rising number of government spending programs, nor is it the expected performance of funds chastened by the industry’s worst year on record in 2008.

No, the biggest concern among hedge-fund investors in 2009 is hedge-fund investors themselves.

In a shrinking fund universe that soon could control just half the assets it did a year ago, hedge-fund clients are eying each other. Withdrawals of money top the list of biggest challenges fund managers face in the next 12 months, according to the 2009 Alternative Investment Survey out today from Deutsche Bank. The very question of survival for hedge funds rests most solidly on the issue of how much money investors will pull, versus how much they will keep in place to ride out the financial storm, the seventh annual report shows.

Deutsche Bank conducted the survey in February, as the credit crisis deepened and the hedge-fund population appeared increasingly divided between survivors on one hand and stragglers with uncertain futures on the other. New investment in these private funds has practically dried up as markets plunged and investment frauds surfaced.

The Deutsche Bank survey reflects the views of roughly 1,000 investors controlling $1.1 trillion in hedge-fund assets. They include funds of funds, which raise money from other investors and farm it out to a number of hedge funds, plus pension funds and banks with hedge-fund accounts.

Some results mirror last year’s sentiments: Hedge-fund investors are holding on tightly to their cash, but they are holding on even more than a year ago. Once again, risk controls by fund managers, meaning their grasp on safeguards that help limit their market losses, rank almost as high as performance among top characteristics for investors choosing managers.

Speaking of performance, more than half of the investors surveyed expect the average hedge fund globally to post a profit this year ranging from slightly positive to up 10%. Such a return would contrast sharply with the average hedge fund’s investment decline of about 19% in 2008, according to Chicago’s Hedge Fund Research.

So far, 2009 fund returns ranging from just slightly down to slightly positive compare favorably to major stock-market indexes. “Hedge funds that have the cash to invest have an opportunity to perform really well this year,” said Scott Carter, head of the bank’s hedge-fund capital group and global prime-finance sales in North America. “The challenge for some funds will be to hang on to their investments for the next 12 months.”

That is where redemptions come into play. For some hedge funds, withdrawals “may force them to sell at a time when the investment outlook looks most promising,” Carter says.

Hedge-fund executives’ desire to avoid selling holdings in desperation by keeping their investors in place is making the executives remarkably flexible in renegotiating terms such as what fees clients pay and how long they promise to keep their money in place.

Last year “was a story about performance,” says Se