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Industry report heralds future of two-tier hedge fund system

A report into setting up and running a hedge fund in an existing long-only or 'mixed' fund management company has revealed market appetite for a hybrid product.

In examining the phenomenon of traditional long-only fund managers entering the world of hedge funds, Investit Intelligence conducted a survey of leading fund managers representing over 40 per cent of mixed-environment hedge funds, administrators, prime brokers, pension consultants and fund of hedge fund managers in Europe

The subsequent report, Hedging Your Bets - Mixing long-only with long-short investment, found the primary drivers causing traditional firms to enter the hedge fund market to be: improving the product range; accessing a new source of clients and generating additional income.

A number of CIOs said that key drivers for setting up hedge fund products were to 'bring back alpha to the long-only product' and to give talented managers opportunities to run hedge funds while staying within the firm.

The report found that the mixed product environment has been successful in a range of companies and that there exists the possibility for the market to split to support a less constrained but still risk and fee-aware hedge fund product, which could appeal more strongly to pension funds.

The key factors defining this emerging hybrid hedge fund product were found to be:

• The product performance benefits from the relaxation of investment constraints - a product set up specifically for pension fund clients will not require an offshore structure and so can still benefit from the regulatory environment already in place for the long-only funds. Established long-only firms are routinely offering investors confidence through rigorous compliance and monitoring procedures.

• Managers can generate an income stream, which is much more strongly linked to their success as investors.

• Additional income from performance fees - the hedge fund performance fee element means that it is possible to make a profit on a relatively small fund. A fund, meeting normal performance goals, could generate nearly GBP 3 million in fees per annum, compared with less than GBP 1 million from a medium-sized unit trust or institutional account. Capacity management, i.e. the determination to keep a fund small, is recognised as a key factor in getting many styles of hedge funds to perform.

The report found that such a hybrid product could also provide the operational reassurance needed to get over the 'headline risk' which many institutional investors cite as a barrier to investing in hedge funds. This type of product may also offer a more attractive option for fund managers wanting to use hedge fund techniques without the brand risk, which a wholesale entry into hedge funds could bring.

Many established long-only firms find that selling in the hedge fund market presents significant challenges. Most said that their long-only brand did not carry over into the hedge fund market. However, mixed firms found three points in their favour when selling to the emerging institutional market for hedge funds:

• having existing strong business management skills within the company which leaves hedge fund managers free to concentrate on their investments

• being able to provide comprehensive risk management and monitoring

• having high quality client support and reporting teams and being willing to provide transparency (i.e. full details of fund holdings).

Significantly, mixed firms were seen as being more likely to be able to support a range of different hedge fund strategies successfully at the same time, reducing the firm's reliance on one 'star' manager.

"In Europe by mid-2004, mixed firms made up around 15 per cent of the European hedge fund market," said Catherine Doherty, Principal at Investit and coordinator of the Investit Intelligence service. "Our report investigates the drivers behind a firm's move into running hedge funds and suggests some 'golden rules' for launching funds. What we found suggests that a future two-tier hedge fund world will emerge - a world where the 'original' hedge product continues to flourish without constraints while a new product enters, a hybrid child of hedge funds and long-only management using hedge fund techniques while providing the security that pension funds require."

"This hybrid is attractive to both managers and clients, and we believe we will see this model becoming established over the next three years."

Background notes:  Investit provides integrated investment and operational advice and research to the fund management industry. Investit was founded in 1998 and includes five core expertise areas: investments, client management, performance and risk, operations and systems. In 2001, Investit People was added to provide specialist recruitment services to clients. In 2004 Investit Projects started work, providing a unique outsourcing service for business projects. Investit Intelligence completes the offering with a range of specialist surveys and detailed research papers.

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