January 11, 2011 / 8:03 AM / 7 years ago

Analysis: Clients get creative as hedge funds lose sex appeal

LONDON (Reuters) - Hedge funds may finally be losing their sex appeal.

A small but growing number of investors believe these once-free spirited portfolios, viewed as the cutting edge of finance for most of the past decade, have become too conservative and boring.

Large and cautious pension fund and endowment clients are increasingly calling the shots in the industry, and investors such as funds of funds and rich individuals need to take matters into their own hands if they want higher returns.

"Some managers ... over the past two years have become too dull and the probability that they will become dead wood in the portfolio is too high," said Morten Spenner, chief executive of funds of hedge funds firm International Asset Management (IAM).

Managers made 10.2 percent last year, according to Hennessee Group, lagging behind the S&P's .SPX 12.8 percent gain and 17.5 percent at the average stock mutual fund.

Having already lost around 20 percent in 2008, many funds opted to cut back bets during last year's choppy markets when fears over Europe's sovereign debt crisis dominated, rather than risk giving up gains made during a rally in 2009.

Brevan Howard's $26 billion Master fund, for instance, rose just 1.5 percent in the 11 months to end-November after shying away from more risky bets.

Many rich people were attracted to hedge funds by stories of George Soros's $1 billion profit from his speculative attack on the Bank of England or John Paulson's $3.7 billion earnings in 2007 betting on the subprime meltdown.

But institutions -- who now account for over half of all hedge fund assets -- often prefer lower-risk funds, targeting single-digit or low double-digit gains.

"Steady, low double-digit returns are typically much better at attracting institutional investors than higher but more erratic performance," said Odi Lahav, vice president at Moody's alternative investment group.

Gross hedge fund leverage globally fell to 1.81 times in November from 1.93 times in August, according to Citi, also a sign the managers have become more wary.

LACK OF SPICE

With the eye-catching gains of 20-30 percent a year often seen in the 1990s now a distant memory, some investors are taking matters into their own hands.

Omar Kodmani, senior executive officer at Permal Investment Management Services, has asked managers to build him tailor-made portfolios riskier than the manager's main fund.

"In credit we asked for a portfolio that was only focused on one sector of the mortgage market -- we wanted a pure play. It is up 100 percent in a year and a half, and we have now reconfigured it to a broader mortgage special situations fund."

"There is a tendency for managers to run lower levels of risk in their portfolios than they used to. The risk is that some portfolios are no longer running with the spice or edge they used to," he said.

IAM's Spenner said he also asked managers whether they have more concentrated or more leveraged versions of their funds, though he would rather see this in their main funds.

TWO-SPEED

Part of the problem facing investors wanting higher returns is they are now in a small minority.

"There is certainly a pocket of family offices and high net worth individuals who are looking for more interesting returns, but from an asset-weighted standpoint, that is not where the industry is trending," said Dan McNicholas, head of Asia financing sales at Merrill Lynch.

The changes could eventually create a two-speed industry, with many larger firms offering more conservative returns, while the hunt by other investors for higher returns could drive part of the industry back to its roots.

Moody's Lahav said some funds of funds had started looking at newer managers, without a long track record, running perhaps $100-$200 million.

"Fund of hedge fund managers have had to reinvent themselves after the crisis. Some of them have realised that where they can add value is in seeking out and investing in smaller, more aggressive hedge funds, like the hedge funds of old."

Additional reporting by Nishant Kumar in Hong Kong; Editing by Dan Lalor

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