Two thousand and eight was all about the big drop in hedge fund returns, while 2009 was all about the big rebound.

So with the markets seemingly having righted themselves, the focus among investors this year is coming back to strategy - convertible arbitrage, distressed, global macro, technology and others that fall under various categories depending upon what their managers do and on what markets they are focused.

One strategy commanding particular attention is merger arbitrage, which still managed to produce so-so returns last year (see chart below).

Source: Barclay Hedge

Merger arb managers are licking their chops this year for a variety of reasons: the global economy apparently on the path to recovery, hoards of cash sitting on companies’ balance sheets, the U.S. dollar seemingly back on the rise – and talk of the day is that funds that invest simultaneously long and short in companies involved in a merger or acquisition are going to bring it home this year.

Many have questioned the very rationale for the strategy in recent years – wondering if the opportunities have all been arbitraged away.  Since we ran a post about that possibility back in March, it appears the extinction of merger arb was greatly exaggerated.  The strategy has since posted a string of nine consecutive up-months.   At the very least, merger arb seems poised to continue its recent propensity to track the S&P 500 (see related post).  But will merger arb produce alpha in 2010?

GLG, one of the world’s biggest hedge funds with more than $20 billion under management, told the Telegraph earlier this week that Kraft’s recent successful bid for Cadbury was a sign of a new cycle of M&A activity. GLG believes conditions are similar to the late 1980s and early 1990s when conglomerates and large companies spun off operations that were not reflected in their valuation.

Indeed, analysts are predicting an M&A revival in 2010, with companies leading the way as private equity firms continue to be dogged by tough credit market conditions. According to KPMG, the M&A market is set for growth after revisions of over-optimistic earnings expectations in 2009, which it blames for skewing market activity last year.

David Simpson, global M&A head for KPMG, said in the firm’s annual Global M&A Predictor released last week that analysts had overestimated corporate earnings in 2009 by some 20%, which had skewed a clear view of the market.

So are merger arbitrage funds poised to pounce on this new era of M&A activity? Do they have their short lists of acquirers and targets ready to go, stop losses and all? After mediocre performance over the past two years, one would expect the M&A guys are more than ready to see some deals by the dozens emerge, and to profit from them.

The question, as with any hedge fund strategy these days, is whether investors are willing to put their chips on the table on their behalf. Not many are, based on the flow of assets going back into the space, which can be seen from the chart below from Barclayhedge.

Source: Barclay Hedge

Then again, if President Obama’s recently declared intention to limit banks’ involvement with hedge funds holds true, a flurry of M&A activity could quickly unfold, leading to some lucrative profits for merger arb managers – at least those betting on the right divestitures, the right acquirers and the right timing – and maybe some flows back into merger arb managers’ coffers.

Let the M&A games begin.  But will merger arb managers come home with any medals?

By: Dr. Bob Swarup, AllAboutAlpha.com Editorial Board.

Over the last year, the hedge fund industry has witnessed a development of truly Olympic proportions.  After a multi-year run-up, gold has finally become the belle du jour of the hedge fund community.  For example, John Paulson recently announced he was launching a gold fund and plugging $250mn of his own money into it; Paul Tudor Jones revealed that he had become the latest recruit to the gold bug movement; and Stanley Fink’s new shop is planning to join the party with a gold fund – the latest in a series of funds focused on the sector.

The sudden love affair caps a remarkable comeback for a commodity that has spent much of the last three decades as an anachronism. Unloved for most of the 1980s and 1990s, its supporters have only recently begun to shrug off the disparaging mantle of ‘gold bugs’ – a transition aided by the fact that gold has outperformed most other asset classes over the decade. (see chart below from Bloomberg).

But that is only the proverbial tip of the iceberg.

The recent meteoric rise past the psychological barrier of $1000 is also symptomatic of the fear lurking beneath the surface amongst a growing body of investors – including the hedge fund community – over the murky economic outlook.  Some, such as Greenlight Capital, have eschewed shares, options and ETFs, preferring to store physical gold instead. There is even a hint that for many there is a paradigm shift in the making with several funds (including Paulson) now offering shares priced in gold rather than the more standard currencies of everyday life.

The mania – for there is no other word – is remarkable. But before we dismiss this as the latest bubble of our times, it’s worth examining the evidence. Bubbles have three key characteristics: a catalyst event, a convincing story and a perceived paradigm shift that renders normal valuation metrics meaningless. The dotcom crash with its new virtual worlds and notions of hypergrowth in a globalised community fulfilled all of these. Unfortunately, few considered how hypergrowth in users might be translated into hypergrowth in revenues. The realization that this might not be the easy or fast-track Mecca envisaged filtered through and the rest became a case study for future MBA students.

Gold has a catalyst – the credit crunch and its aftermath. As regards the story, proponents maintain that it was oversold by the end of the 1990s and there are fundamentals underpinning its rise since. Among the reasons trotted out are the commodity supercycle, emerging market demand, a growing appreciation amongst investors of its portfolio diversification properties and most common, that it reflects the devaluation of the US Dollar against almost everything else since the turn of the century. As the dollar declined in recent years thanks to a growing government deficit and an accommodative Federal Reserve’s low interest rates, gold edged upwards and found a new lease of life with fears over the future of the Western financial system during the credit crunch and the subsequent turning on of the taps by central banks worldwide. The inevitable inflation at the end of the quantitative easing road is the paradigm shift and explains why increasing numbers of investors have jumped on the bandwagon (see chart, right from Andrew Butter at SeekingAlpha).

There is some truth to the inflation argument. Given the sheer scale of fiscal stimulus pumped by governments into the global economy, inflation is a near certainty eventually and precisely what many central banks are aiming for.

However, the jury is still out on the precise timing and the paradigm shift may be a while in coming. For most, deflation has been the more familiar sensation over the last couple of years – hardly surprising, given the extent of deleveraging that has taken place across the global economy.

Many bulls (and central banks, though that is another post) also ignore the problem of velocity. The Fed, ECB and others can have a direct impact on the quantity of money in the system, but not the velocity of money in the system – they have no control over this. You can pump as much money into the system as you want but for it to actually have an effect and turn things around not to mention generate that dreaded future inflation, the velocity of money needs to increase.

In other words, where we end up on the inflation/deflation seesaw depends not just on the quantity of money in the system, but also how fast that money is moving through the system. That is determined by the entities that buy and borrow and lend, i.e. banks, businesses and ordinary consumers. In order to have an effect on the economy, the money needs to move through the system and that can only be determined by their willingness to borrow and lend, rather than hoard and save. When banks hesitate to lend, businesses begin to conserve cash and consumers stop buying and borrowing, monetary velocity goes down – even as the money in the system piles up.

The hope of both gold bugs and central banks is that quantitative easing will succeed in lowering borrowing costs, reviving economic demand and stoking inflation. But history offers only limited guidance. The only central bank to have tried quantitative easing policy measures in the recent past was the Bank of Japan between 2001 and 2006, with ambiguous results. Lending did not accelerate after the BoJ started its asset-purchasing scheme, credit lending actually declined and one lost decade soon became two.

Much as the hypergrowth of Google and Apple came too late to save the dotcom boom, inflation may arrive only long after the party has ended and the gold carriage has turned back into a pumpkin. The deleveraging by consumers and businesses is a powerful headwind and deflation may persist longer than we would like. Moreover, the inflation thereafter may well be greeted by relief at an incipient recovery – a poor omen for gold – and we shouldn’t forget gold failed to sparkle during the inflation of the 1980s.

But hidden in the detail above is another potential paradigm shift. This one is linked also to quantitative easing and hinges on whether you believe this is a ‘normal’ recession or something worse. It also explains much of the hoarding seen by hedge funds in recent months and some of the more unusual steps taken, such as storing physical gold and issuing shares priced in gold.

Gold is an oddity. It has no yield and its uses are limited beyond the decorative, unlike other precious metals such as platinum and silver. Its sole value comes from the fact that for centuries, we have all rather liked the lustre of the metal and it happens to be increasingly rare. Since 2001, annual worldwide mine production has decreased by 9.3%, despite the near quadrupling in prices, and the two previous decades of neglect have meant little new exploration was done. It has become ingrained in our psyche as a store of value.  (see chart, right from Barrick Gold).

Recent events have only reinforced this perception. We live in an era of fiat currencies – all only as strong as the faith put in them. Economics 101 tells us that as governments pile on debt, the value of their currency is debased relative to others. It explains why gold rose in the first part of this decade against the dollar. However, what happens when everyone plays the same game and every government begins to spend indiscriminately?  (see chart below from dollardaze.org via Casey Research).

That they are doing so is of little surprise. There may be faint signs of recovery in the world economy recently but this is unlikely to be a standard recession. We are still in a process of deep deleveraging because the developed world has too much debt and excess capacity. To cope, central banks have invoked their last line of defence – quantitative easing: fight the tide of deflation by drowning it in an ocean of new money, as the below chart of the US money supply demonstrates.

In such a scenario, it is better to own what governments and central banks cannot make a lot more of. Gold is not going up, rather everything around it is going down. It is a response to our new era of competitive devaluation, with everyone jostling to see who can fall fastest. Inflation – as and when it occurs – is only an enhancer.

The bubble has yet to fully mature. For now, hedge funds are simply buying their puts against the central bankers of the world.

- Dr. Amarendra (Bob) Swarup

The hedge fund industry’s insatiable thirst for market research will be temporarily quenched this week by an interesting new report from SEI and Greenwich Associates.  The document, called “The Era of the Investor” contains results from the firms’ second annual survey of institutional investors (conducted in November 2009) and is sure to generate a lot of press in the next few days.

Since this thing is destined to be well covered by the mainstream media, we thought we’d try to look a little deeper into the results and focus on some findings that aren’t immediately obvious or covered in the executive summary.

But first, the headlines…

• The good news continues to roll for hedge funds, as 95% of the 96 institutional investors surveyed this year said they would either increase or maintain their hedge fund allocations over the next year.
• “Diversification” remains the #1 reason to invest in hedge funds – followed closely by “absolute returns.”
• During 2009, transparency rose in importance with over 70% of respondents said they now request “more detailed information from managers than they did a year ago.”
• Since last year, “poor performance” has been overtaken by transparency and liquidity as the main sources of “concerns” about investing in hedge funds.
• The report says that “fee pressures have intensified” as 20% of respondents reported having “negotiated fee arrangements different that the standard ‘2/20′ for single-manager funds and ‘1/10′ for funds of hedge funds.”

Now here are some of our observations…

Why hedge funds?

While “diversification” remains the #1 reason to invest in hedge funds, fewer respondents cited it this year (31%) than last year (62%).  This year, “absolute returns” ranked only a couple of percentage points behind.  According to last year’s edition of the survey (conducted in August 2008 – available here – covered by AAA here), absolute returns were a distant second – more than 20 percentage points behind.

November 2009 survey…

August ‘08 survey…

Still, while “diversification tanked from 62% to 31%, more than 10 percentage points more respondents rated “non-correlated investment strategies” (a euphemism for diversification) as a primary objective.

Perhaps in response to their experience, respondents also seem to be less concerned about volatility.  Last year, 20% said “decreased volatility” was an objective.  This year,that number dropped to below 10%.

Transparency

A call for greater “transparency” makes for great headlines.  But as SEI and Greenwich point out, “participants described their transparency expectations in various ways.”  It seems that some investors wanted traditional position-level transparency while others wanted to have a better understanding of the strategy itself.  (This makes a lot of sense.  If your hedge fund manager traded only S&P 500 futures, but did so using some kind of market timing algorithm, then knowing whether or not you had an S&P position at a given point in time would likely not be particularly insightful.)

Nearly 85% said they were now seeking more information on “valuation methodology.”  Since a majority of hedge funds trade in publicly-listed securities, this could just mean that investors wanted to confirm, say, how the manager valued securities that were untraded on the last day of the month.  It does not necessarily suggest that investors have begun vetting some kind of complex valuation procedure for exotic derivatives.

Returns

As the report contends, “poor past (2-3) year performance” has all but dropped off the manager-selection checklist of institutional investors.  In August 2008, 40% said it was “very important.”  By November 2009 – perhaps in recognition that a lot of their favorite funds totally sucked eggs in the preceding 12 months – only 20% said immediate part performance was very important (see chart below from this year’s report – click to enlarge).

Despite calls for greater transparency, it appears that “quality of reporting and communications” is also less important now than it was in August 2008.  Back then approximately 40% ranked it as “very important” in the selection process.  Today, that number is down to 25%.

What keeps investors up at night?

There were also some dramatic changes in some of the respondents’ “biggest worries” about hedge fund investing.  “Failing to achieve primary objective” was cited by over half of institutions as a “biggest worry” this year.  However, in the heady pre-Madoff days of August 2008, “not accomplishing stated goal” only kept 20% of respondents up at night.  Even in November 2008, after the market fell off a cliff, only 40% of respondents said this was a “biggest worry.”  (See chart below from report.)

Looking forward

While corporate, public and government pensions had not yet reached their “target” hedge fund allocations, foundations and endowments’ “actual” allocations to hedge funds was already higher than they have targeted.  This suggests that foundations and endowments may actually pare back a little over the coming years.

The authors are a little cynical when they write that some hedge funds have accommodated managed accounts “perhaps with an eye to resetting high watermarks.”  In our opinion, investors more likely used the negative incentive of walking away, rather than the positive incentive of forgiving past performance sins.

Technological evolution invariably brings with it a chorus of concerns about the loss of a human element.  Some point to Frankenstein or the Terminator as examples of what could happen if we put too much trust in technology, while other brand them as Luddites and say that technological progress has saved lives, improved our lot in life, and given birth to this website.

In the investment industry, this multi-front battle takes the form of the debate between quants and fundamental managers.  Different terms are often used, but the debate is usually the same.  Were market neutral (quant) managers responsible for the fiasco of August 2007?  Do 130/30 funds really require hundreds of positions to execute properly?  Did the birth of algorithmic trading cause the 1987 market crash?

Now a new study examines the difference between so-called “quant” managers (devilishly difficult to define) and “qual” managers.  (Hat tip to CXO Advisory via Abnormal Returns via GuruFocus via Opalesque…take that Luddites!)

Ludwig Chincarini of Pomona College in California searched thousands of fund descriptions for a series of keywords that would indicate whether the fund was quantitative or qualitative in nature.  Then he compared the two categories on the basis of their management factors (fees etc.) and their performance.

Here is what he found (our opinion about winners and importance of any differences):

Despite a few significant differences, Chincarini concludes that the things that separate quants and quals aren’t as strong as those things that bring them together:

“Overall, despite some minor differences, the management characteristics of quant and qual funds do not seem to be altogether different.”

We designated one of these comparisons – SEC Registration – to be a “draw” even though it would appear that qualitative funds have the clear edge.  This is because quantitative funds include three Macro subcategories that pull the quant average way down.  When you compare Equity sub-strategies, Equity Market Neutral and Equity Fundamental Value, you get 48.5% and 50.8% (% of funds SEC Registered).

So who performed better?  It would appear that quants took this prize with a higher annual return and a lower standard deviation.

But a closer look reveals an apparent inconsistency – qualitative funds have a higher average Sharpe ratio.  What gives?

Note that Chincarini used the average Sharpe ratio, not the Sharpe ratio of the average return and volatility of each category.  In other words, the distribution of returns, standard deviations and Sharpe ratios may be skewed one way or the other.  Investors would prefer a higher-return, lower-volatility quant fund ceteris paribus. But with markets rising more than falling, perhaps the higher upside capture (possibly reflected in the higher average Sharpe) of qualitative funds is worth it…

Despite some interesting differences in management and performance attributes, this paper doesn’t seem likely that we’ll be saying “Hasta la vista!” to the never-ending debate between quants and fundamental managers.

A year ago, even a few months ago, talk of M&A activity in the asset management space was about how it was all but inevitable – that despite the market rebound and ongoing hopes for a return to normalcy, that getting back to where things were before 2008 happened was increasingly unlikely, and that in turn the only way out other than shutting down was to merge or get bought.

In other words, “rationalization” of the hedge fund industry was coming, something we too focused on not too long ago.

The reality appears to be played out a bit differently, quantified by a recent survey by New York brokerage firm Jefferies & Company, Inc. showing that M&A in the global asset management industry in 2009 was not only big, but dominated by mega-deals, with a record nine transactions announced involving firms with more than $100 billion in assets under management.

According to the report, some 61 independently-owned managers changed hands last year, the lowest level in more than a decade, and 57% below the previous year’s tally. The deals that did get done – BlackRock’s purchase of Barclay Global Investors,  and Invesco’s purchase of Morgan Stanley’s retail asset management business, including Van Kampen Investments, among others, were if nothing else, big.

Yet several deals in the fourth quarter of last year appear to be signaling a new phase driven by a greater number of transactions primarily involving smaller independent firms, according to Jefferies.

‘’We expect divestitures to continue to play out through the first half of 2010 when the urgency of capital raising and strategic realignment of financial institutions should taper off,’’ said Aaron Dorr, a managing director within Jefferies’ Financial Institutions Group. ‘’We also anticipate aging owners of independent firms who missed the last bull market to seek to transact in 2010 given improving market conditions, asset flows and pricing.’’

It is indicative of the new and more sober landscape of M&A activity within the hedge fund space that many have predicting. From the go-go days of investment banks and institutions one-upping themselves to bring entire hedge fund operations under their umbrella at double-digit multiples and perks galore, the marriage landscape post-credit crisis and market meltdown has decidedly shifted from seller to buyer.

At the same time, those same dire predictions of a massive M&A wave triggered by multitudes of managers behind the eight ball with no other option other than absorption or closure appear to have been a bit premature, mainly thanks to the marked improvement in performance last year (illustrated in the chart below by HFR) – an improvement many hoped for but few thought would happen so definitively.

Source: Hedge Fund Research

According to Jefferies, deal volume in the October to December 2009 period totaled 30, compared with 45 announced transactions in the fourth quarter of 2008. Managed assets transacted fell to $522 billion from $638 billion a year earlier. However, disclosed deal value jumped to $6.5 billion from $4 billion in the fourth quarter of 2008 – led by the Deutsche Bank/Sal. Oppenheim and Invesco/Van Kampen transactions. The median deal value was $156 million, compared with a median $38 million in the fourth quarter of 2008.

For all of 2009, deal volume declined to 143 against 219 in 2008. Yet an all-time high $4 trillion in assets under management changed hands, 51% ahead of the total in 2006, the previous record year. By contrast, the 2008 tally was $1.95 trillion in assets transacted. Total disclosed deal value in 2009 was $24.9 billion, up substantially from the previous year’s $15.9 billion.

For 2010, it’s clear that deals are going to ramp up – smaller deals that either make economic sense or provide critical mass as a way to compete for assets that are finally beginning to flow back into alternatives again. What may not come true are the predictions of fire sales that dominated headlines at the beginning of last year. To use an insurance analogy: the land a house sits on is still worth something – even after the house has already burned to the ground.

By: Ranjan Bhaduri, AllAboutAlpha.com Editorial Board & Bijan Warner, AlphaMetrix Alternative Investment Advisors

Credit rating agencies (CRAs) have recently gained attention from the SEC and others due to their possible role in the financial crises of 2008.  This attention to CRAs presents an opportunity to reflect on the role of CRAs in capital markets and how they arrive at particular kinds of evaluations of credit and risk.  A recent paper by Bruce Carruthers and Barry Cohen of Northwestern University develops a history of CRAs, demonstrating that while credit markets have changed dramatically since the 19^th century, many of the constraints faced by CRAs, as well as the complaints and accusations levied against them, have not.

It is commonly argued that CRAs perform a critical function in contemporary credit markets: given a lack of available information on the creditworthiness of particular firms or financial instruments, investors depend on these agencies to resolve information asymmetries, with the result of freeing up credit markets.  Anyone who has had to evaluate companies, bonds, or structured financial instruments, is accustomed to unique features of rating systems: a grade (Aa, Baa, etc.) is given to indicate the relative safety of an investment or creditworthiness of a counter-party, but the sources of information and method for arriving at a rating are obscured—with the advantage of simplifying decision making, but the downside of losing potentially important information.  Additionally, the categories are ordinal ranked, such that the distance between two categories is unknown: the distance (measured in creditworthiness or risk) between “AAA” and “AA” is not the same as the distance between “AA” and “A.”  And the rating is not represented as being factual and quantitatively precise, but rather as an “opinion” of creditworthiness.

Dry Goods

Why have all these different rating systems converged on a set of shared features?  In their recent working paper, Carruthers and Cohen explore the history of CRAs in the U.S., tracing their origin to dry goods wholesalers in the 19^th century New York City.  As networks of trade expanded in the U.S. from the regional to the national level, dry goods wholesalers faced a dilemma: when trading within local networks, they could rely on reputation and familiarity with the business party the extended credit to, but how could they evaluate the creditworthiness of distant businesses?  This dilemma threatened to freeze the expansion of trade and credit networks in a rapidly developing country.

A standard narrative tells us that the predecessors of today’s credit rating agencies, the mercantile agencies, stepped in to fill this vacuum, resolving information asymmetries and promoting the growth of national capital markets.  But a closer look at these agencies, the dilemmas they faced, and their own competition with each other reveals a much more complex picture.  In 1841, the Mercantile Agency (which later became R.G. Dun), was founded and began providing information to New York wholesalers.  The first reports were not the alphabetical categories that are common today, but were written and verbal reports, and full of qualitative information about specific firms.  Beginning in the 1850’s Bradstreet, a competitor of Dun’s, started publishing reference books in which summaries of firms’ creditworthiness were listed.  Another competitor, McKillop’s Commercial Agency joined the fray in 1860.

Unpaid Correspondents

But where did this information on creditworthiness come from?  R.G. Dun initially relied on unpaid correspondents to provide background information on firms.  This information was then transformed into a categorical rating, but the methodology behind this transformation was never made public.  In early reports, R.G. Dun would provide more concrete information on a firm’s capital, real estate holdings, and overall creditworthiness.  But providing information on capital and real estate posed two problems: 1) it was difficult to gather this information once the number of firms grew into the millions, and even more importantly, 2) this was information that could easily be copied by competitors.  R.G. Dun’s next step was to drop the information on capital and real estate, instead relying on a one-dimensional system to measure creditworthiness.  Later category systems introduced two dimensions, one on firms’ general creditworthiness and one on firms’ “pecuniary strength,” or level of capital.

According to Carruthers and Cohen, credit rating firms faced three constraints in coming up with an adequate rating system:

1. the system must be perceived as useful by clients,
2. the rating must not give away too much information, otherwise competing agencies could poach on their hard work to gather this information, and
3. the rating must not make the agency legally liable—the rating was presented as an “opinion,” and agencies were careful to protect themselves from lawsuits from both creditors and lenders who felt they were materially harmed by the rating.

Competition between rating agencies, the emulation of successful innovations, and the demands of investors resulted in the rating agencies settling on the now-standard ordinal rating system.

Enter the “Big 3″

Other firms joined the landscape, including the “big 3” of Standard & Poor’s (with an early strength in rating railroad companies), Moody’s, and Fitch IBCA.  CRAs expanded into areas where sparse information on creditworthiness threatened to lock up credit markets: from their origins in rating wholesalers, these rating systems were applied first to railroad bonds, then corporate bonds and bond issues, and most recently into the realms of structured finance (notably CDOs and MBSs).  While each firm has its own proprietary ranking system to reduce an overwhelming amount of information into an easily comprehended grade, they use similar alphabetical categories, and rely on ordinal ranked categories.

Recent complaints (see also here) against CRAs argue that they have an inherent conflict of interest given that in some instances they are paid by the issuers of the very securities they rate.  Deven Sharma of Standard & Poor’s has responded to these criticisms with a defense of his industry.  In light of Carruthers and Cohen’s historical study, the complaints of today echo those of the past.  When a highly graded investment fails, who is to blame?  Look for legislation in 2010 to address this question.

The National University of Singapore’s Risk Management Institute (RMI) has recently announced a non-profit, large-scale credit rating on Asian firms.  This non-profit credit rating initiative is being undertaken as a response to the recent financial crisis, with the intent to serve as a academic competitor to the commercial credit rating agencies (CRAs) and spur research in this vital area. The RMI has stated this initiative will provide ratings on 500 Asian firms by 2011. More details on this initiative can be found here.

Although CRAs may shoulder some responsibility for the financial crisis, there is a consensus that they play an important role in capital markets.  And as Carruthers and Cohen show us, this certainly isn’t anything new.

Efficient markets require that prices are totally unpredictable, that future returns are in no way predictable based on current trading activity.

While this may be true for highly liquid markets, there is now evidence that in illiquid markets,  such as the secondary market for existing stakes in hedge funds, current buying and selling activity may have predictive power.

This, according to a new study by Tarun Ramadorai of Oxford, who has made a career of late in analyzing historical trading data from the hedge fund industry’s oldest secondary market, Hedgebay (see related posts).

Ramadorai’s use of secondary market data is novel because previous studies of investor interest in hedge fund have been based on new allocations (i.e. AUM growth).  As students of the industry are aware, hedge fund investors are return chasers.  When a fund posts good numbers, the money starts to flow in.

But as Ramadorai points out, AUM growth is actually a very “noisy” measure of investor interest and intent.  Subscription and redemption rules, lock-ups, and gates have a significant influence on the timing of new inflows.  In addition, inflows themselves can affect future returns – raising questions about whether new inflows were a predictor of future (positive or negative) performance or the very cause of that future performance.

Instead, “indications of interest” in buying and selling  stakes in gated, locked-up, or closed funds is a more exact measure of investor intent.

As you might expect, Ramadorai finds that buyers tend to come out of the woodwork following  periods of (strategy-specific) outperformance.  But what’s amazing is that the performance of those funds tends to continue to rise during the two years after the indication of interest to buy.  Fund return is represented by the blue line in the chart below taken from the paper.  (The red lines are +/2 2 standard error confidence intervals.)

As you can see, the cumulative excess return during the 2 years prior to the buying interest was about 13% (54 bps a month).  But rather than picking the top, these buyers participated in a further relative outperformance of about 4% during the ensuing 24 months.  Not a bad call.

The great thing about analysing secondary market data is that, like a stock market, researchers are able to examine both the bid (above) and the ask (expressions of interest in selling).  It turns out that sellers are also pretty good at judging the future prospects of their funds.  (Remember, both the buyers and sellers can be right at the same time since a transaction needn’t actually be executed.)

Sellers seem to get antsy after a few months of relatively poor returns.  Their decision to look for the exit door seems to be a harbinger of poor returns for the next two years.

So should you track these indications of buying and selling and attempt to trade accordingly?  And if so, should you track the buyers or the sellers?

To answer this question, Ramadorai constructs a portfolio of long positions in the funds that caught the eye of buyers and a portfolio of short positions in funds that sellers tried to dump.  It turns out that the demand portfolio significantly outperformed the supply portfolio.

Curiously, he also finds that the expressions of buying and selling interest from large investors (i.e. large trade tickets), were more predictive of future returns.  This seems to line up with research showing that large equity transactions from institutional investors embed more information about future returns.

Other researchers may have a lot to say about why this anomaly seems to exist.  But for now, we can safely say that this study is likely to be a successful predictor of the volume of future research on this topic.

“Come back, come back to be me,” British actor Kiera Knightley whispers to her lover James McAvoy in the 2007 drama Atonement each time he’s about to have another breakdown and go over the proverbial edge.

Now hedge fund managers, after subconsciously crying Kiera’s line for well over a year, can take heart: Capital is finally coming back, and it’s going to come back strong this year.

This according to a recent summary of survey results by third-party marketing firm Agecroft Partners, continued improvement of capital flows into alternative investments will be the trend in 2010. More…

During our regular skimming of Web sites and newspapers over the past week or so, we at AllAboutAlpha.com came across a headline that at first blush seemed quite pithy and incredibly apropos: Should old articles be forgot.

Our first thought was that the piece, a New York Times op ed column, would be about some of the not-so-good scribblings published over the past year or decade – the outright made-up stuff a la Jayson Blair, or just the outright error-riddled stuff a la Alessandra Stanley – and how in a perfect world they might be forgotten.

But no, the piece was actually about how much information there is on the Internet – so much so that, according to the Times, it’s easy to miss a lot of really good stuff. More…

As Barron’s points out this week, 2009 was a “year of recovery and transparency for the hedge fund industry.”

If there is any sort of broad, non-investment-related corollary that has emerged in the alternatives world this past year, it is the emergence of the “third party” in everything from middle- and back-office administration to independent portfolio valuation.

Not to be confused with the counter-party, which we discussed in detail here (or with a third party marketer), the “third party” has become the investment world’s new way of (hypothetically) ensuring that processes, numbers, valuation practices and everything in between are calculated and signed off on at arm’s length from the fund manager.

For hedge fund managers, particularly those with institutional allocations, it has quickly become a new reality: Either have your portfolio independently valued and verified, or lose the business. More…

Despite increased due diligence, particularly on the operations front, and a lot more tire kicking, sizing up and in many cases just saying no, money is flowing back into hedge funds’ coffers. Where it’s flowing, though, isn’t to emerging hedge fund managers or start-ups, or even to funds with less than $1 billion in assets under management (AUM).

According to a report released this month by Barclays Capital’s prime services division, some $150 billion in cool cash flowed into the hedge fund industry in the first nine months of the year, mostly to mid- and large-sized funds with assets of $5 billion to $10 billion and more.  Managers of mid-sized funds in particular – those in the $5 billion to $10 billion AUM camp – reported that year-to-date inflows actually outpaced outflows, resulting in net positive flows of approximately 5%. More…

Here’s a stocking stuffer for you.  Just in time for Christmas, the ECB has released its semi-annual Financial Stability Review.  According to the Bank, the world may not actually be coming to an end.  In fact, Santa seems to be about to reward mega-financial institutions.

Writes the ECB: More…

By: Steve Deutsch, AllAboutAlpha.com Editorial Board

In September, the Institutional Limited Partners Association (ILPA) rolled out its “Private Equity Principles.” This document has been getting a lot of attention and is described by the organization as…

“…a set of principles and best practices for the private equity industry with the goal of strengthening the long-term viability of the asset class as an institutional investment strategy.”

Both the means and the message are worth taking a closer look. More…