Institutional Hedge Fund Investing Comes of Age

A New Perspective on the Road Ahead

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I N T RO D U C T IO N C ON T E XT K E Y FIN D IN G S / TA K E AWAYS FOR HEDGE FUND M ANAGERS S U RVE Y R E S U LTS A BO U T T H E S U RV E Y

Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

In the annals of hedge fund investing, 2010 will be remembered as the time when investors began to apply consistently the lessons learned during the financial crisis. Meanwhile the hedge fund industry, after being badly shaken by the upheavals of 2008 and their aftermath, appears to be back on a growth track. Investors who stayed the course were generally rewarded with a strong rebound in 2009 and positive, if modest returns in 2010. Confidence in hedge funds is returning. Yet there is no doubt investor perceptions and practices have been fundamentally altered by their recent experiences, as revealed by this fourth SEI Knowledge Partnership global study of institutional investors. In the process, the practice of hedge fund investing has leaped in maturity, as investors and fund managers alike have learned they can take nothing for granted, including liquidity and absolute returns. Having survived the firestorm, investors still believe in the benefits of hedge funds, but are seeking a better handle on the complexities. For hedge fund managers this brings both challenges and opportunities.

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

Context
SEI’s 2009 survey was conducted against the backdrop of an industry in recovery mode after reeling from the experiences of 2008—the worst year on record for average hedge fund performance, and one in which expectations for non-correlated returns were challenged. By the third quarter of 2009, with average performance on the upswing, the tide of net outflows had reversed on an industrywide basis and fund launches were beginning to outpace liquidations, trends pointing toward stabilization and possibly a new cycle of expansion. The record for 2010 has justified institutional investors’ ongoing commitment to hedge funds, but has underwhelmed those hoping for a vigorous if not spectacular rebound. Market and economic conditions remain less improved than many hedge fund managers and investors had hoped.
MANY HEDGE FUNDS CONTINUE TO OUTPERFORM LONG-ONLY STRATEGIES. The HFRI Fund Weighted

On the plus side, having experienced a 21.4% cumulative decline during the crisis, the HFRI Fund Weighted Composite Index recovered all of those losses. In fact, the index was up 30% between its trough in March 2009 and the end of November 2010. When 2010 is viewed on balance, the glass is at least half full.

Composite Index posted a gain of 8.48% over the 12 months ending on November 30, 2010, placing hedge fund returns on par with domestic stock indices over the short term. During the past five years, however, the index produced an annualized return of 5.64%, well ahead of the 0.98% produced by the S&P 500 Total Return Index. Going back to the beginning of the past decade reveals an even more dramatic difference. While the S&P 500 Total Return Index stayed flat, the HFRI Fund Weighted Composite Index doubled in value [Figure 1].

Figure 1: Relative performance of HFRI Fund Weighted Composite Index since January 1, 2000 (Indexed to 1000)

HFRI Fund Weighted Composite Index 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 00 01 02 03 04 05 06

S&P 500 Index (TR)

07

08

09

10

Sources: Hedge Fund Research, Standard & Poor’s

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

Figure 2: Estimated number of hedge funds launched and liquidated (2000 - Q3 2010)

Launches 2000 1800 1600 1400 1200 Number of Funds 1000 800 600 400 200 0 -200 -400 -600 -800 -1000 -1200 -1400 -1600 2000 2001 2002 2003 2004 2005

Liquidations

2006

2007

2008

2009

Thru Q3 2010

Source: Hedge Fund Research

STAR PERFORMERS WERE FEW AND FAR BETWEEN.

INDUSTRY ASSETS ARE GROWING, IF MODESTLY. In

Last year, some hedge funds came roaring back from the carnage of 2008 to post eye-popping returns. The average top decile return in the HFRI Fund Weighted Composite Index for 2009 was an astonishing 100%. In contrast, top decile returns averaged 15.2% in Q1 of 2010 and 10% in Q2. Dispersion in 2010 was relatively low: bottom decile returns averaged -8.6% and -16% in Q1 and Q2 respectively.
THE SHAKEOUT CONTINUES. Approximately 2500

2009, hedge funds bounced back with a respectable 13.7% growth in assets for the year—regaining a good share of the painful 24.7% contraction in 2008. Asset growth in 2010 was substantially slower. Assets rose only 10.5% during the first three quarters of the year, reaching $1.77 trillion [Figure 3]. At that point, the industry’s total assets under management remained short of the peak of $1.93 trillion recorded in Q2 2008, as well as the annual peak of nearly $1.87 trillion at the end of 2007. Nonetheless, there is reason for cautious optimism, in that the industry’s fortunes have improved over the course of 2010. The third quarter saw hedge funds gain a net $19 billion in new capital, the largest quarterly inflow since late 2007.

hedge funds were liquidated in 2008 and 2009, far in excess of the 1443 launched during that period. While fund closures slowed, only 130 net new funds were introduced during the first three quarters of 2010 [Figure 2]. The upshot is that the number of funds is stabilizing, but is unlikely to grow quickly anytime soon. Many managers remain in retrenchment mode, taking a wait-and-see approach to new product launches. Meanwhile, start-up managers face significant barriers to raising capital and clearing higher regulatory hurdles.
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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

Figure 3: Global hedge fund assets through Q3 2010 ($ billions)

Assets Under Management 2000 1800 1600 1400 1200 $ billions 1000 800 600 400 200 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Thru Q3 2010

Source: Hedge Fund Research

Key Findings
INSTITUTIONS ARE NOT ONLY MAINTAINING, BUT STRENGTHENING, THEIR COMMITMENT TO HEDGE FUND INVESTING. That’s good news for hedge

goal in hedge investing, up from 24% last year. The percentage that say they invest mainly with the objective of lowering portfolio volatility also jumped, rising from 8% in 2009 to 18% in this year’s survey.
INVESTORS ARE KEENLY AWARE OF PERFORMANCE CHALLENGES, AND HAVE MODIFIED THEIR EXPECTATIONS ACCORDINGLY. In response to

funds, which have become increasingly reliant on institutional asset flows as their growth driver. More than 54% of the investors surveyed said they plan to increase target allocations to hedge funds in the next 12 months—over three-and-a-half times the percentage giving that response in 2009.
ACCESSING NON-CORRELATED STRATEGIES HAS EMERGED AS THE TOP INSTITUTIONAL AIM IN HEDGE FUND INVESTING. This reflects a shift in

an open-ended question, “meeting performance expectations” tied with “transparency” as the greatest challenge in hedge fund investing. Still, 54% of participating institutions said they are “satisfied” with the performance of their hedge fund investments, and another 13% reported being “very satisfied.” Only 9% expressed dissatisfaction and just 3% pronounced themselves “very dissatisfied.”
TRANSPARENCY DEMANDS HAVE NOT ABATED. In

objectives since our 2009 survey, when institutions reported investing in hedge funds primarily with an eye to diversification and absolute returns. Those objectives have dropped to the second and third, respectively. This year, having been surprised by higher-than-expected correlations among asset classes and investment strategies during the financial crisis, 30% of respondents named exposure to non-correlated strategies as their #1
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fact, concerns with hedge funds’ level of disclosure have intensified. Nearly 70% of investors name a lack of transparency as their biggest worry. While respondents to our 2009 survey were focused on

Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

hedge fund valuation methods, more than three out of four investors in this year’s survey said they also want more detail on sector-level positions, use of leverage, and risk analytics.
SENSITIVITY TO LIQUIDITY RISKS AND TERMS PERSISTS. Fifty-eight percent of this year’s

restrictive lockups or gates, or favoring funds with less restrictive terms.
HEDGE FUND SELECTION FACTORS HAVE SHIFTED WITH INVESTOR PERCEPTIONS. In 2009,

investors placed the most weight on “the quality of management teams” in selecting hedge funds. Among this year’s respondents, “clarity of investment philosophy” was named the #1 selection factor. “Risk management infrastructure,” which did not even appear on last year’s list of the top 10 selection factors, jumped into second place in this year’s survey results.
A MAJORITY OF INVESTORS AND CONSULTANTS EXPECT HEDGE FUNDS’ INSTITUTIONAL BUSINESS TO GROW. Nearly nine out of ten respondents—and

respondents cited liquidity risk as their biggest worry. “Liquidity terms,” which did not even appear on the 2009 list of the top hedge fund selection factors, cropped up this year as the fifth-ranked decision-making factor. Over 43% of respondents have had hedge fund investments subject to gates or suspension of redemptions. Among those respondents, three out of four perceived those actions negatively while nearly one in four viewed them as a positive measure potentially mitigating damage from a rush to the exits by fellow investors. A sizable share of investors reported taking steps to enhance the liquidity of their investments, such as avoiding funds with side pockets, negotiating less

100% of those representing large institutions with more than $5 billion in hedge fund investments— expressed a positive outlook for the industry over the foreseeable future.

ON A GROWTH CURVE: INSTITUTIONAL COMMITMENT TO HEDGE FUND INVESTING

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

Takeaways for Hedge Fund Managers
Our 2010 survey findings show this to be a time of significant opportunity for hedge funds to differentiate themselves from competitors in the eyes of institutional clients and prospective investors. While more than half of the institutions we surveyed say they intend to increase their hedge fund allocations, their responses show that investors are operating with a shifting set of objectives and selection criteria. Hedge fund managers can apply these insights to reposition their funds and proactively address primary areas of concern to investors. Specifically, managers should consider taking steps to:
ENSURE THEY CLEARLY ARTICULATE HOW THEIR STRATEGIES ADD VALUE. Investors now put greater EMBRACE TRANSPARENCY. Last year we advised

managers to embrace transparency, and it warrants repeating. With investors’ transparency concerns continuing to broaden and intensify, fund managers need to: • Understand that investors require a growing body of information to satisfy their range of constituencies and gain comfort with a firm and its capabilities. • Institutionalize their transparency policies, so as to create operating efficiencies and a consistent investor experience. • Be aware of possible conflicts of interest. While managers appropriately consider the needs of individual clients, legal experts warn that hedge funds may find themselves on shaky ground if some clients are treated preferentially. Seek counsel when in doubt.

emphasis on earning non-correlated returns than on absolute returns. Nonetheless, survey respondents identified “meeting performance expectations” as a top challenge and “failing to achieve the primary objective” as their second biggest worry regarding their hedge fund investments. Consequently, managers should have clear, succinct explanations of how their strategies fit within a diversified portfolio and are expected to perform under varying scenarios. While the opaque and exotic may once have evoked visions of outsized returns, an overly complex description of the investment process is an impediment to asset raising and retention. Institutions are increasingly focused on understandable strategies grounded in an investment philosophy with defined risk-return characteristics and a readily identifiable source of alpha.

CONTINUE INVESTING IN RISK MANAGEMENT INFRASTRUCTURE. With institutions giving this factor

more weight in fund selection, the efforts that hedge funds make to enhance their risk management measures and personnel will be time and money well spent. Strong risk management is essential not only to mitigate financial losses and attract new capital, but to protect a firm’s reputation—its ultimate asset.
INCREASE CLIENT SERVICE AND RETENTION EFFORTS.

Given the shifts occurring in investor perceptions and objectives, fund managers cannot take for granted their continued fit with the needs of existing clients. In this climate, timely, two-way communication and consistent reporting are more important than ever. Hedge funds should also redouble their efforts to add value through ongoing improvements to client service, especially investor reporting.

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

SU RV E Y R E S U LTS

Institutions are voting “yes” with their allocations
PO RT F OL I O A L L O C ATIO N S TO HEDGE FUNDS CONTI NUE TO RI SE
Institutional investors have maintained—indeed, bolstered—their commitment to hedge funds. More than 54% said they plan to increase target allocations in the next 12 months, a much larger vote of confidence than survey respondents gave hedge funds last year, when only 14.6% anticipated a rise in allocation targets [Figure 4]. Respondents reported that on average, hedge funds represent nearly 14% of total portfolio allocations— more than a 10% increase since our 2008 survey was completed in the early stages of the financial crisis. Another way of viewing the trend: two years ago, 39% of investors had more than 10% of their portfolios in hedge funds; this year, that figure rose to 59%. Current hedge fund allocations are highest among foundations and endowments, lowest among corporate plans, survey responses show [Figure 5]. Allocations by foundations and endowments, early adopters of alternative investing, have held steady since our 2009 survey, standing at 16.3% of total assets. Corporate allocations increased slightly over the same period, rising from 9.7% to 10.2%. Meanwhile public funds participating in the survey, beginning to catch up with other institutions, made a substantial leap in hedge fund allocations, which rose from 6.4% in 2009 to 11.5% this year.

Figure 4: Planned changes to target allocation over coming 12 months (% of investors)
2009 No Change, 78.1% Increase, 54.1% 2010

Decrease, 10.6%

Increase, 14.6% Decrease, 7.3% No Change, 35.3%

Source: SEI Knowledge Partnership

INTERPRETING THE DATA This year our sample of 97 senior professionals representing institutional
investors was augmented by 14 respondents from consulting firms (see p. 23). Figures are labeled to show percentages for all respondents, investors alone, or consultants alone, as appropriate.

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

Figure 5: Actual and target allocations to hedge funds by investor type (% of portfolio)

25% 20% 15% 10% 5% 0% 16.3 17.4 13.1 x.x% Legend 11.5 25th Percentile Average Median 75th Percentile

Percentage of total portfolio

10.2

11.6

Actual Target Foundation / Endowment

Actual Corporate

Target

Actual Target Public / Government

Source: SEI Knowledge Partnership

RU MO R S O F T H E H E D G E FUNDS OF FUNDS’ DEM I SE HAVE BEE N GR E AT LY E XA G G E R AT E D
It is true that single-manager funds have grown more popular in the last two years. Almost 24% of respondents say they invest in single-manager funds exclusively, up from 19% in 2008. Still, while the percentage investing exclusively in hedge funds of funds has declined from the 56% recorded in our 2008 survey, nearly half of 2010 respondents said they invest exclusively in funds of hedge funds [Figure 6]. Moreover, among institutions who invest in both single-manager funds and funds of funds, 60% of assets are directed to funds of funds. The share of assets going to funds of funds is highest among Not surprisingly, larger firms show a greater propensity to use single-manager funds, while smaller ones are more likely to invest via funds of hedge funds. Only 40% of the smallest investors with less than $500 million in assets use singlemanager hedge funds on their own or alongside funds of hedge funds, compared to 81% of large investors with $5 billion or more in assets. Similarly, 81% of small investors use funds of hedge funds on their own or alongside single-manager funds, compared to only 50% of large investors. corporate plans (71%), lowest among foundations and endowments (57%).

Figure 6: Use of single-manager hedge funds vs. funds of hedge funds (% of investors)

Funds of hedge funds, 48.5% Both, 27.8%

Single manager funds, 23.7%

Source: SEI Knowledge Partnership

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

Hedge funds play an important, but evolving role in institutional portfolios
T H E F OC U S N O W IS O N A C C E S SI NG NON- CORRELATED STRATEGI ES
In 2009, diversification and absolute return were the top objectives for institutions investing in hedge funds, named by 31% and 30% respectively. This year those objectives dropped to the #2 and #3 rankings. Investors now name as their primary objective, “gaining exposure to non-correlated investment strategies.” That was named a primary goal by 30% of 2010 respondents as compared to 24% in 2009 [Figure 7]. This shift in goals comes as no surprise. During the financial crisis, investors certainly encountered challenges in achieving their diversification objectives, although hedge funds on average did continue to provide diversification benefits relative to long-only indices. Investors also learned not to assume hedge funds will deliver absolute returns under all conditions.

Figure 7: Primary objective when investing in hedge funds (% of investors)

2009 40% Percentage of investors 30% 20% 10% 0% Ability to exploit market opportunities Decreased volatility Absolute return

2010

Diversification

Non-correlated investment strategies

Source: SEI Knowledge Partnership

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

Figure 8: Satisfaction with overall hedge fund portfolio return (% of respondents)

Very Satisfied Satisfied Neither Satisfied Nor Dissatisfied Dissatisfied Very Dissatisfied 0% 10% 20% 30% 40% 50% 60%

Percentage of respondents

Source: SEI Knowledge Partnership

I N S T ITU TIO N S A R E R E ALI STI C AND M EASURED I N THEI R VI EWS ON H E D G E F U N D P E R F O R MANCE
Interestingly, despite the precipitous drop in hedge fund indices during the financial crisis and uneven rebound since, 54% of respondents said they are “satisfied” with performance of their hedge fund investments and another 13% pronounce themselves “very satisfied.” Only 12% express any level of dissatisfaction. More than one in five, however, describe themselves as neither satisfied nor dissatisfied [Figure 8]. Seen in the context of other survey results and the generally uncertain investment climate, this response suggests that investors are reserving judgment on performance of their hedge fund investments. Nonetheless, when survey participants were asked to name the single most important challenge they face as hedge fund investors, “meeting performance expectations” tied with “transparency” as the most frequent answer [Figure 10]. This reinforces the point that managers should strive to clearly convey how their strategies fit within a diversified portfolio and are expected to perform under varying circumstances.

TOP CHALLENGES
TRANSPARENCY MEETING PERFORMANCE EXPECTATIONS
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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

F E E P RE S S UR E S A R E R E A L, B UT RATHER THAN REDUCI NG FEES F U N D S A RE N E G O TIATIN G O T HER TERM S
Institutions appear increasingly aware of the costs they pay for hedge fund performance. “Receiving value for money” was named the top challenge by 13% of respondents this year as compared to 4% a year ago, ranking third among all challenges cited [Figure 10]. Large institutions were much more likely to give this response, due perhaps to awareness of their greater bargaining power. With returns now generally harder to come by, hedge funds’ customary 2/20 fee structure (1/10 for funds of funds) has come under growing scrutiny. Yet the evidence indicates that overall, management fees have been lowered only modestly and performance fees have remained largely intact. Hedge Fund Nonetheless, many investors have succeeded in negotiating other terms related to fees. This is particularly true of larger institutions. For example, 88% of those with more than $5 billion in assets report having negotiated fee arrangements including hurdle rates—more than double the percentage of those with less than $500 million in assets [Figure 9]. Research (HFR) pegs the median management fee for single-manager funds as 1.5% across all major strategies. According to HFR, 40% of all funds (and all of those in the Macro category) still have a 2% management fee. Performance fees, meanwhile, remain unchanged at 20% for all major strategies.

Figure 9: Negotiated fee arrangements including this feature (% of respondents, by AUM)

<$500m 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Hurdle rates Benchmarks

$500m-$1B

$1B-$5B

$5B+

Clawbacks

Performance fees based on realized gains

Ex post beta fee adjustments

Source: SEI Knowledge Partnership
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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

Investors’ list of concerns has grown, with a particular focus on risk management
T R A N S PA R E N C Y E X P E C TAT I O N S C O N T I N U E T O R I S E
The drumbeat of institutional demands for greater transparency, already being heard before the financial crisis, has grown steadily stronger since then as investors seek to identify and understand the multiple facets of their exposure to risk. As noted above, transparency tied for first place as the greatest challenge in hedge fund investing [Figure 10]. Moreover, nearly 70% of respondents name transparency as their top worry, up from 56% a year ago [Figure 11]. Figure 10: Single most important challenge faced (% of respondents) This finding suggests that while hedge funds may have generally increased their level of disclosure in response to investor demands, their responses have not necessarily assuaged investor concerns. It may be that, after the experiences of the past two years, the more institutions know, the more they feel they need to know.

Transparency Meeting performance expectations Fees / Value for money Liquidity Earning non-correlated returns Understanding risk Manager selection Headline risk / Bad press Educating board 0% 5% 10% 15% 20% 25%

Percentage of respondents

Source: SEI Knowledge Partnership

O N VIRTU A L LY E VE RY ISSUE, I NVESTORS EXPRESS SUBSTANTI A LLY H E I GH TE N E D C O N C E R N
One of the most notable findings of the survey is the sharp rise in the level of anxiety reported by respondents. While the most frequently cited worries have remained consistent, the percentage of respondents naming them has jumped markedly, at least doubling since last year’s survey in the case of headline risk and poor performance, for example
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[Figures 11 and 12]. Strikingly, concern with the failure to achieve the primary objective tripled since 2008, underscoring the need for managers to do a better job of clarifying their investment process and setting realistic expectations for performance results under varying scenarios.

Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

A CONSULTING PERSPECTIVE
Consultants are important influencers concerning hedge fund Figure 11: Biggest worries about hedge fund investing (% of respondents) allocations, and their influence keeps growing. Accordingly, SEI interviewed several consultants as part of this survey. Here’s their take on the single greatest challenge in hedge fund investing:
Lack of transparency Failing to achieve primary objective Liquidity risk Headline risk Leverage Poor performance Limited regulation 0% 10% 20% 30% 40% 50% 60% 70%

”Separating the winners from the losers relative to performance and costs” “Ability to protect on the downside” “Communicating realistic expectations and reminding stakeholders of long-term objectives when hedge funds lag targets during strong equity bull markets” “Poor management of tail risk” (i.e., dealing with high correlations
Source: SEI Knowledge Partnership
Percentage of respondents

in down markets) “Generating a return that is truly independent of the market”

Figure 12: Trends in worries cited regarding hedge fund investing (% of respondents)

“Underestimating the tails of return distribution” “Understanding the risk associated

Aug. 2008 90% 80% 70% Percent of respondents 60% 50% 40% 30% 20% 10% 0% Liquidity risk

Nov. 2008

Sep. 2010

with the strategies; sometimes the managers do not seem to fully comprehend where their risk exposures truly lie” “Understanding what you are buying” “Establishing realistic benchmarks and time horizons for measuring performance” “Paying a fair fee for equity-like returns with lower volatility”

Failing to achieve primary objective

Poor performance

Headline risk

Source: SEI Knowledge Partnership
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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

D E M A N D S F O R MO R E D I SCLOSURE ARE RI SI NG ACROSS THE BOA RD, W I T H PA RT IC U LA R E MP HASI S ON RI SK ANALYTI CS
In our 2009 survey, in which transparency emerged strongly as a top concern, investor demands for more detailed information were focused overwhelmingly on valuation methodology. While that concern persists in this year’s survey, the percentage of investors wanting more detail has increased substantially (by 20 percentage points or more) when it comes to hedge funds’ sector exposure, More than three out of four want more information on hedge funds’ use of risk analytics, a factor that didn’t even appear on last year’s list of top requests. Just under half of 2010 investors want more position-level detail, consistent with 2009 results. use of leverage, counterparty exposure, geographic exposure, and hedging positions [Figure 13].

Figure 13: Types of information sought from hedge fund managers (% of investors)

Sector level detail Valuation Leverage detail Risk analytics Counterparty exposure Geographic exposure Hedging positions Position level detail 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Percentage of investors

Source: SEI Knowledge Partnership

I N V E S TO R S A R E IN C R E ASI NGLY FOCUSED ON HEDGE FUND M A N A G E R S WH O S E S T R ATEGI ES AND RI SKS THEY CAN UNDERSTA N D
“Clarity of investment philosophy” has come to the fore as the #1 factor in selection of hedge fund managers [Figure 14]. The percentage of investors naming it “very important” rose to 79% from 61% in 2009. “Risk management infrastructure,” which did not even appear among the top 10 hedge fund selection criteria named in 2009, emerged this year as the second-ranked criterion. It was deemed “very important” by three out of four investors.

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

IN V E S T O R S C O N TIN U E T O B R O ADEN THEI R HEDGE FUND SELECTI ON C RI T E R I A WH ILE IN TE N S IF Y IN G THEI R LEVEL OF SCRUTI NY
Our survey shows that institutions have not only expanded the criteria they apply to manager selection decisions, but are also putting more emphasis on many of those factors. In our 2009 survey, 11 factors were named by at least 50% of respondents as “very important” or “important” in fund selection. A year later, 16 factors are so described by a majority of respondents [Figure 14]. Comparison of year-to-year survey results also reveals shifting investor priorities concerning fund selection. Factors such as “having an identifiable source of alpha” and “separation of investment and operations management” now loom larger than before. Among the new selection factors cropping up on this year’s list, the highest ranking were “liquidity terms” and “restrictions imposed by managers during the crisis,” which were ranked #5 and #8 in importance, respectively. Figure 14: ‘Important’ or ‘very important’ factors in the selection of hedge fund managers (% of respondents)

Very Important Clarity of investment philosophy Risk management infrastructure Quality of firm's investment team Identifiable source of alpha (excess returns) Liquidity terms Portfolio transparency Fees Suspended redemptions or used gates during crisis Separation of investment and operations mgmt. Quality of reporting and communications Past investment performance (2 - 3 years) Overall client service Firm(s) that serve as prime brokers Assets under management (size) Willingness to accept managed accounts Use of multiple prime brokers 0% 10% 20% 30% 40% 50%

Important

60% 70%

80%

90%

100%

Percentage of respondents

Source: SEI Knowledge Partnership
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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

I N V E S TO R S D O N O T S E E REGULATI ON AS THE SOLUTI ON T O T HE IR C O N C E R N S
At a time of keen competition among hedge funds, SEC registration may increasingly become a basic qualifying factor for funds seeking institutional mandates. Still, survey results make it clear that institutional investors are not waiting for or relying upon bureaucrats to improve hedge fund disclosure, liquidity, or risk management. While 30% of respondents cite “limited regulation” as one of their biggest worries regarding hedge fund investing, that issue is eclipsed by concerns with transparency, liquidity, headline risk, leverage, and poor performance [Figure 11]. Moreover, despite the growing number of mutual funds and UCITs utilizing hedge-like strategies, less than 22% of investors say they plan to invest in such Among those investors who do plan to invest in registered products, the primary reasons for doing so are liquidity and transparency (named by 81% and 65% of that sample subset, respectively). Only half name the desire for regulatory oversight as their primary reason. registered products in addition to their current hedge fund allocation. Even fewer say they plan to replace existing hedge fund investments with allocations to registered funds [Figure 15]. Nonetheless, these numbers may grow in the future, given that more than one in three of the consultants we interviewed say they plan to recommend investing in registered products.

Figure 15: Plans to invest in registered products in addition to current hedge fund holdings (% of investors)

Investors

Consultants

Yes 21.6%

Yes 35.7%

No 78.4%

No 64.3%

Source: SEI Knowledge Partnership

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

HEDGE FUND SELECTION FACTORS ARE SHIFTING

T H E A DV I C E O F C O N S U LTA N TS I S RELI ED UPON BY M OST IN S T I T U T I O N S , A N D N E A R LY A LL PUBLI C PLANS SURVEYED
Institutional investors are generally not inclined to navigate the world of hedge funds on their own. More than three out of four respondents said they work closely with consultants when selecting funds in alternative asset classes. Reliance on consultants is highest among public funds (91%) and lowest among foundations and endowments (69%).

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

Liquidity remains a top-of-mind issue for investors
L I QU ID IT Y T E R MS H AV E EM ERGED AS AN I M PORTANT FUND S E L E C T IO N FA C TO R
In our 2009 survey, liquidity was not even named among the top 10 selection factors. Just a year later, “liquidity terms” ranks #5 on the list, named “very important” by 36% of respondents and “important” by another 45%. Investors’ growing focus on liquidity is confirmed by the share of respondents naming liquidity risk as their biggest worry in hedge fund investing. That percentage rose from 46% in 2008 to 58% in our 2010 survey.

I M P OS ITIO N O F G AT E S OR SUSPENSI ON OF REDEM PTI ONS I S V I E W E D N E GAT IVE LY B Y MO S T —BUT NOT ALL—I NSTI TUTI ONS
Slightly over 43% of investors say they have had first-hand experience with gates or suspension of redemptions. Within that group, 76% saw gates or suspensions as detrimental. As one participant put it, “It’s always negative if you’re looking to liquidate and cannot.” Others cited concerns that liquidity restrictions expose their board members to criticism and point to poor risk management on the part of fund managers. This negative view is not universal, however. Of those investors who have been affected by gates or suspensions, nearly one in four saw that experience as a way of protecting their investments from a potential tidal wave of outflows at an inopportune time.

ALERT: LIQUIDITY RISK
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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

A SIGNIFICANT SHARE OF INVESTORS AND CONSULTANTS HAVE TAKEN STEPS TO ENHANCE THE LIQUIDITY OF HEDGE FUND INVESTMENTS
More than 40% of investors say they have either avoided investing in funds with side pockets or have allocated to funds that make side pockets optional. More than a third report having negotiated shorter lockups or allocated to funds with shorter lockups. Approximately one in four say they have either negotiated less restrictive gate provisions or allocated to funds with less restrictive gate provisions. Survey results indicate that overall, foundations, endowments and corporate investors have been more active in this regard than public funds [Figure 16].

Figure 16: Steps taken in past two years to ensure greater liquidity (% of investors)

All Investors 50% 40% 30% 20% 10% 0%

Foundation & Endowment

Corporate

Public

Avoiding side pockets

Shorter lockups

Less restrictive gates

Source: SEI Knowledge Partnership

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

Institutions foresee continued growth of hedge fund investing among their peers
L A R G E R IN S TITU TIO N S ARE ESPECI ALLY POSI TI VE
Nearly nine out of ten respondents expect institutional use of hedge funds to either grow or hold steady for the foreseeable future. Perceptions do, however, vary by investor type and size. Among investors with more than $5 billion in assets, nearly 70% expect hedge fund investing to grow, compared with 37% of small investors (those with less than $500 million in assets). In fact, one in five small investors say they expect a decline in institutional hedge fund investing; not one of the investors in the $5 billion-and-up segment shared that view [Figure 17].

Figure 17: Perception of future hedge fund use by other institutional investors (% of respondents)

Growing 70% Percent of respondents 60% 50% 40% 30% 20% 10% 0% Less than $500m

Holding steady

Declining

$500m-$1B

$1B-$5B

More than $5B

Source: SEI Knowledge Partnership

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

MORE GROWTH, NEW CHALLENGES AHEAD

RE S OU R C E S F O C U S E D O N H E DGE FUNDS ARE EXPECTED TO HOLD S T E A D Y O R G R O W MO D E S TLY
Nearly all investors (96%) anticipate either no change or modest growth in the resources their organizations devote to evaluating, monitoring, and selecting hedge fund investments [Figure 18]. This points to both the need and the opportunity for managers to differentiate themselves through client service, reporting, and education. Consultants, for their part, were more inclined than investors to anticipate growth in the organizational resources they devote to hedge funds, with 71% expecting some growth, compared with 37% of investors. In fact, another 7% of consultants expect “significant” growth.

Figure 18: Expected changes to resources for managing hedge fund investments (% of respondents)

All Investors 80% 70% Percent of respondents 60% 50% 40% 30% 20% 10% 0% Significant growth Modest growth No change

Consultants

Modest decline

Significant decline

Source: SEI Knowledge Partnership
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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

Conclusion
Hedge fund investors and managers alike have endured a tumultuous period characterized by unexpectedly high degrees of correlation, unanticipated illiquidity, and widespread failure to achieve absolute return objectives. Against that backdrop, this year’s survey results provide some especially welcome news for hedge fund managers. As they did in last year’s survey, institutional investors voiced a strong, continuing commitment to hedge fund investing. Even so, it would be a mistake for hedge fund managers to take too much comfort from these findings. Through the financial crisis, institutional hedge fund investing has entered a new phase of maturity—one in which investors have not only modified their performance expectations, but also dialed up their transparency demands, intensified their due diligence, and heightened their focus on risk management. As survey findings show, investors’ concerns have evolved and investors have rethought their selection criteria, signaling the challenges and opportunities ahead for hedge fund managers. With “clarity Those managers who understand and respond to investors’ rising expectations and level of vigilance will be the ones to benefit from their continuing commitment to hedge fund investing. The hedge fund managers best equipped to compete in this new phase will be those able to demonstrate certain characteristics: • An ability to clearly articulate their value proposition within an investor’s diversified portfolio. • Sufficient scale to support institutional-quality operations and risk management infrastructure. • Understandable investment strategies with readily identifiable sources of alpha. of investment philosophy” emerging as the top selection criterion and investors naming the “lack of transparency” as their number-one worry in hedge fund investing, performance also remains a key concern. Investors clearly recognize the difficulties posed by an uncertain, volatile climate.

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

About the Survey
SEI’s fourth annual global survey of institutional hedge fund investors was conducted in October, 2010 by the SEI Knowledge Partnership in collaboration with Greenwich Associates. Online questionnaires were completed by senior investment professionals at 111 institutions, including 97 institutional investors and 14 consultants. Telephone interviews were also conducted with the consultants. Consultant responses were broken out where appropriate. Characteristics of the survey universe were as follows: • Foundations and endowments represent nearly half the participating organizations, with public pension plans (21%), corporate funds (14%) and consultants (13%) accounting for most of the remaining institutions. • Participating organizations range in size from less than $500 million to more than $20 billion in assets [Figure 19]. • Approximately 85% of respondents are based in the United States with the rest based in the United Kingdom, Canada, and Scandinavia.

Figure 19: Survey universe by asset size (% of respondents)

$1B to $5B, 24.7%

$500M to $1B, 15.5%

$5B+, 16.5%

<$500M, 43.3%

Source: SEI Knowledge Partnership

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Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead

About SEI
SEI (NASDAQ:SEIC) is a leading global provider of outsourced asset management, investment processing and investment operations solutions. The company’s innovative solutions help corporations, financial institutions, financial advisors, and affluent families create and manage wealth. As of September 30, 2010, through its subsidiaries and partnerships in which the company has a significant interest, SEI administers $402 billion in mutual fund and pooled assets. SEI serves clients, conducts or is registered to conduct business and/or operations, from numerous offices worldwide. For more information, visit www.seic.com. SEI’s Investment Manager Services division provides total operations outsourcing solutions to global investment managers focused on mutual funds, hedge and private equity funds, exchange traded The SEI Knowledge Partnership is an ongoing source of action-oriented business intelligence and guidance for SEI’s investment manager clients. It helps clients understand the issues that will shape future business conditions, keep abreast of changing best practices, and develop more competitive business strategies. The Partnership is an initiative of SEI’s Investment Manager Services division. funds, collective trusts, separately managed accounts and institutional and private client services. The division applies operating services, technologies, and business and regulatory knowledge to each client’s business objectives. Its resources enable clients to meet the demands of the marketplace and sharpen business strategies by focusing on their core competencies.

About Greenwich Associates
Greenwich Associates provides research-based strategy management services for financial professionals. Greenwich Associates’ studies provide benefits to the buyers and sellers of financial services in the form of benchmark information on best practices and market intelligence on overall trends. Based in Stamford, Connecticut, with additional offices in London, Toronto, Tokyo, and Singapore, the firm offers over 100 research-based consulting programs to more than 250 global financial services companies. For more information on Greenwich Associates, please visit www.greenwich.com.

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The Investment Manager Services division is an internal business unit of SEI Investments Company. This information is provided for educational purposes only and is not intended to provide legal or investment advice. SEI does not claim responsibility for the accuracy or reliability of the data provided. Information provided by SEI Global Services, Inc.
©2011 SEI 101895 (1/11)

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