Absolute return funds are set for renewed growth as investors focus on risk-adjusted returns. We see the early stages of a turnaround in hedge fund flows with redemption pressures easing and inflows growing. Our research suggests sovereign wealth funds, foundations and pension funds have overtaken endowments and high net worth hedge fund of funds as the largest source of funds.

We think the market is underestimating the potential upsurge in demand for absolute return funds from private clients and smaller institutions via UCITS III. In the UK, in the third quarter of 2009 alone there were $2.1 billion in inflows into absolute return funds, three times that of the first quarter, and we see this as a growing seam for managers to mine. Our base case assumes hedge fund assets under management return to second quarter 2007 levels by the fourth quarter of 2010, although we see risks posed by performance, regulation and reputational issues.

Liquidity, transparency, not having gated, road-tested risk management, and institutional (quality) are the sine qua non for success today. Fundamentals will matter more (vs. arbitrage strategies), and the greatest interest going into 2010 seems to be in macro, equity long-short and commodity trading advisor mandates, although our work shows growing interest in distressed, emerging market and event-driven strategies.

Key risks include reputational and regulatory. The regulatory outcome is still fluid – and bad apples are not helping. But we believe some policymakers realize the supportive role providers of risk capital can play: we estimate that 30-40% of capital raised in 2009 by US and European banks came from hedge funds. Despite uncertainties of regulations, we see the minimum scale required to rise with incremental associated costs.

Growth Outlook