Hedge funds appear to be benefiting from renewed interest from institutional investors, which will enable them to shift from cost cutting to business building, says Fitch Ratings.

The rating agency reports that hedge fund inflows turned positive in the second half of 2009 and investor interest has increased, according to asset managers polled by Fitch and data vendors.

“Hedge funds are now perceived as better able to exploit the current market environment, at least until more discernable market trends emerge,” it says.

As most asset classes rallied in 2009, hedge funds were less sought after, it says. Managers of funds of hedge funds largely focused on downsizing, restructuring, and resolving liquidity and suspension issues last year, since then, they have renewed their focus on investment idea generation, strategy reallocation and the launching of new funds, it adds.

“As credit spreads have narrowed after last year’s rally and the future of equity returns are more uncertain, active management in a less constrained format has become more appealing for certain investors,” says Aymeric Poizot, head of Fitch’s EMEA Fund and Asset Manager Rating Group “The drive for an absolute return is being sought by investors as dispersion and divergence increase both within and between asset classes, regions and sectors.”

Alongside traditional funds of hedge funds, where inflows turned positive late last year, there is increased demand for segregated mandates, tailored for single investors, Fitch reports. “Institutional investors want to be more directly involved in hedge fund selection and FoHF managers are expected to act more as solution providers, via managed accounts or advising services,” says Olivier Fines, associate director in Fitch’s Fund and Asset Manager Rating Group. “Investors have also become more demanding in terms of selected hedge funds, strategies, and fee structure, whilst others are even participating in the selection process or bringing the selection in-house through direct investments in hedge funds.”

In contrast to the increased demand from institutional investors, demand from private banking, historically the biggest client of European hedge funds, is still being dampened by risk aversion and regulatory uncertainties, it says.

Nevertheless, Fitch says that if improved fund performances and inflows continue, it expects performance fees to increase and asset bases to expand, as many hedge funds and FoHFs are approaching their “high water marks” (the historical net asset value high above which performance fees are charged again). As the financial situation of rated managers improves, Fitch also expects a reversal of the recent trend of restructuring and cost cutting to occur.

IE