Why Are Hedge Funds So Gloomy?

Svea Herbst-Bayliss of Reuters reports, Hedge fund managers a gloomier lot in 2012-survey:

Faced with new regulatory oversight, fierce competition for investment dollars, and uncertain markets, nearly half of the hedge fund industry is bracing for a difficult year, a survey shows.

Accounting, consulting and audit firm Rothstein Kass found that 47.5 percent of managers said 2012 will be "difficult" or "somewhat difficult", making for a noticeably gloomier outlook from a year ago when only 32.3 percent of respondents said they expected 2011 to be a tough year.

One surveyed manager warned that bigger funds may fail to meet their investors' expectations. Another manager said that the pressure to perform is on in 2012.

"We are in a new world," said Howard Altman, Rothstein Kass' co-chief executive officer, adding "I t is a time of inflection for the industry with registration and how difficult it is to raise to capital."

As of March 30, all but the smallest hedge funds are required to register with the U.S. Securities and Exchange Commission, providing the agency with more information about the funds' investment philosophies and operations and giving regulators a closer look at who is doing what in the $2 trillion hedge fund industry.

Rothstein Kass surveyed 400 hedge fund managers in January and will release the findings of the survey on Wednesday. Reuters obtained a draft of the report.

One year after sounding an optimistic tone in early 2011, but losing 5 percent on average for the year, the $2 trillion industry has adopted a darker outlook.

Gone are the days where traders could quickly raise millions to launch their own funds, said respondents, adding that raising money is now one of the industry's biggest concerns.

Indeed, 79 percent believe that finding a deep pocketed seeder who will commit capital in exchange for a chunk of the firm is critical to a successful launch this year.

Still nearly half of the polled managers expect to see more competition this year with 48 percent expecting that the pace of hedge fund launches will pick up this year, the survey found.

At the same time with many funds still reeling from the 2008 financial crisis and lasting fears about Europe's debt crisis and growth in the United States which contributed to losses, managers expect to see more funds liquidate.

Like last year, pension funds, endowments and family offices are seen as the main source of funding for hedge funds as many of these institutional investors try to make up for past poor investment returns by adding hedge funds into the portfolio.

Six years ago when Rothstein Kass first put out its annual survey, only 20 percent of the managers expected institutional investors would become the dominant source of capital.

And with more funds chasing investment dollars, one out of every two managers said fund raising and marketing is the single biggest concern for 2012. Indeed 90 percent of the respondents said they expect competition for assets to increase in 2012.

Not surprisingly, raising money is especially hard at smaller funds with many managers saying they feel investors generally prefer to invest with bigger funds. During the last three months of 2011, investors sent less than $7 billion of new money into hedge funds with most of it going to firms that managed at least $5 billion, industry data show.

"One of the frustrations we sense is that emerging managers needing to fight above their weight class," Rothstein Kass' Altman said. "You are dealing with an industry where the top 250 funds control the bulk of the capital."

Even though it will be tough, 66.2 percent of the respondents said they want to boost their capital by 25 percent or more, the survey found.

One of the ways to attract more institutional investors may be to be more conciliatory, respondents said, with 72 percent expecting hedge funds to offer special terms to pension plans and sovereign wealth funds this year.

Please read my last comment on hedge funds fighting back. There is no question that institutional investors prefer larger funds, all part of the 'placebo effect' of large hedge funds. The irony is that smaller hedge funds typically outperform their much larger rivals.

To be sure, some of the biggest hedge funds have earned their asset growth through stellar performance. Global macro funds like Bridgewater and Brevan Howard are two of the biggest and best hedge funds so it doesn't surprise me that Brevan Howard is cashing in on its popularity.

But buyers beware, when I see the world’s biggest publicly traded hedge-fund manager as a likely takeover target, I start getting nervous. And if that doesn't phase you, how about Red Kite's announcement to open up a $1 billion long-only metals fund. You read that right, a LONG-ONLY metals fund!!!

In some ways, it feels like 2005-2006 all over again except this time, underfunded pension funds and other institutional investors are going all-in on hedge funds and other alternative investments.

So cheer up dear hedgies, Apple crushed Street targets, the world isn't coming to an end and you can still ride the big beta wave higher, for now. Just make sure you're not adopting a stay-liquid-and-wait strategy because if that's your game plan, you'll woefully underperform again in 2012.

You can watch Reuters Fred Katayama's interview with Rothstein Kass co-CEO, Howard Altman, here. Below, "BWest Byte" Bloomberg's Emily Chang and Jon Erlichman discuss Apple's cash pile.