Hedge Funds Adapt to New Climate

NEW YORK (TheStreet) -- For decades, hedge funds focused on serving wealthy individuals. But since the financial crisis, many individuals have fled hedge funds. Now most assets flowing into the funds are coming from pensions and other big institutions. As a result, the shape of the hedge fund business is changing. Big funds favored by institutions are prospering, while many smaller funds are struggling to survive.

The exodus of individuals has been a special blow to vehicles known as funds of hedge funds. These take money from investors and put it into 20 or more hedge funds. In 2007, funds of funds had $798 billion in assets, or 42% of all money in hedge funds, according to Hedge Fund Research. Then during the next two years, investors withdrew $159 billion in assets. Today funds of funds have $672 billion in assets and account for 33% of hedge fund assets.

"The wealthy individuals who invested in funds of funds are still frightened," says Nadia Papagiannis, a Morningstar analyst who follows alternative investments.

Individuals had long favored funds of funds because the vehicles seemed to offer diversification and the safety that comes from professional managers who can pick sound investments. But in 2008, funds of funds lost 20%, according to Hedgefund.net. The losses were particularly unnerving because some funds of funds had been invested with Bernard Madoff and were wiped out in the Ponzi scandal.

While many individuals have decided that hedge funds are risky, institutional investors found that top hedge funds provided important diversification during the downturn. By selling short and using other techniques, the best performers recorded small losses or actually made money. Many of the star funds are only available to institutions that can invest large amounts.

"Institutions want diversification, and they are increasing their allocations to hedge funds," says Amy Bensted, manager of hedge fund data for Preqin, which tracks alternative investments.

Preqin says that public pension funds now have 7% of their assets in hedge funds, up from 4% in 2007. Many endowments of colleges and other institutions have reported putting more than 20% of assets into hedge funds. According to Preqin, institutions now account for 61% of hedge fund assets, up from 45% in 2008. As result of the inflows from institutions, total assets of hedge funds topped $2 trillion this year, up from $1.9 trillion in 2007.

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