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.

Institutions prefer investing with big hedge funds that have long track records. The largest funds have sizable staffs that manage portfolios and give personal service to important clients. In contrast, small hedge funds don't have the resources to handle institutions that may want to invest $50 million or more at a time.

In the first quarter of this year, most inflows went to hedge funds with more than $5 billion in assets, according to Hedge Fund Research. Funds of that size now account for 63% of all hedge fund assets. Funds with $1 billion to $5 billion account for 25% of assets.

Funds with less than $500 million in assets account for less than 7% of hedge funds assets. Unable to attract new clients, hundreds of the smaller funds have shut their doors in recent years and many are still scrambling to stay afloat. As institutions become bigger players, they are demanding more concessions from hedge funds. In the past, hedge funds traditionally charged 2% annual expense ratios along with performance fees that equaled 20% of profits. Recently institutions have been negotiating discounts. Preqin says the average expense ratio is now 1.65%, while performance fees average 19.1%.

Institutions are also demanding better access to their money. In traditional hedge funds, investors put their money into commingled pools that include assets from many clients. Investors can only make withdrawals after waiting for a fixed period, such as a quarter or a year. During the financial crisis, many investors raced to make withdrawals, but funds barred their gates. Investors waited months longer than they expected to obtain their cash.

To avoid a repeat of the delays, institutions are demanding separate accounts. A separate account includes only assets of one client, who has freedom to make withdrawals on short notice. By gaining more control over their assets, institutions have the confidence they need to keep increasing their investments.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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