Writing in Julius Baer's first-quarter 2009 investment policy quarterly document, Zaker notes that different investors were attracted to hedge funds for different reasons.
"Original hedge fund investors were attracted to the primarily stable high return streams of hedge funds, " Zaker says. "Later, when institutional investors began looking at hedge funds, the focus was much more on uncorrelated returns to the traditional markets. Much lower returns were acceptable in that case."
"This new wave of investors created demand for a wide variety of new strategies including, paradoxically, illiquid and leveraged relative value strategies. 2008 changed the premise for these institutional investors. They will re-examine the case for hedge funds and decide on the “if and if yes, how much” allocation to hedge funds."
Hedge funds are not all the same, and Zaker believes that the idea of a hedge fund as an asset class probably has more to do with the mindset and perception of institutional investors than with what hedge fund managers do.
Zaker argues that the probable outcome will be a move away from a “broad-brush” allocation to a more differentiated allocation process, which he says will be a positive change for the industry.
He concludes: "For many crowded strategies, the effect of redemptions will be salutary: a shrinking number of competitors, fewer leveraged buyers, shrinking bank balance sheets and proprietary capital, and an increase in inefficiencies will offer a better opportunity set for hedge fund survivors.
"But in the short term, redemption overhang will cloud the technical aspects of the industry. In anticipation of redemptions, cash levels are high and the risk level is low. This would suggest that while the fall in hedge fund performance will stabilise, there still will be no significant upside in the short term."
Rob Gleeson, an analyst at Financial Express Research, agrees that a reduction in competition for returns will benefit hedge funds, especially, he says those engaged in arbitrage strategies.
However, he believes that the possibility of change in behaviour by institutional investors is more significant:
"What is interesting here though, is the prospect of a change in direction from institutional investors, " Gleeson says.
"With credit lines harder to come by, institutional investors are likely to be one of the largest sources of funds for hedge funds going forward. A change in attitude by institutional investors is likely to have a profound effect on the behaviour of the hedge fund industry in the future."
Another analyst at Financial Express Research, Harpreet Sajjan, believes that as a result of the recent turmoil experienced by this asset class hedge funds will once again be considered riskier alternative investments, rather than being disguised by complex strategies that make them appear relatively less risky than they actually are.
"This means that institutional investors would revise more thoroughly any large sums of cash that they are preparing to allocate to this asset class," Sajjan says.
He adds: "In an environment of shrinking fund sizes and less strategies employed, the scope for exploiting value gaps for mispriced securities increases. Recent years saw these opportunities dwindle as hedge funds grew – thus whenever a mispriced opportunity arose the sheer size of hedge fund trades meant that arbitrage opportunities disappeared very quickly from the market.
"The theory is simple, the less hedge funds trading the longer these opportunities will last, and the more profitable those surviving hedge funds will be."