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Why Are Investors Losing Interest in Hedge Funds?

Juliette Fairley

NEW YORK (MainStreet)—Alternative mutual funds and ETFs are eclipsing investor interest in hedge funds with mutual funds becoming the dominant vehicle among advisors and institutions while investors shift from hedge funds to alternative mutual funds.

"ETFs and alternative mutual funds have grown in breadth and quality in recent years," said Nadia Papagiannis, director of alternative funds research for Morningstar.

Alternative mutual funds saw inflows of $19.7 billion in 2012 compared to $7.6 billion that flowed out of single-strategy hedge funds, according to a March 2013 survey by Morningstar and Barron's.

In contrast ETFs have grown from $68 billion in June 2012 to $75 billion in June 2013 in the U.S. market alone, according to BlackRock data.

"We think ETFs will continue to grow fast and mimic the growth of the mutual fund business in the '80s and '90s when financial advisors made it easier for funds to be owned by individual investors. That's how mutual funds became a consumer product, which is what's happening with ETFs now," said Martin Beaulieu, BlackRock's Head of U.S. iShares Wealth Advisory Group.

While institutions maintain interest in equity long-short strategies, advisors are searching for yield in private real estate and master limited partnerships (MLPs).

Managed futures were out of favor in 2012 among advisors who had cited them as their top pick in the two previous surveys. Performance may have been a factor as managed futures ETFs and mutual funds lost 15.6% and 7.4%, respectively last year similar to their losses in 2011.

Another negative cited by institutions and advisors is the undisclosed performance fees managed futures funds frequently charge.

"High fees have overtaken liquidity and transparency as the primary reasons why advisors and institutions may choose to forego alternative investments," said Papagiannis.

Only 4% of advisors said their typical client had no money in alternative investments compared to 17% in the 2008 survey.

"Many investors have a piece of money that's adviced and a piece of money they manage themselves," said Raj Seshadri, managing director with BlackRock. "Given that the individual is the same person with two wallets, ETF growth is coming from both self-directed and advisory investments."

Among institutions, the number of heavy users of alternatives seems to be growing with 20% of institutions compared with 17% last year expecting alternative investments to make up more than 40% of holdings over the next five years.

"Institutional investors are starting to see alternative mutual funds as substitutes for hedge funds and more financial advisors are incorporating these liquid, transparent investments into their client portfolios," Papagiannis said.

About 61% of institutions said they accessed long-short strategies via hedge funds in 2010 compared to only 26% that indicated they used hedge funds for that strategy this year. In contrast, more than 45% of institutions said they access long-short strategies via mutual funds versus 38% in 2010.

--Written by Juliette Fairley for MainStreet

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