Large investors are reassessing their hedge fund investments in the wake of the industry’s worst year on record, with some questioning the role of middlemen in the wake of the Madoff debacle and others investing in black box replication strategies. (PDF)

However, the industry is fighting back, with a wave of new launches in the pipeline, most of which appear to have already attracted seed funding.

David Butler, partner at Kinetic Partners, a London-based hedge fund consultant, said: “We have got 30 new managers launching at the moment, which is more than I have ever had in the last 12 years. Virtually all have seeding from large family offices or institutions,” added Mr Butler, who said traders were leaving large hedge funds and investment banks to set up long/short equity, distressed credit and macro funds.

The flurry of activity comes after a year of record losses and redemptions in the hedge fund industry, with many investors shocked by the restrictions funds have imposed to stem withdrawals and the $50bn (£33bn, €38bn) fraud allegedly perpetuated by Bernard Madoff, which many funds of funds and other intermediaries failed to spot. The average fund lost 18.3 per cent last year, according to Chicago-based Hedge Fund Research, with the typical fund of funds down 20 per cent after fees.

Slower moving institutional investors have generally remained invested, even as fleeter footed rich individuals have headed for the hills, but some big players are now reassessing their exposure.

AP7, the Swedish pension fund, has invested $315m into a hedge fund replication strategy run by Goldman Sachs, giving the fund the freedom to withdraw money whenever it chooses.

Richard Grottheim, chief investment officer, said: “Liquidity is one reason why we have been migrating out of fund of hedge funds and into replicators. I would like to have the possibility of quick withdrawal in times of crisis,” added Mr Grottheim, who also lauded the low cost of replication at less than 75 basis points a year.

IndexIQ, a New York-based provider of hedge fund replication products, said it had seen a jump in interest since the Madoff scandal broke, although this had yet to translate into significant asset flows.

But Amin Rajan, chief executive of consultancy Create Research, believed replication would struggle to take off in the current environment, with investors preferring simplicity to complex “black box” products.

Fund of fund managers, many of which failed to spot the alleged Madoff fraud, are also under pressure, with 118 closing in the four months to October, according to HFR.

Martin Brookes, director of portfolio management at Prudential, said the insurer’s £55bn with-profits fund, which has invested via Grosvenor Capital Management, a Chicago fund of funds, for the past seven years, was now also looking at direct investment for the first time, a path he believed others were following.

“We have hired a couple of people to start thinking about the process of picking managers ourselves and taking out the middleman. It is early stage thinking but I suspect a lot of institutions are having the same discussion,” he said. “The bigger investors might start to think of doing it themselves if they are not going to get the protection they thought from a fund of fund manager

Mr Rajan also believed intermediaries would come under pressure, particularly as some had missed earlier collapses such as Amaranth Advisors in 2006. “If you are an intermediary, now is the time to seriously panic . . . They are going to find it difficult to justify their existence post-Madoff,” said Mr Rajan.

However, Mr Butler remained confident that underlying funds would see a better 2009. “I have no doubt whatsoever that money is going to flow back into the industry,” he said.

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