(August 24, 2011) — Agecroft Partners — a third-party marketing firm — has asserted that the hedge fund industry will withstand major market swings better than it did during 2008.

Due to industry adjustments, a mature investor base, and less reliance on leverage, Donald Steinbrugge of Agecroft Partners claims that in the current market environment, hedge funds will escape the pains felt during previous market declines and increases in volatility.

Steinbrugge credits institutional investors for the continued positive net inflows into the hedge fund space. “The make-up of the hedge fund investor base is very different from 2008 and is dominated by institutional investors who are much more long-term oriented and stable,” he notes in a statement. “Pension funds over the past few years have been responsible for a significant percentage of positive net flows to the hedge fund industry,” he says, noting that this trend could actually be enhanced by a market decline as pension funds strive to reduce their unfunded liability by enhancing returns and reducing downside volatility.

The statement asserts: “Pension funds need to generate a return equal to their actuarial assumptions which typically are in the 7.5% to 8% range. This is difficult to achieve when the fixed income portion of their portfolio is yielding around 3%. Endowments and foundations, which were criticized for their redemptions after the 2008 market correction, have repositioned their portfolios to better withstand ‘liquidity’ events. These liquidity issues were primarily driven by the private equity portion of their portfolios, where common practice was to over allocate to private equity in order to maintain a targeted allocation. This caused significant issues when capital calls increased while return of capital came to a halt. Most of these liquidity issues have now been resolved. Going forward endowments and foundations will be much more active allocators to hedge funds given a similar sell off.”

The evidence of institutional investors increasingly pursuing hedge funds is supported by recent research by Citi Prime Finance that showed institutional investors had $1.1 trillion in hedge funds at the end of the first quarter. This compares with $125 billion in 2002, an amount that represented about a fifth of the hedge fund industry.

At the same time, following the global financial crisis, the firm found a noticeable shift to direct investing in hedge funds by pension and sovereign wealth funds, as opposed to using traditional fund-of-funds. “While the conventional wisdom is that directly allocated capital is going only to the largest hedge fund managers, we actually found that smaller hedge funds managing between $1 billion and $5 billion experienced the largest net growth in 2010,” Sandy Kaul, US Head of Business Advisory Services, told the Financial Post. Kaul added: “Fund managers in this range occupy a ‘sweet spot’ for investment allocators, with interest extending as low as $500 million in developed markets and $250 million in emerging markets. Above $5 billion we see a bifurcation in the industry among hedge fund managers that are limiting new investment and those that are developing into larger asset management organizations.”

Since the financial downturn, hedge funds have also enhanced their due diligence process to reduce the probability of fraud, with a greater focus on transparency, operational due diligence and the quality of service providers.”Investors focus on how reputable the accounting firm is that does the audit. In the case of Madoff it was some guy who had an office in a strip mall. They also focus on who is the prime broker, law firm and administrator. The due diligence also includes doing reference checks from the service providers,” Steinbrugge tells aiCIO. He continues to explain that there is a lower probability of another Bernie Madoff scandal, which caused a ripple effect throughout the industry that led to massive redemptions from investors in funds of funds that had Madoff exposure.

Furthermore, Agecroft asserts that large decreases in leverage used by hedge fund investors and managers across the board should help stabilize performance while reducing the amount of withdrawals in the event of a steep market decline.