Fitch Ratings says in a new hedge fund sector update that stronger flows to hedge fund and absolute return strategies in 2010 should increase during 2011, as institutional investors seek diversifying sources of performance and downside risk protection.

In Fitch's view, this post-crisis change is structural, partly driven by regulation changes which push institutional investors to take active risk while satisfying regulatory de-risking of their balance sheet, and by the general perception of market asymmetry (little to gain, more to lose).

Fitch considers that hedge funds and most absolute return strategies served their purpose in 2010 and Q4 2010 on a risk-adjusted performance basis. By contrast, newcits (regulated funds managed by HF managers) have had disappointing performances, somewhat questioning the validity of this hybrid segment.

"Investors which were recently attracted to absolute return products for their downside risk protection characteristics also need to recognise that these strategies may not able to capture fully market upside," says Manuel Arrive, Senior Director in Fitch's Fund and Asset Manager Rating team. Indeed, long-only traditional funds are better positioned than absolute return funds to participate in bull markets, as reflected for example in the relative marginal flows to emerging market (EM) hedge funds, compared to large inflows into long-only EM funds.

Global macroeconomic imbalances combined with trend reversals provided opportunities to relative value-oriented strategies. Meanwhile, rising risk appetite and the short-lived appearance of clearer macro trends in Q4 favoured alternative directional strategies until another sharp trend reversal in late February 2011.

Some of the successful 2010 long beta calls (credit, EM, equities) are being reassessed in the face of current valuations, rising geopolitical risks, potentially weaker growth, higher inflation and on-going fiscal consolidation. This current uncertainty should further support interest in absolute return strategies.