Top hedge fund managers are again receiving big pay-outs, but not all wealth managers and investors have stayed on board.

Hedge funds are in the news again, this time for the record pay-outs of the top managers.

The top 25 managers averaged $1 billion each last year, led by David Tepper of Appaloosa Management, who made $4 billion in fees and capital gains, largely because he bet big that the government wouldn’t let big banks fail.

Appaloosa was up more than 130 per cent in 2009, and Quantum Endowment, the fund run by George Soros, the earnings runner-up in last week’s AR: Absolute Return + Alpha magazine rankings with $3.3 billion, grew a less stratospheric but still impressive 29 per cent.

But while the very best did very well, there are over 9,000 hedge funds around the world, many of whom definitely did not do so well.

In fact, thousands of hedge funds have gone out of business in the past three years, leaving the industry with about 25 per cent fewer firms than at its peak.

Losses industry-wide averaged around 20 per cent in 2008, and even the top performers - including Tepper - suffered double-digit losses.

So how are wealth managers and their clients approaching hedge funds these days?

Two tiers

It appears to be a tale of two tiers of wealth, with many high net worth investors pulling back from hedge funds, and ultra-high net worth clients tending to stay in.

Some investors were simply spooked by the scary market downturn and weren’t willing to take the kinds of risks that hedge funds take; others lost money and weren’t able to meet the $1 million-plus minimums or pay the high fees and percentage of gains that funds demand.

And as the market tightened and the Bernard Madoff scandal spread, so did well-founded concerns about liquidity and transparency in a very lightly regulated industry.

“It’s clear that there is now much greater appreciation for liquidity constraints,” said Stephen Horan, head of private wealth management for CFA Institute in Charlottesville, Va. “It turned out that liquidity was the chink in the armor for the endowment model.”

Not being able to have ready access to cash was worrisome even for wealthy families, said Rick Pitcairn, chief investment officer for Pitcairn, the Jenkintown, Pa.-based multifamily office that has approximately $3 billion in assets under management.

“Investor demand for illiquid holdings fell dramatically as people got scared,” Pitcairn said.

Clients also want greater accountability, wealth managers say.

“They are more educated now,” said Ira Rapaport, chief executive of Private Wealth Advisors LLC of Wellesley, Ma. “They want a better understanding of what a fund is holding. They also want transparency, liquidity and they are more fee-conscious.”

Risk concerns have also made many investors think twice about hedge funds, according to wealth mangers.

“There’s been a real change in investor appetite,” Pitcairn said. “There was not a lot of attention paid to risk before 2008, but now investors are taking a close look at the risk side as well as return,”

Rapaport, whose firm has around $500 million in assets under management, agreed.

“People are not looking for the highest return now,” he said. “They are looking for the strongest risk-adjusted returns, and they are being much more selective.”

Ultra-high net worth investors who have more than  $20 million or $25 million in investable assets are also being more demanding, but are more likely to stick with traditional hedge funds,  according to wealth managers.

“Many of our clients have hedge funds and we have not seen them running for the exit, nor are we advising them to do so,” said Greg Van Slyke, a founder and partner of Lake Street Advisors of Portsmouth, NH.

The firm has over $2 billion in assets under management and the average family client has over $50 million invested, Van Slyke said.

“Clients are staying with the hedge funds, but they are also looking for a higher level of scrutiny and asking more questions, and the hedge funds have been more forthcoming than they used to be,” he added.

Pitcairn said most of his wealthier clients have also maintained their position in hedge funds.

“They’ve been able to meet the accreditation standards and we’ve seen good activity with that group,” he said.

Jamie McLaughlin, who worked closely with ultra-wealthy clients while chief executive of New York-based Geller Family Office Services, said the investors in the best funds stayed the course even through the market free-fall.

“They tend to be more sophisticated investors and they were patient,” McLaughlin said.

What’s more, long/short hedge funds are well-positioned to maintain their popularity with ultra-wealthy investors, he argued.

“In a market environment where you’re beginning to have pressure on interest rates, have  anemic fundamentals for equities and an uncertain business cycle what are you going to do? “ McLaughlin said.

“Long/short hedge funds have very good stock pickers who can analyze the intrinsic value of a stock for and against. Because they can short a stock they can exploit whatever market vicissitudes unfold.”

Van Slyke agreed.

“The ability to short is a powerful tool,” he said, “although dangerous in the wrong hands.”

Part Two of this story appears tomorrow and will examine alternatives wealth managers are using in place of hedge funds.