Volatile financial markets forced hedge fund net inflows to their lowest level last quarter since the fourth quarter of 2005. Inflows fell 78.7%, to $12.5 billion, in the second quarter from a year earlier, according to data released Friday by Hedge Fund Research.


In the first half of the year, investors allocated $29 billion of new capital to hedge funds. That was 75.4% less than in the first half of 2007 and the lowest amount of inflows in the first half a year since 2003, when inflows were $28.3 billion, Hedge Fund Research said. For the 12 months of 2007 the industry had record inflows of $194.5 billion, the firm said.


Analysts said the difficult economic conditions will force investment managers selling hedge funds to adjust the strategies they offer customers as many remained concerned about credit exposure in certain hedge fund strategies. Investors withdrew more than $3.6 billion from relative value funds in the second quarter while allocating nearly $7 billion to macro strategies, said Hedge Fund Research, a subsidiary of HFR Group LLC of Chicago.


Macro has continued to perform because these portfolios do not have direct exposure to credit markets, Hedge Fund Research said. The HFRX Macro Index has gained more than 14% in the past 12 months.


Despite the volatility, industry capital increased by $56 billion in the second quarter, as the broad-based HFRI Fund Weighted Composite Index gained more than 2.25%, partially offsetting losses in the first quarter. Capital under management stood at $1.931 trillion at midyear, up 2.98% from the end of the first quarter.


Assets in hedge funds-of-funds funds rose 32.4% in the second quarter compared with the first quarter, to $825.9 billion. Investors allocated nearly $9 billion in new capital to such funds during the quarter, according to Hedge Fund Research, which tracks more than 12,000 funds.


"There were some interesting allocation preferences in response to performance volatility in the second quarter," said Kenneth J. Heinz, Hedge Fund Research's president. "In some cases, investors allocated opportunistically to areas of weak performance, like emerging markets and growth equity, while in others they reduced capital in response to negative performance and allocated to areas of strength."


Many investors allocated assets "to established funds and funds-of-funds but also funded several new launches in the quarter," Heinz said. "The marketplace appears to be expecting a volatile environment, and portfolios are being positioned to benefit from this."


Fundamental growth strategies had the largest quarterly inflows, taking in $6.7 billion, while two macro substrategies — discretionary thematic and systematic diversified portfolios — had inflows of $6.2 billion and $5.2 billion, respectively. Multi-strategy hedge funds had the largest outflow, with investors pulling almost $8 billion from such funds.


New hedge fund firms attracted $6.7 billion of new capital in the quarter. Existing firms attracted $5.8 billion. More than 100% of new capital allocated to existing firms went to those with more than $5 billion of assets under management; firms with less than $5 billion had net redemptions.

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