Hedge funds may have to change tactics, notably by cutting their leverage, and adapt to regulations that likely will restrict their investment strategies, according to a recent report about the $2 trillion alternative asset management industry published by Standard & Poor’s.

“Investors will be more attracted to hedge funds that use low-to-modest balance-sheet leverage relative to their investment strategy in conjunction with a strong risk-management system,” says S&P. The rating agency defines funds with low leverage as those with 1x to 2x assets to risk capital.

There are roughly 10,000 funds, according to the Hedge Fund Association, an industry trade group. Many were forced to cut their leverage in the last 18 months as the credit crisis eroded the value of assets posted as collateral. Also, fewer prime brokers were able to or willing to lend to their hedge fund clients during the credit turmoil.

In addition to reducing leverage, S&P said hedge funds likely will have to improve transparency of their operations and the credit rating agency warned that regulatory restrictions could crimp the investment styles of funds.

“Traditionally, hedge funds have been able to take both long and short positions in any instrument, in any cash or derivative markets, without restrictions by regulators. But that may change in the coming year,” S&P warns in a report entitled “Hedge Funds Now Need More Than Performance To Attract and Retain Investors.”

When it comes to the issue of leverage, S&P analysts wrote in their report that they expect investors to be drawn more to funds that use low-to-modest balance sheet leverage.

In addition, the credit rating agency warned that limits on the amount of money that investors can take out of a fund, known as gating, likely will haunt some fund managers. These gates were dropped often during the credit crisis, particularly in the third and fourth quarters of 2008. In some cases funds that dropped the gates likely will see investor exodus, says S&P, which warned that “many investors that have been gated will redeem their holdings when funds lift their gates.”

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