Flows to U.S. hedge funds are expected to slow this year as investors seek out greener pastures overseas, particularly emerging markets. According to Deutsche Bank AG’s 2006 Alternative Investment Survey, domestic hedge funds are poised for outflows of 8 percent this year, while managers focused on China could see inflows gush—perhaps as high as a 39 percent jump in net new money, the survey estimates. Managers of other emerging markets funds that specialize in Singapore, Hong Kong and Latin America could see inflows of at least 13 percent in 2007, Deutsche Bank estimates.

Emerging markets hedge funds were the top performers last year, and investors are likely to continue to move cash to those regions in their quest for big returns. “There’s a desire to diversify away from U.S.-centric managers,” says John Dyment, global head of Deutsche Bank’s hedge fund capital group. “The investment dollars will go to places such as China and Latin America, increasing their exposure to those regions. The money has to come from somewhere.”

Despite the dropoff in U.S.-centric hedge fund sales, overall flows to hedge funds in 2007 are expected to rise 10 percent from 2006, taking in $110 billion in net new money. Overseas expansion, stricter due-diligence screening and competing products (there are roughly 9,000 hedge funds) have made it more difficult on individual fund managers to win assets. “Pensions and endowments have become much more rigorous in their approach to evaluating managers,” Dyment says.

Matthew Nelson, a senior analyst at the TowerGroup’s investment-management research unit, agrees: “Hedge funds are becoming more organized, structured businesses due to increased competition and more demanding institutional investors,” he says. In addition, Congress, regulators and the media have tightened the noose on hedge funds. The SEC has been contemplating making registration mandatory for hedge funds, which, while it has been temporarily tabled, prompted many hedge funds to register with the commission.

As for performance, Dyment says he is anticipating a slight pullback across the board with the median return for hedge funds pegged at 10 percent, down from 13 percent in 2006, which trailed the 15.8 percent gain by the S&P 500 index. The average hedge fund posted a 9 percent gain in 2005, according to Hedge Fund Research. (Although it should be noted that it doesn’t necessarily make sense to lump them all together, since there are many different strategies used.) “We’re seeing more moderating performance. We’re certainly not seeing the high-flying returns of a couple years ago,” Nelson says.

Still, there are always players that will continue to deliver outsized returns. SAC Capital Advisors and Citadel Investment Group, two of the largest hedge funds, put up 30 percent and 34 percent gains in 2006, respectively. And despite the aforementioned obstacles, financial advisors continue to express an interest in these once-esoteric vehicles. “[Given that] there are more choices than ever and a wide open field of managers, there is continued interest among financial advisors,” Dyment says.

Strategies that will resonate with advisors in 2007 are likely to be merger-arbitrage funds and market-neutral funds. The Deutsche Bank survey shows that these strategies are poised for a significant ramp-up, exhibiting “the most predicted change in assets because, historically, they haven’t been well represented,” Dyment says. Long/short equity is also expected to remain popular with advisors while interest in credit long/short will fall out of favor, he says. “130/30 funds will continue to be popular,” TowerGroup’s Nelson says. “Global macro funds have done well and long/short strategies will remain popular.”

But, in terms of pricing, advisors face a significant hurdle in delivering hedge fund products to their well-heeled clients. “Funds of funds remain an entry point for advisors, although the trouble there is the extra layer of fees,” Nelson says. “They can be really expensive.” An alternative to investing in a fund of hedge funds is to purchase shares of publicly traded hedge funds such as Fortress Investment Group, which went public in 2006. A public listing allows hedge funds, usually considered short-term vehicles, access to long-term money, which they can invest in deals more familiar to private equity investors. “It’s a way to tap into liquidity without relying on prime brokers,” Dyment says.

Another way for advisors to gain exposure to hedge funds is to invest in mutual funds with hedge-like strategies, like funds currently offered by Rydex Investments, Charles Schwab and Diamond Hill. These funds have been sprouting up in recent months and are likely to become much more popular if the SEC changes the definition of accredited investor to $2.5 million in liquid assets from its current $1 million. So while hedge funds may experience slower growth and slightly lower returns, they’re gaining in popularity with the average retail advisor and his client.

The Deutsche Bank survey tracks the opinions of nearly 700 investor firms, representing more than $900 billion in assets invested in hedge funds. It is the largest survey of investor sentiment in the $1.5 trillion hedge fund industry. The findings are based on online surveys and one-on-one interviews with more than 1,000 investors.