Looking ahead - themes and trends

The hedge fund industry is at a crossroads. Events over the past year have severely tested business models and strategies, and we see our industry undergoing a period of reformation, led by scale players such as Man.

Hedge funds have enjoyed explosive growth since 1990, both in terms of assets under management and number of managers, but these trends reversed sharply in 2008.

We believe that funds under management will gradually recover and, in time, resume their upward trend. A major shake-out is under way. There is already strong evidence of a consolidation in favour of larger players, with a permanent reduction in the number of managers and concentration of assets among a few leading players.

Growth prospects remain good because, despite an overall downturn in performance in 2008, the value that hedge funds can add remains evident, particularly when the challenges facing other investments are taken into account. This provides a firm foundation for the industry as a whole but only those that are appropriately positioned in this new environment will prosper.

The competitive landscape is already reforming as a large number of hedge funds have closed their doors and many of the proprietary trading desks of major investment banks have been closed down or greatly reduced in scale. This has resulted in an overall shrinkage in the industry, in which only the strongest managers have survived to pursue their strategies in what is likely to be a far less competitive environment in future.

The hedge fund value proposition will be reaffirmed

It is widely acknowledged that hedge funds have delivered considerable value over the years, providing significant capital growth and protection. However, 2008 was, as a whole, one of the worst years for the industry. The mean performance disguises the full story as some sectors - notably managed futures - had one of their best years on record. Nevertheless, the industry needs to answer the charge that the hedge fund model has been damaged.

Man firmly believes that hedge funds will continue to form an important segment of the investment world. Their flexibility and large diversity of styles and strategies mean that there are inherently more opportunities for hedge funds to deliver long-term risk-adjusted returns than traditional asset managers. This underpins their ability to recover more quickly from downturns. Hedge funds continue to produce beneficial capital protection and risk reduction through generally low correlation to traditional assets, demonstrating resilience even during the recent downturn - as they have, historically, during major bear markets

Already, the substantial repricing of risk in recent months has created highly attractive opportunities in several hedge fund styles.

As the industry moves closer to the mainstream, consolidation will intensify

Hedge funds are already adapting their business models and investment techniques to respond to the new financial environment.

Investors, whether institutional or private, are reassessing their requirements of investment managers in the light of recent events. There is increasing awareness of the importance of controlling non-financial risks, with particular emphasis on such factors as liquidity, transparency, security, manager pedigree, governance and sustainability. Scale brings benefits - and this shift favours the larger, well-established players such as Man.

The shift in investor priorities is likely to play into a long-established trend towards consolidation, as the bigger players continue to increase their market share. Nearly three-quarters of hedge fund assets worldwide are held by managers with over $1 billion under management. This trend is likely to continue as smaller businesses, which will struggle to provide the additional layers of regulatory compliance, infrastructure and resources that institutional and private investors are demanding, fall by the wayside or are absorbed. The medium- to long-term outlook for the survivors of this industry rebalancing, of which Man is a prime example, is very positive.

Regulation will increase, benefiting better-resourced managers

Increased regulatory controls have been a catalyst for the institutionalisation of the hedge fund industry over the past few years. Some of these changes have been driven by the industry itself, with Man at the forefront of introducing voluntary codes of conduct. At the same time, the financial crisis has inevitably brought more attention on hedge funds and heightened governance can be expected.

Man supports all efforts towards increasing market stability and the protection of investors. As active members of the Hedge Fund Standards Board in the UK and the working group for the Guide to Sound Practices for Fund of Hedge Fund Managers, we are long-standing advocates of the development of guiding principles for the industry. Man is already fully regulated, on a consolidated basis by the FSA, and by national regulators wherever we have offices - currently we operate from 19 separate locations. As a result, we welcome increased governance and institutionalisation of the industry, as this will lay the foundations for an even stronger hedge fund value proposition in the future. The industry will become more investor friendly, as greater accountability will foster the spread of 'best business practices'.

A more focused set of investment strategies will be successful

Some styles and managers will find it hard to prosper in the new environment, particularly those that have traditionally relied on leverage to enhance returns. It is going to take some time for the credit markets to return to normal and so the easy availability of capital, which was a driving feature of previous years, is likely to be absent for the foreseeable future. We are already seeing evidence that investors are attracted more to styles that combine strong and persistent value creation with transparency and simplicity of the underlying investment proposition. At a business level, well-capitalised companies such as Man will be best placed to ride through the credit contraction - and our competitor base will continue to weaken as some business and investment models fail.

As the hedge fund industry reshapes itself, Man stands to benefit from these prevailing trends - and will build on its reputation, capital strength, geographic spread and resources.