Large hedge funds to dominate as banks, small funds withdraw

Large, diversified hedge funds with institutional-quality operations are more likely to survive their smaller rivals as the sector continues to contract, according to a research note by Morgan Stanley.

Larger, institutional-quality managers are expected to gain market share as smaller funds continue to shut-down – a process that appears to be accelerating, Morgan Stanley writes in a January 2009 Investment Focus note.

The larger managers are more likely to commit resources to compliance and operational infrastructure than their smaller rivals as regulation of financial markets continues to evolve.

New, increasingly demanding regulation will also limit the ability of smaller managers to exploit investment opportunities.

While larger managers can also build customised trading programs to adjust to changing regulation, smaller firms must often wait for off-the-shelf trading programs to be modified by vendors.

“Institutional-quality managers, who typically possess more sophisticated risk infrastructures, have the ability to pursue non-standard means to hedge exposures and, thus, can capitalise on the greater inefficiencies created by new regulatory restrictions,” Morgan Stanley states.

The surviving hedge funds will find themselves with fewer competitors as banks, under pressure to reduce leverage and, by extension, proprietary risk-taking operations, withdraw from markets in which they once competed with hedge funds.

“While the outlook on near-term returns for hedge funds remains unclear, we believe that opportunities are abundant for investors with a longer-term time horizon to take advantage of significant distortions in the market.”

Such opportunities exist in the convertible arbitrage, bank loan and investment-grade corporate bond markets, Morgan Stanley writes.