The hedge fund sector has been growing at breakneck speed during the last few years, with more than 500 new funds emerging in 2004. But risi...

The hedge fund sector has been growing at breakneck speed during the last few years, with more than 500 new funds emerging in 2004. But rising costs and spectre of regulation will lead to wholesale consolidation in the sector during the next five years, according to a study by TABB Group, a US-based consultancy. Despite two years of underperforming the major equity indexes, hedge funds continue to grow at a very strong pace, with more than 8,600 funds currently in existence. But consolidation is around the corner, according to the TABB study. “While we are not expecting many large hedge funds to acquire small ones,” said Josh Galper, director at TABB Group, “we do see funds of funds as well as more traditional asset management businesses launching or acquiring small funds under their umbrellas to fend off the threat posed by large funds, using their scale, talent, technology and distribution to protect their core business activities.” For the next five years, the report said, the industry will be marked by increasing pressure to strengthen yields in the face of trying market conditions and a rush of new cash into the marketplace. “The struggle to improve yields was primary concern driving most of the funds interviewed,” said Larry Tabb, chief executive of TABB Group. Key statistical findings drawn from the report include: Goldman Sachs and Morgan Stanley are the two largest prime brokers. Each garners over 40 per cent of hedge funds' prime brokerage relationships. As many as 50 per cent say their broker relationship directly dictates which algorithms they use. The primary reasons funds use brokers beyond trading and financing are research (66 per cent), technology (52 per cent) and capital introduction (39 per cent). Nearly 40 per cent of hedge funds are increasing their broker relationships, the major reasons being the need for increased research (31 per cent), product diversity (24 per cent) and improved trading technology (21 per cent). Of the 20 per cent of firms that are reducing their broker relationships, 68 per cent cited the need to consolidate their execution platforms. While 69 per cent believe they should be registered (regulated), only 50 per cent of large funds believe in regulation.