In the entire financial services arena, the sector showing the most growth is clearly the area of hedge funds. While brokerage commissions continue to decline, investment banking fees start to come under pressure and the entire financial services industry worries about intensified regulatory scrutiny, the hedge fund industry with its rapid growth stands out from the crowd.

New funds are starting up every week and many are beginning with an excess of a billion dollars under management from day one.

The amount of money under management with hedge funds has gone up four times between 1996 and 2004 and is expected to further triple between now and 2010 to over $2.7 trillion.

Public funds, endowments, and corporate sponsors have all increased their allocations to hedge funds within the context of an increased allocation towards alternative investments more generally.

This move towards increased investments in real estate/private equity/hedge funds (alternative investments) is driven by the need for a higher return to compensate for the expected lower returns from more conventional investment strategies focused on US bonds and equities.

There is also a clear desire among this investor base to be more focused on absolute-return strategies rather than relative return. Given the current level of allocations most of these large long-term investors have towards alternative investments, and their professed long-term target allocation, the flow of funds to these asset classes will remain strong.

One of the intriguing developments in the hedge fund world is the clear desire and ability of the newer funds to charge higher fees and impose more stringent terms on investors.

No longer are funds charging a 1 per cent management fee and 20 per cent of profits -- the norm for the first generation of funds set up in the early to mid 1990s.

As per an interesting study done by Morgan Stanley's prime brokerage unit, about a third of the funds opening in the past six months are charging a 2 per cent management fee and 20 per cent of profits or higher, while the majority are charging a 1.5 per cent management fee and 20 per cent of profits.

Many of the new funds have more stringent lock-ups and stiff penalties if you redeem early, as well as modified high-water marks.

The hedge fund business thus seems to have the unique characteristic of being possibly the only business that I know of wherein new players (most of whom are unproven) have the ability to charge more and get better terms than the established operators.

This implies a negative franchise value for the established large fund complexes which have survived and prospered through the years. Given that most of the best hedge fund complexes are closed to new investors, the new guys seem to be taking advantage of the huge demand-supply mismatch for quality money managers.

There is a feeding frenzy currently under way in the world of alternative investments and clients are paying up the higher fees for fear of being locked out from these funds at a later date, if they actually survive and grow.

One reason why the new boys are focusing more on fees and lock-ups could be the difficulty all hedge funds are having in generating adequate alpha (excess return) to ensure an adequate payout for themselves.

In a study done by Morgan Stanley on the excess returns generated by hedge funds over the last decade, this trend of declining returns was very apparent. In the study they defined excess returns as the return of the Hedge Fund research composite over one month LIBOR (a proxy for cash returns).

In the 1995-97 period, excess returns were 14 per cent; these returns have consistently declined dropping to as low as 5 per cent in 2001-03 and have dropped further since.

The current huge inflows into funds focused on emerging markets make sense if you look at performance numbers over the past three years.

Hedge funds focused on the emerging markets had the best returns with an 18 per cent annual return during 2001-04, closely followed by distressed debt focused funds at 17 per cent. More conventional hedge fund strategies of tech at 0 per cent and risk arbitrage at 3 per cent annual return lagged far behind.

Given the constant inflows into new hedge funds, clients do not yet seem to be bothered about paying higher and higher fees for lower returns, but this is a discussion that I am sure will come up at some stage in most investment committees.

At some stage if the hedge fund community continues to show declining alpha (excess returns), clients will need to question whether the proliferation of hedgies has reduced returns because the field has become too competitive.

The beauty of the hedge fund business and the reason why the upward drift in fee structure is even more surprising is the ease of entry of new players into the game. The average long short hedge fund needs only about six back office staff per billion dollars, while a global macro fund needs about 11 people for a fund of similar size (Morgan Stanley survey).

The typical long short US equity manager has only nine investment professionals and three in the back office. These funds are also not really regulated and have very limited disclosure requirements, if any.

The start-up costs of these vehicles are also minimal and most funds will be able to break even at sub $100 million in assets under management. There is no other industry that I am aware of where exit and entry are as simple.

Hedge funds till date in 2005 have had a tough year; there have been few strong trends to capitalise on and most funds are struggling to show a positive return. If the hedge fund industry ends the year flat or even (god forbid) negative after disappointing relative performance in 2003 and just about average numbers in 2004, some of the more sophisticated clients may migrate back to more conventional forms of investing with lower fee structures.