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It’s a natural response to a cold environment. Faced with a wave of redemptions and pounded by losses, almost 1,500 hedge funds out of some 10,000 closed shop last year. Although some 650 new funds were launched, the net shrinkage looks set to continue.

Hedge funds suffered net outflows of more than $154bn last year as bedraggled investors pulled their money out, according to Hedge Fund Research. Most respondents to a Deutsche Bank survey of investors with $1,100bn managed by hedge funds expect more than a fifth of hedgies to fold in 2009. Close to a third expect outflows to top $200bn this year.

After 2007, when net inflows topped $194bn, hedge funds only enjoyed about half a year of decent returns before they hit the buzz saw of the credit crunch. So it’s not surprising to see hot money heading for the exit. Investors who plan on sticking round – such as big institutional investors – are mainly interested in larger funds with long track records.

Small funds will suffer most. The old business model of a 2 per cent management fee and 20 per cent of profits is finished. Some funds are now marketing their services at 1 and 15. If that becomes the new norm – and even that may be high – smaller funds, even if able to attract investment, will find it hard to attract talent and pay the bills.

In the future, big funds will therefore likely get bigger as smaller managers combine or disappear. Talent will become stickier. Economies of scale mean young bucks who might have struck out on their own two years ago during the wave of easy money will be more likely to stay put. A smaller industry will make it easier for investors to sift through competing funds to find the best managers – making the rationale for the existence of the fund of funds industry ever more dubious.

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