Hedge fund assets are expected to bottom out at around $1 trillion this year. However, capital appreciation and an estimated $800 billion in net inflows over the next four years are expected to push global levels to $2.6 trillion by 2013. All that is according to a new study of institutional investors, investment consultants and hedge funds released today by The Bank of New York and Casey, Quirk & Associates. 

The study notes that institutions remain firmly committed to hedge fund investing. Institutional investors comprised less than 20% of hedge fund redemptions in 2008-2009, and North American pension plans will represent the single largest source of new capital between 2010 and 2013, followed by British and Northern European institutions. Global high-net-worth investors could account for as much as 60% of new net flows between 2010 and 2013, although their return to hedge fund strategies will rely on capital market conditions and hedge fund performance.

Funds of hedge funds will solidify their role as the primary hedge fund distribution channel, capturing almost 60% of net inflows between 2010 and 2013 by continuing to offer services that most investors will find difficult to replicate on their own, such as manager-sourcing and ongoing due diligence, the survey notes.

According to the report, the hedge fund industry is facing a "transformational crisis" and must address key shortcomings in its business and operating models. As a result, hedge funds will rely more on third parties for a growing range of administrative support. Fund administrators will play a greater role in hedge funds' operations, which will require stronger integration of hedge fund servicing activity with traditional custody and cash platforms.

"The events of 2008 have changed the old dynamic. Investor and regulatory demands for new levels of transparency mean the legacy operating model no longer works," says Brian Ruane, executive vice-president of Alternative Investment Services at The Bank of New York Mellon. "Hedge funds increasingly will turn to independent third parties for middle- and back-office functions such as portfolio accounting and reconciliation, custody of non-collateral assets, pricing and valuation, cash management, and counter-party risk-mitigation. Allowing third parties to play a bigger role in their business will be a sign the hedge fund industry is maturing."