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Hedge fund industry shows improving trends, but challenges remain

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The hedge fund industry is showing signs of a recovery from the crisis and this is likely to continue in the near term, Moody’s Investors Service says in a new Industry Outlook on this sector.

However, the rating agency says the positive trends merit a degree of caution, especially as a number of individual failures occurred during the crisis and some funds are still dealing with the aftermath.

Nevertheless, Moody’s says that hedge funds on the whole showed resilience and flexibility in 2009 and many are now well positioned for growth.

In its review of 2009, Moody’s highlights that the early part of the year was arguably one of the most challenging and important periods in the hedge fund industry’s history.

"Having coped with difficult and erratic markets in 2008, including a massive systemic shock, the industry then had to face redemptions at an unprecedented level," says Odi Lahav, a Moody’s vice president – senior credit officer and author of the report.

Moody’s believes the industry as a whole is successfully adapting to the new market conditions and is recovering as performance improves and investors begin making allocations to hedge funds.

The recovery should continue in 2010, barring another major economic shock or regulatory shifts.

The report also indicates that net inflows and new start-ups will likely increase, albeit at subdued rates, and fund managers will very likely continue expanding their product offerings beyond hedge funds, testing different markets.

"We expect operational quality in the industry as a whole to improve, as market instability and uncertainty subside and as investors continue to maintain pressure on managers to strengthen their operations," says Lahav.

Moody’s also believes the credit quality of funds has started to improve and is likely to continue doing so in the near term, although many challenges persist, particularly for smaller funds and managers that remain somewhat distressed after the crisis.

The report cautions that these positive trends are largely dependent on economic conditions and investor confidence, as well as the global regulatory and taxation environment, which will remain sources of uncertainty in the coming months.

Lahav adds: "Another systemic shock or reputation damage caused by a large-scale failure may have knock-on effects on investor confidence and, if sufficiently severe, could undermine the foundations of the recovery."

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