LONDON (HedgeWorld.com)–First the good news: a new McKinsey study sees the creation of hedge funds continuing unabated. Now the bad news: the management consulting firm forecasts that the trend will stall and reverse itself by 2010.

McKinsey’s study, The Asset Management Industry in 2010, aligns with the conclusions of other commentators who foresee a ‘barbelling’ of the hedge fund industry. It means that there will be very large-scale firms managing a minimum of $20 billion at one end and boutique alpha generators managing less than $5 billion at the other. Indeed, McKinsey expects the absolute number of funds at the small end to fall.

Data cited for the three years to 2004 shows the number of hedge funds grew 67% to 7,436, while the percentage of assets under management of the top 100 firms grew to 58% from 49%. In fact, the compounded annual growth rate of AUM of the top 100 firms was 29% – more than double that of the remaining firms.

But the study foresees other pressures on the big hedge funds. Chief among them is that they will face crowding as the big long fund managers turn to leverage and shorting to seek new sources of alpha.

McKinsey also expects some fee erosion at large-scale funds due to institutional client pressure and product commoditisation. Smaller alpha boutiques will be less prone to fee erosion as long as superior performance is achieved, and will continue to be attractive to entrepreneurial investment managers, the study says.

In the meantime, traditional managers are expected to up the rate of either developing or acquiring alternative asset management capabilities. “This trend will only accelerate, due primarily to the increasing appetite among investors (particularly institutional) for such strategies,” the report says. “Alternatives will shift from being a ‘special case’ for many traditional managers to becoming a core asset class.”

But this inflow of institutional money carries a price. McKinsey says “alternative players will face pressure to “professionalize” their business models.” This means developing more scale, creating traditional products, broadening distribution and increasing transparency in order to help investors gauge how performance is achieved.

William.McIntosh@Reuters.com

Contact Bob Keane with questions or comments at bkeane@investmentadvisor.com.