By Scott Paul Frush, CFA, CFP, President, Frush Financial Group, Author of "Understanding Hedge Funds" and "Optimal Investing"

Hedge funds have become a significant force in investing and wealth management. The growth of the trade is truly astounding. Today, there are over 9,000 hedge funds with approximately $1.4 trillion in assets under management. The market over the most recent couple of decades provided the foundation and support for hedge funds to grow and flourish, with the conditions ripe for an industry with strong potential and interest.

However, let's put the past behind us for a moment and think about the future and what it may hold for hedge fund investing. Many questions quickly surface when we think about this topic. Will present-day conditions continue into the future, or will they disappear? Will government regulations squeeze the industry, essentially turning hedge funds into glorified mutual funds, or will government continue to provide minimal regulation?

Given the colossal collapse of Amaranth Advisors in 2006 and the near failure of Bear Stearns' hedge fund group in 2007 from massive subprime mortgage losses, changes are needed to protect investors and safeguard their money. Therefore a solid balance between good regulation and overregulation must be struck to benefit all stakeholders.

One thing is for certain: The hedge fund trade will experience changes over the foreseeable future. But what will these changes specifically affect? The following are the five probable changes to the hedge fund trade:

1. Hedge Fund Companies Will Increase in Size and Offerings

This trend has been developing for some time as existing hedge fund companies expand in size and scope and establish new hedge funds in their product offerings. Over the next few years, hedge fund companies will strive to add more funds and grow their companies, thus capturing economies of scale. With the money many of these hedge funds earn, financing more expansion will not be especially difficult. This expansion most likely will create mega-hedge fund companies that offer hedge funds in each strategy, with multi-strategies and fund of funds offerings included to enhance and complete what they offer to institutional and high-net-worth investors. A push to become more consultative also will occur over the next several years.

2. Hedge Fund Regulation Will Increase

This is another trend that has been ongoing and is expected to continue into the foreseeable future. Without doubt, the Securities and Exchange Commission (SEC) will hunt for ways to regulate hedge funds. We have seen this in practically everything the SEC does and says regarding hedge funds. The end result of this heightened regulation most likely will include the following:

  • Full registration of hedge fund managers

  • Greater disclosure of hedge fund holdings and tools employed

  • Modest limitations on tactics and techniques used

  • Increased liquidity

  • More stringent regulations on who is an accredited investor (occurred in 2007)

Entities that will bring their influence - both positive and negative - to bear on the hedge fund trade include governmental regulatory entities, related third parties such as broker-dealers and institutional investors, and political entities. It is only a matter of time before regulatory entities sink their teeth into hedge funds.

3. Reduced Hedge Fund Fees

The question is not if but when hedge fund fees will decline overall. Asset-based fees are most likely to remain largely intact and untouched, but performance-incentive fees will see pressure owing to two primary factors. First, with so many new hedge funds being established, managers will reduce their rates from the typical 20 percent of profits to give them an advantage over other managers. This will set them apart and attract additional investors.

Second, with many institutional investors increasing their allocations to hedge funds, pressure to reduce rates will increase. These institutions will swap capital invested for a reduced rate - a quantity discount of sorts. Many managers will continue to keep their 20:1 (performance-incentive and investment-management) fees steady given strong historical performance and resulting demand for their services. However, for the most part, hedge fund managers will experience declines in the fees they charge, much like what mutual funds experienced many years ago.

4. More Robust and Additional Hedge Fund Indices

Index-based investing is not a new approach to traditional investing but is new to hedge fund investing. Over time, more standardized investable indices will emerge that will enable investors to generate returns that mirror the performance of any one of the different hedge fund strategies. Soon hedge fund investors will be able to hold index-based derivatives, now in their infancy.

In addition, hedge fund indices themselves will improve because there is a concerted effort by data providers and hedge fund managers to provide the best data possible to construct acceptable indices. Given the pressure from institutions to provide greater transparency, hedge fund managers will improve the data provided not only to their institutional investors but also to those who construct indices. This means that both institutional and retail investors will have better and more reliable benchmarks to facilitate performance measurement and ongoing investment decisions.

5. Enhanced Investor Liquidity

Most hedge funds impose one-year lockup periods for new money and 90-day notice periods for withdrawing money from existing investments. For hedge funds that invest in long-term investments such as venture-capital projects or highly illiquid assets, requiring long periods of time before withdrawing money is more than fair and appropriate. However, many of the remaining investments held in a hedge fund can be liquidated in a relatively short period of time, such as weeks or even days. This means that hedge fund managers have the flexibility to change their requirements and thus enhance investor liquidity.

In doing so, hedge fund managers will set themselves apart from other managers, and this will help them to attract additional investments from both institutional and high-net-worth investors. Many hedge fund managers will move toward enhancing investor liquidity on their own, whereas others will be either highly motivated or required to do so by institutional investors and governmental entities. The end result will benefit investors and help hedge funds to compete with more traditional investments that, in today's investing marketplace, are more advantageous in this regard.