“Absolute return funds are set for renewed growth as investors focus on risk-adjusted returns. We see the early stages of a turnaround in hedge fund flows with redemption pressures easing and inflows growing,” the note from the Wall Street firm said yesterday.

Echoing other comments by professionals inside and outside the hedge fund space, Morgan Stanley said it expected the revived interest in hedge funds to be led by pension funds and foundations.

“We think the market is underestimating the potential upsurge in demand for absolute return funds from private clients and smaller institutions via UCITS III,” it said, referring to the cross-border European fund-wrapper structure.

As reported recently by WealthBriefing, investment consultants say the UCITS III fund model, which enables funds to harness derivatives to manage exposure in a manner akin to hedge funds, is likely to be increasingly popular, because these funds offer high liquidity and are transparent about their dealings.

The note pointed out that in the UK alone, there were $2.1 billion of inflows during the third quarter of this year into absolute return funds, triple the size of the inflows seen in the first three months of 2009.

Morgan Stanley said it has an “overweight” stance on Man Group, the London-listed hedge fund firm.