Hedge funds, like so many other things, had a horrendous year in 2008. They posted their worst performance on record, a decline of 19 percent; meanwhile, several high profile funds blew up and nearly one-third of the hedge funds tracked by Morningstar closed their doors. Of course, there were few asset classes and strategies that did perform well last year. But the stereotypical hedge fund was supposed to be different: An alpha generator with the mandate to go anywhere, to claw out gains no matter the state of the capital markets.

Stronger performance has returned this year—most indices showed gains of 9 percent through May—but hedge funds continue to close at a record pace. (A shakeout was needed.) And, more important, what happened in 2008? Was it a one-off black swan event? Or does it change how financial advisors and investors should regard hedge funds from here on out? In the new environment, advisors will have to be more careful about selecting non-correlated alternative strategies and making them fit into client portfolios, according to a recent white paper called “Alternatives 2.0: What is the Prudent Investor To Do,” sponsored by Rydex and SGI Security Global Investors.

But the paper also suggests that alternatives remain a viable and crucial part of wealth management. This may be especially true as more hedge fund products become available to retail investors. They now come in many more kinds of wrappers—1940 Act mutual funds, managed accounts and, for the first time this year, ETFs. These vehicles are worth considering if only for their transparency and potentially reduced costs.

The Upset in 08
Hedge funds are generally expected to perform well regardless of the direction of equity markets because correlations between hedge funds and equities are thought to be very low. But last year, correlations proved to be relative, according to data from the white paper. “Correlations between equity and alternatives suddenly changed last year,” says Maarten Nederlof, co-author of the white paper and principal of consulting group Safari Advisors. “They became much more similar due to volatility.” For one thing, there was more exposure to equities in many hedge funds than most people thought, he says.

The other problems were perhaps less of a surprise: leverage and liquidity. Because the hedge fund space has gotten more crowded over the years, competition increased, managers began mimicking each other, and returns shrank, he says. As a result, in order to continue to get equity-like returns, many hedge funds piled on the leverage. When managers began to get margins calls, they couldn’t sell their illiquid assets and so they sold what equities they had instead, putting further pressure on the equity market and reducing their liquidity. The result was a major liquidity crunch.

So far, investors and advisors seem to have put the brakes on new hedge fund investments. After all, not only did hedge funds generally have a horrible year in 2008. The spectacular frauds of Bernie Madoff and Alan Stanford also made many suddenly skittish about the relatively illiquid, opaque investment limited partnerships. Redemptions slowed in the second quarter to around 5 percent of total industry assets of $1.3 trillion, according to estimates in a Morgan Stanley research report titled “Wholesale Financials.” That’s down from redemptions of nearly 10 percent in the first quarter and 25 percent in the fourth quarter of last year. But on a net basis, new money is not flowing into hedge funds at the moment.

The Road Ahead
Hedge funds still offer better risk/reward efficiency, when used properly, than equities and bonds do over time—and this was the case even during the last market decline. Between January 2007 and December 2008, a standard portfolio of 60 percent equities and 40 percent bonds would have posted an average annualized return of negative 8.8 percent, where as a portfolio with 50 percent equities, 30 percent bonds and 20 percent alternatives would have returned negative 8.4 percent, according to the white paper.

But the landscape has changed. Today, the process of due diligence that financial advisors need to conduct before selecting a product has become much more complex, says the white paper. Alternatives will need to be evaluated using a more disciplined approach and more rigorous criteria. Choosing the right the right strategy and managers is going to require a lot more hard work.

And here’s why: Even if last year was a black swan—an event so rare that it is highly unlikely to occur again in decades—the kind of shock that losses on the order of 20 to 40 percent deliver to portfolios, and the difficulty of ever making up for those losses over time, is too great to ignore, the paper says. The lesson of last year’s upset, then, is that financial advisors need to begin to focus more on downside risk protection.

Alternatives can help with this. But “selection, modeling and allocation techniques must be much more robust in their treatment of alternatives,” writes Nederlof. A mix of alternative strategies needs to be selected not just based on traditional risk/return measures, but after an examination of the leverage, liquidity and transparency characteristics of the strategies, their exposures to key market risks and the way they respond to volatility, and how all of these things compare to other portfolio holdings. The study offers detailed steps for evaluating a portfolio and a manager, and then suggests these steps must be repeated, and often.

New Stuff
Some advisors may want to consider newer more transparent vehicles, such as ETFs and mutual funds that use hedge fund-like strategies, or even hedge funds wrapped in managed accounts, a structure to which many hedge funds have moved since the beginning of 2008. A couple of hedge fund ETFs have been launched in recent months, and many more have been filed with the SEC. In late March, IndexIQ launched the first of these hedge fund ETFs, called IQ Hedge Multi-Strat ETF (QAI), which has exposure to all of the major hedge fund strategies. And IndexIQ told the SEC in April it plans to launch as many as 15 more ETFs that track different hedge fund strategies. Meanwhile, WisdomTree Investments, has filed with the SEC to offer three actively managed hedge fund ETFs: WisdomTree Real Return Fund, WisdomTree Managed Futures Fund and WisdomTree Long-Short Fund.

“The benefit is that you can buy it and sell it within a minute, the transparency, the tax benefits, the convenience and, of course, the fees,” says Rob Ivanoff, research analyst with Financial Research Corp. of Boston. Instead of the 20 percent performance fees charged by a typical hedge fund, investors would pay less than 1 percent for an ETF. On the other hand, the ETFs are, obviously, new and untested. “They might not perform well based on the models they have been structured around. And they haven’t been rated by any agencies yet, because they don’t have any performance history,” Ivanoff continues. This will affect the bid-ask spread on the product and make it less liquid and more expensive to trade in and out of.