Should investors keep faith with hedge funds?

In the first half of this decade, those who promoted hedge funds complained that there was no movement in the markets from which they could not make money.

They were adamant that when the markets moved, they would make money for their investors.

We were repeatedly told that, because of the variety of assets which could be held and the trading practices that could be employed, hedge funds had the flexibility to make money even when markets fell.

They went further still, arguing that what they really desired was volatility - a volatile market would allow them to produce spectacular returns for their clients.

This is when they would really earn the elevated management fees they were charging.

So why, investors are asking, have the majority of hedge funds imploded since September 2007?

One hedge fund manager estimates the current size of the hedge fund industry to be around $1.2 trillion (down from $2.5 trillion at peak).

Why, in the most volatile markets in living memory, have the hedge funds not produced the spectacular returns they promised, or even hedged out the risk and broke even? And why have they made monumental losses and, in many cases, suspended trading?

Combine this sentiment with the financial sector's desire to stop short-selling and increase hedge fund transparency and it would be a logical conclusion that this is not the time to be buying hedge funds.

Hidden opportunities

Indeed, some would argue that the end of hedge funds is nigh. But are there hidden opportunities in the hedge fund wreckage and would an investor be wise to speculate against the trend as so often proves most profitable?

Sure, it is probably wise to stay clear of some of the existing funds with impaired liquidity and the risk collapsing under the weight of their own borrowing. But for new hedge funds, and those which were more prudent in the past, there is a greater potential for profit than at any time previously. If hedge funds can raise the money, there are some great buying opportunities for them at present.

Additionally, hedge funds continue to add diversity to a balanced portfolio, along with access to trading strategies which are not normally accessible to the average investor - arbitrage being the prime example.

Whilst it is important to remember that hedge funds are not the panacea that they were built up to be, do not write them off as a valuable part of a diverse investment portfolio.

If care is taken when selecting a fund, it could punch well above its weight. Take some time and enquire how much debt the fund took on in the 'boom years'. Also look at how much money is being taken into the fund now - whilst there are great opportunities at present, a hedge fund cannot take advantage of these if it is not receiving new money to invest.

Lastly, research the fund managers, have they come from a long-only background and, if so, were they able to adjust to the long/short world of hedge funds - and continue to produce alpha when the markets turned?

If your findings are positive, it is likely the fund will not only survive these turbulent times but actually flourish in the months and years to come. And who knows, these phoenixes which rise from the ashes may even give hedge funds a better name.