Marten Co recently provided some research on a fund of hedge funds, Altin (ALTN). As we were drafting the note, one thing became quite obvious. In the UK investment company space at least, funds of hedge funds are close to extinction.

The pace of the decline has, if anything, accelerated over the last few months as first Lyxor Focus Fund was liquidated and now Dexion Absolute (DAB ) and Acencia Debt Strategies (ACD ) are about to hand back about half their assets to exiting shareholders.

Just five years ago these investment trusts, which invest in hedge funds, had net assets of almost £3 billion. Today this is less than £400 million and falling. Clearly this is not a popular part of the market but has the shrinkage gone too far?

Funds of hedge funds are doubly damned in some investors’ eyes for being both funds of funds and for being invested in hedge funds.

As a former fund of funds manager, I know these funds are not popular with some investors who baulk at two layers of fees.

It is not practical however for most investors to replicate the portfolios of most funds of hedge funds. The minimum size requirements for direct investments in most hedge funds would rule this out for all but the richest investors and the depth of resource needed to replicate the research and due diligence of most fund of hedge fund managers is beyond most investors.

So if you accept the need to outsource investment into hedge funds to a specialist, that person has to be paid. How much is debatable but covering the 10,000 odd funds available is not a simple or cheap task.

The important thing is to look at historic and projected returns excluding fees and decide whether you feel these are attractive.

The hedge fund universe encompasses an enormous variety of investment strategies with very different risk and return characteristics. A fund of hedge funds blends these into a portfolio that can produce attractive returns with lower levels of volatility than an equivalent long-only fund. 

The hedge fund sector has been unpopular in the UK since the Bernie Madoff scandal and the bursting of the credit bubble. Frauds pop up from time to time in all industries and, in hindsight, it is easy to ask why nobody saw them coming.

The culture of secrecy that surrounds hedge funds (particularly about what they hold and are buying and selling) was partly responsible for Madoff and still creates a sense of unease for some people.

However, there is a big difference between the level of disclosure offered to investors and that offered to non-investors, and this is another argument for outsourcing the choice of funds to an expert who has been following them for a while.

Madoff just compounded an existing image problem for the hedge fund industry. The events surrounding the bursting of the credit bubble, particularly the Lehman bankruptcy, really turned investors off hedge funds. Many people bought listed hedge funds in the run up to these events hoping they would offer them some downside protection. However, the near systemic collapse triggered by Lehman left nowhere to hide.

A desperate search for liquidity drove down the values of all assets and overwhelmed many hedge funds who could not fund redemptions. Discounts on listed funds spiked and what was supposed to be a safe investment became problematic.

For many months afterwards the listed hedge fund story was all about discount control – and, as managers struggled to realise assets to fund buy-backs, the illiquidity of underlying portfolios. Arbitrageurs and discount driven investors smelled blood and started buying these funds just to shut them down.

It would be silly to say the events of 2008 could never happen again but theoretically a lot of the action taken by regulators and central banks since then has been aimed at preventing this. In a more normal market correction, hedge funds should have a much better chance of proving their worth as vehicles designed to offer low volatility and low correlation to markets.

It became apparent, as we wrote the note, that it is important not to have too little risk in the portfolio. When I last wrote on hedge funds back in April 2011, I speculated that many funds had been diversifying away returns in an effort to reduce risk. Altin admits it was guilty of taking too little risk at this time.

Managers were, perhaps understandably, shell-shocked after the events of 2008/09 and then the euro crisis sparked fears of a repeat of this. Altin tackled the problem with changes to its management but still sees evidence of an over-aversion to risk leading to lacklustre returns from many managers of hedge funds, particularly in Europe.

One conclusion from the work we did on Altin was that you need a closed-end structure to do justice to this sector. While investors had concerns about the illiquidity of the underlying portfolios of these funds, the reality is that some of the best performing hedge funds need long notice periods because of the nature of their holdings.

A fixed capital structure lets you hold these and Altin’s portfolio advisers argue that closed-end funds of hedge funds should be taking full advantage of the benefit of the structure as it gives them a big advantage over open-ended ones like unit trusts and Oeics.

In the US, the hedge fund industry is thriving. I believe these funds have a role to play, especially after a long bull run, and it is time to call a halt to the shrinkage of this part of the investment companies market.

James Carthew is a director at Marten Co