Times have been tough for hedge funds and their investors of late. Once the cold-eyed monarchs of the investment realm, charging controversially high fees and taking extravagant rewards, the recent spectacular setbacks of some of the most celebrated practitioners have cast the whole sector in a garish light.

But many have managed to buck the bearish trends born of the credit crunch and recession and some are coming back to the market with new products adapted to the changed circumstances of today. Colin Maclean, head of Scottish Value Management, which is now launching its new UK Absolute Alpha Fund, insists the “main failures have been in regulated banks and insurance companies. There is no systemic failure in hedge funds”.

A move from the present unregulated hedge fund market to products covered by the EU’s Undertakings for Collective Investments in Transferable Securities Directive (UCITS 3) is gaining momentum to bring back cautious investors. At the same time, managers are shunning some of the more risky and illiquid activities of yore, such as leveraged buy-outs, where investors’ exits can be hard to discern and the weight of borrowings can choke the enterprise.

Global hedge fund assets have fallen more than 30 per cent from last July’s $2.6 trillion (£1.86 trillion) peak to around $1.8 trillion now, according to Hedge Fund Intelligence. The industry expects a further fall of some 20 per cent to $1.4 trillion in 2009, caused by the same mixture as last year’s negative investment performance and net redemptions by investors, where the funds have not closed the ‘gate’ and suspended redemptions.

Keeping their nerve

That does not mean it is all over for hedge funds, whose managers seek to enhance returns not by simply buying shares, currencies, commodities, property or other investment products, but to achieve better results by using derivative strategies, selling short in falling markets and other techniques. Far from it, argues Scottish Value’s Maclean, who explains its new UK Absolute Alpha Fund, with an initial target of £20 million and an ultimate cap of £200 million, launched under the auspices of UCITS 3, is able to go long and short and perform certain other hedge fund-type manoeuvres.

Ironically, the Financial Services Authority has for some time been taking soundings about creating a regulatory structure to allow funds investing in alternative investment funds, such as hedge funds, to be marketed directly to UK retail investors, which their perceived risk and complexity currently prevents. With a move to launching funds regulated under UCITS 3 in progress anyway and current recession-era investor caution holding sway, feeling in the market is that this change is no longer a hot priority.

“Investors are sitting on cash now,” says one fund manager, “but they may come back in the second quarter of the year.” The £23 billion Universities Superannuation Scheme, the UK’s second largest pension fund, recently made it clear it was sticking to its medium-term plan to double its exposure to alternative investments, including hedge funds, to 20 per cent of its portfolio.

But these days, investors are more concerned about the ability to get out as well as into their investments, maintains Maclean. “Clients now do not want hedge funds to get involved with leveraged buy-outs, where price discovery is obscure, structured finance or quasi, shadow banking”.

He sees merit in commodity trading and a “global macro” approach, which are the hallmarks of AHL, the $20 billion (£14.3 billion) managed futures fund run by the giant ‘alternative investment management’ concern Man Group. Covering currencies, commodities, equity and fixed interest indices, AHL achieved a positive return of 24.9 per cent last year, against a global industry average of -15 per cent recorded by Hedge Fund Intelligence.

Others have outperformed the markets spectacularly, too. Emerging markets player Emergent Asset Management, a London-based group partly owned by Toronto Dominion Bank, achieved a return of more than 75 per cent on one of its portfolios in 2008, a year when more than a quarter of the hedge funds which went out of business were invested in developing economies.

Stayers and leavers

Some among the plutocratic ranks of hedge fund managers are still keeping their heads very much above water. Lansdowne Partners, run by Stuart Roden and Peter Davies, which made £100 million from short selling Barclays Bank for two years, but lately said the UK banking sector was undervalued, is carrying on as before, say spokesmen. US hedge fund tycoon John Paulson made more than £200 million by short selling Lloyds Bank shares in September.

Crispin Odey, who steered Odey Asset Management to predict the banking crisis in time, has also said now is the time to invest in banks – and wheat. Nevertheless, the stage is clearly set for further drastic shakeouts among the hedge funds.

“Three quarters of the industry will go”, says one analyst at investment group Hargreaves Lansdowne. Funds of funds, which invest in a collection of hedge funds and whose fees are often even higher than the two per cent annual fee and 20 per cent profit commission typically levied by hedge funds, are seen as particularly vulnerable.

Another practitioner argues, “there are between 7,000 and 10,000 hedge funds, many spun out of banks as tame off-balance sheet clients. Half could fold with no impact whatsoever”.