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Recent figures have suggested that funds of hedge funds (FoHFs) are not the panacea for the ills of the investment world many financial advisers were hoping for. While Standard & Poor’s Fund Research revealed that year-to-date while FoHFs fell less than mainstream funds, “it is somewhat disappointing to report that they have shown more directionality this time around than in the 2000-03 bear market”, noted lead fund analyst Randal Goldsmith.

What this means in practice is that investors seeking non-correlated returns with the equity markets are likely to have watched in dismay as their returns went the same way as the more traditional markets. For example, a recent Lipper HFIR research study found that nine out of the 13 CS/Tremont hedge fund sub-strategies had correlations with the CRB/Jefferies commodity index of over 0.70. In plain English, this meant they were all highly correlated one way or another with the commodity market bull run, translates Ferenc Sanderson, a senior analyst at Lipper,

So are the days of FoHFs producing consistent and, more importantly, non-correlated absolute returns over? “It is a very challenging environment,” admits Andrew Gibson, head of client management at International Asset Management. A fund that is down by 3-4 per cent year-to-date in a strategy that has regularly been averaging an annual 12-15 per cent could be seen by clients as disappointing. However, he says, “considering we have been going through the worst financial crisis of the last 30 years I don’t think that our clients are feeling we have underperformed our mandate. It is very difficult to get the diversity benefit. When the markets tend to correlate, the fundamentals go out the door and everything becomes very sentiment driven".

Short-term market movements should always be seen in the light of the longer term, cautions Guy Boden, head of research at S&P Fund Research. “No one buys a FoHFs for a six-month period,” he says. “That would just be a mistake.”

But the bigger question is not necessarily whether or not this is a cyclical blip, but a secular shift. Most are agreed this is unlikely. What we are currently seeing a very rare occurrence of correlation between equities, bonds, property and certain commodities. “Certain strategies might not invest in equities,” explains Andrew Lodge, managing director of Ned Group Investments, “but the factors that drive returns are based on the same economic factors that drive the equity markets.”

What is likely to occur in this tough economic situation is many FoHFs – and their underlying hedge funds – will simply not survive. “What happens in this environment is that, as always, the strongest will survive,” says Mr Lodge. “Some funds will go under.”

The fall-out in the hedge fund market, driven by hubris as much as economic necessity, will have an obvious knock-on effect on those funds that invest in it.

To a certain extent, argues IAM’s Mr Gibson, this is healthy. “It’s a form of economic catharsis,” he says. “You live and die by performance, which can happen in good markets, but is heightened in a period of volatility.”

Paul Meader, a director of Corazon Capital, agrees. “What’s happening is not great for the investor or for the manager,” he says, “but it is good for the overall health of the industry.”

Conversely it might also provide a boon to those funds that have been more recently launched, adds Lipper’s Mr Sanderson. “You should also expect more institutional investors to be willing to look at good single manager performers with shorter tracks records and lower assets under management,” he says. “Today the bar is being lowered in an effort to find and get into alpha producers.”

There could also be a “massive turnover of hedge fund managers”, he adds. “If you do not perform then you are out. Approximate turnover was 20 per cent of a typical FoHFs portfolio a few years ago; this may now be as high as 40 per cent for some FoHFs.”

Those funds that are nimble – and perhaps smaller – are more likely to weather the oncoming storm, adds Mr Meader. “We can look at a manager with $100m who is looking to close at $400m, but the very big funds of funds can’t invest at that level,” he says.

“Just as big asset gatherers and big household names are not necessarily the route to success in the traditional equity markets so too they are not always the route to success in alternative investments.”