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Hedge funds are unregulated investment vehicles pursuing a multitude of strategies that aim to exploit inefficiencies or anomalies in the markets.

They set out to achieve a profit regardless of the direction of the equity or other markets. Although often treated as an asset class by investors, hedge funds in fact trade traditional asset classes, while benefiting from less constrained investment mandates and the ability to vary their market exposure through the use of leverage, derivatives and short selling - and more recently deleveraging in order to protect investors' capital.

They have grown in popularity dramatically in the last 10 years as investors flocked towards the industry in an attempt to capture their superior risk-adjusted returns and capital preservation features.

Until 2008, hedge funds had produced very attractive, generally uncorrelated returns and effectively protected capital through various market crises. They emerged successfully in positive territory after the three-year bear market that followed the technology bubble burst in 2000. Unfortunately, this year has been another story. As the sub-prime crisis spread throughout the financial industry, hedge funds found there was nowhere to hide and produced negative results in the 12 months to the end of September, albeit still performing better than equities.

A fair criticism is that there has been increasingly high correlation between the hedge fund strategies themselves, removing some of their diversification benefits. Hedge funds have continued to show some capital preservation characteristics in comparison to their traditional counterparts. However in recent months they have failed to generate the uncorrelated, absolute returns investors had expected. The impact of liquidity in this crisis meant that many hedges put in place to protect portfolios did not work as intended and in some cases hedge funds, along with many investors, have been caught out by artificial market movements caused by political intervention. So the question arises as to where to invest?

An extreme flight to safety by investors caused treasury bills to rally to such an extent as to offer a negative real yield. They are an apparent safe investment in the short term, but as the world starts to emerge from this crisis investors will be looking for ways to put capital back to work and the volatility seen in traditional markets is exactly what many are trying to avoid. Investors are understandably wary of hedge funds given how 2008 performance has deviated so violently from previous trends. Short sellers in particular, have come under fire recently for driving financial stocks into failure. Short sellers can not be wholly blamed for this crisis but they certainly had their part to play. For now, short selling of financials is prohibited by most regulators and although this is a temporary ban it is reasonable to expect increased regulation and disclosure requirements in the future.

There are those that claim this will be the demise of the hedge fund model. By contrast there are those with a polar opposite view that hedge funds will be the biggest winners from this crisis. Of course, reality will end up somewhere in between and it is likely that investors will be saying with the benefit of hindsight that they should have asked which hedge funds to invest in and how to go about investing, rather than whether or not to invest at all.

Beyond investment risk, the biggest risk to hedge funds at the moment is a 'run on the bank'. An important factor here is the liquidity offered to investors versus the real liquidity of the underlying investments. Many hedge funds have found themselves caught in a liquidity trap, not dissimilar to those effecting banks, unable to price or sell portions of their portfolios. Although this makes monthly net asset value pricing difficult it poses a more real problem as investors redeem assets. The hedge fund industry at large is preparing for this by raising cash levels ahead of potential year-end redemptions.

One solution for funds is to lock-up investors for long periods of time and require lengthy notice periods prior to redemptions. This can make sense from an investment perspective, where the funds hold illiquid securities, but does little to alleviate investors' concerns in the current environment. Hedge funds have also had to become increasingly conscious of counterparty risk, which came to a head this year with the demise of Bear Sterns and Lehman Brothers.

Finally, in the unfortunate event of a fund closing its doors and liquidating assets there is not always an alignment of interests between investors and the managers. It is the investors’ priority to receive the maximum value for their assets in the shortest time possible. Although this should be also the goal of the fund, understandably they will be balancing this with a desire to protect their business.

What protection is available?

Investing through a managed account platform reduces many of these risks, by allowing investors greater liquidity, transparency and security. Managed account platforms set-up dedicated, segregated accounts where the hedge fund manager replicates their positions, under specific risk limits and guidelines, but the assets remain under the control of the platform provider. Transparency is integral to the approach of a managed account platform allowing for true independent risk management and valuation. These platforms typically offer preferential liquidity to investors, which mean avoiding illiquid or hard-to-price securities. This secure set-up provides investors comfort by eliminating idiosyncrasies between the legal and operational set-up of individual funds. Since the start of the credit crisis last year the benefits of this type of investing have come to the forefront of investors minds.

Undoubtedly market turmoil and regulatory changes make the environment substantially more difficult for hedge fund managers and, for that matter, for any investor. One thing the hedge fund industry has shown is an outstanding ability to innovate and for those managers that survive the crisis there are a multitude of investment opportunities. A mass of inefficiencies have been created as markets have been driven by fear and lack of liquidity rather than fundamentals.

Market participants have focused on the negative impact of the regulatory changes prohibiting short selling. Of course, this changes the playing field, and will likely reduce shorting of small-cap stocks as managers avoid the risk of a short squeeze. This is in no way a one way street and there will be advantages to those who successfully adapt. Finally a reduction in assets across the board from redemptions, closures and massive deleveraging should make these opportunities all the more profitable. You just have to stay in the game.

A sensible conclusion would be that allocations to hedge funds are still appropriate, although more than ever, you need to be highly selective and positioned in the correct strategies and funds with a heightened focus on liquidity and security.

Kate Brown is portfolio manager on the investment team for SG Hambros.