This publication has spoken with wealth advisors in recent days to find out about the issues, problems and goals that they have in regard to the hedge fund sector as it has recovered from the lean year of 2008.

Hedge funds are in the news again, this time for the record pay-outs of the top managers.

The top 25 managers averaged $1 billion each last year, led by David Tepper of Appaloosa Management, who made $4 billion in fees and capital gains, largely because he bet big that the government wouldn’t let big banks fail.

Appaloosa was up more than 130 per cent in 2009, and Quantum Endowment, the fund run by George Soros, the earnings runner-up in last week’s AR: Absolute Return + Alpha magazine rankings with $3.3 billion, grew a less stratospheric but still impressive 29 per cent.

But while the very best did very well, there are over 9,000 hedge funds around the world, many of whom definitely did not do so well.

In fact, thousands of hedge funds have gone out of business in the past three years, leaving the industry with about 25 per cent fewer firms than at its peak.

Losses industry-wide averaged around 20 per cent in 2008, and even the top performers - including Tepper - suffered double-digit losses.

So how are wealth managers and their clients approaching hedge funds these days?

Two tiers

It appears to be a tale of two tiers of wealth, with many high net worth investors pulling back from hedge funds, and ultra-high net worth clients tending to stay in.

Some investors were simply spooked by the scary market downturn and weren’t willing to take the kinds of risks that hedge funds take; others lost money and weren’t able to meet the $1 million-plus minimums or pay the high fees and percentage of gains that funds demand.

And as the market tightened and the Bernard Madoff scandal spread, so did well-founded concerns about liquidity and transparency in a very lightly regulated industry.

“It’s clear that there is now much greater appreciation for liquidity constraints,” said Stephen Horan, head of private wealth management for CFA Institute in Charlottesville, Va. “It turned out that liquidity was the chink in the armor for the endowment model.”

Not being able to have ready access to cash was worrisome even for wealthy families, said Rick Pitcairn, chief investment officer for Pitcairn, the Jenkintown, Pa.-based multifamily office that has approximately $3 billion in assets under management.

“Investor demand for illiquid holdings fell dramatically as people got scared,” Pitcairn said.

Clients also want greater accountability, wealth managers say.

“They are more educated now,” said Ira Rapaport, chief executive of Private Wealth Advisors LLC of Wellesley, Ma. “They want a better understanding of what a fund is holding. They also want transparency, liquidity and they are more fee-conscious.”

Risk concerns have also made many investors think twice about hedge funds, according to wealth mangers.

“There’s been a real change in investor appetite,” Pitcairn said. “There was not a lot of attention paid to risk before 2008, but now investors are taking a close look at the risk side as well as return,”

Rapaport, whose firm has around $500 million in assets under management, agreed.

“People are not looking for the highest return now,” he said. “They are looking for the strongest risk-adjusted returns, and they are being much more selective.”

Ultra-high net worth investors who have more than  $20 million or $25 million in investable assets are also being more demanding, but are more likely to stick with traditional hedge funds,  according to wealth managers.

“Many of our clients have hedge funds and we have not seen them running for the exit, nor are we advising them to do so,” said Greg Van Slyke, a founder and partner of Lake Street Advisors of Portsmouth, NH.

The firm has over $2 billion in assets under management and the average family client has over $50 million invested, Van Slyke said.

“Clients are staying with the hedge funds, but they are also looking for a higher level of scrutiny and asking more questions, and the hedge funds have been more forthcoming than they used to be,” he added.

Pitcairn said most of his wealthier clients have also maintained their position in hedge funds.

“They’ve been able to meet the accreditation standards and we’ve seen good activity with that group,” he said.

Jamie McLaughlin, who worked closely with ultra-wealthy clients while chief executive of New York-based Geller Family Office Services, said the investors in the best funds stayed the course even through the market free-fall.

“They tend to be more sophisticated investors and they were patient,” McLaughlin said.

What’s more, long/short hedge funds are well-positioned to maintain their popularity with ultra-wealthy investors, he argued.

“In a market environment where you’re beginning to have pressure on interest rates, have  anemic fundamentals for equities and an uncertain business cycle what are you going to do? “ McLaughlin said.

“Long/short hedge funds have very good stock pickers who can analyze the intrinsic value of a stock for and against. Because they can short a stock they can exploit whatever market vicissitudes unfold.”

Van Slyke agreed.

“The ability to short is a powerful tool,” he said, “although dangerous in the wrong hands.”

Seeking more liquid alternatives

While hedge funds remain popular with ultra-high net worth investors, those with relatively less wealth are looking beyond traditional limited partner funds with high fees and percentages and limited liquidity and transparency.

“Hedge funds are not going away, but we are seeing a trend toward more liquid alternatives,” said Gary Carrai, senior managing director for outsource platform provider Fortigent.

“We’re seeing more mutual funds structured in a way that look and feel like a hedge fund only with daily liquidity and more transparency. There are now long/short funds that are not limited partnerships but separate accounts so investors know what’s happening with trading, and can get around the Madoff issue, so to speak," Carrai said.

“It’s philosophically important for us to retain liquidity and be able to get out of things if they go bad,” said Norm Boone, president of San Francisco-based Mosaic Financial Partners.

Boone said he has shied away from putting his clients in traditional hedge funds and instead considered other options, including mutual funds, individual securities, commodities and real estate funds. (In the case of some of these options, these are typically long-only investments but some of them, such as ETFs, can come in forms where they make money from a bear market as well as a rising market).

Open-ended mutual funds with hedge-fund characteristics, fund of funds and exchange-traded funds appear to be the most popular replacement for traditional hedge funds in wealth managers’ portfolios, managers said. (In the European Union, hedge fund-"lite" products such as UCITS III funds have been popular, due to their high liquidity, transparency and relative ease of access to even retail investors).

Mutual funds

In fact, in a recent survey of financial advisors by the Boston-based research firm Aite Group, nearly one-quarter of advisors surveyed said they expect mutual funds to gain the most as a percentage of their assets under management in the next three years, and 13 per cent cited exchange-traded funds.

“We’re seeing ETFs getting traction and gaining in popularity as investors demand liquidity and see how hedge funds have been performing,” said Alois Pirker, research director for Aite Group.

“Investors are re-thinking the size of their commitment to hedge funds,” said Stephen Cucchiaro, president of Boston-based Winward Investment Management.

Cucchiaro cites Winwards’ 30 per cent-plus gains in assets under management  in 2008 and 2009 as evidence, bringing the firm’s assets to over $3.6 billion.

“Investors and wealth managers who  want liquidity are looking for alternatives and see firms like ours as a solution,” Cucchiaro said. “We have a globally diversified strategy using ETFs that has been very successful.”

ETFs are also being employed more by multi-family offices who have become more concerned with liquidity after the market downturn, and as transferring generational wealth becomes an issue, said Mark Wickersham, senior associate for Family Office Metrics in Boston.

“They like the fact that they’re cost-effective and can be sold when the families need to sell,” Wickersham said.

Even ultra-high net worth investors, who have stayed loyal to traditional hedge funds, are now “willing to have conversations about ETFs,” said  Stephen Horan, head of private wealth management for CFA Institute in Charlottesville, Virginia.

“It’s in the context of a core-satellite strategy,” Horan said, “and those investors are now comfortable with ETFs in their core holdings.”

So-called “replicator” or “tracking” funds  that try to reproduce hedge fund strategies at a much lower price are also seen as emerging alternatives to fill the void left by second thoughts about traditional  hedge funds.

Industry expert Bruce Lipnick, chief executive of Asset Alliance, an investment firm that specializes in acquiring, seeding and growing hedge funds, said in a recent interview with Finalternatives that over the next five years he expects to “see more ‘tracking funds,’ or funds that mimic a basket of hedge funds.”

No matter what investment vehicles are being used to replace hedge funds, investors - and wealth managers - are being driven by concern about risk, said Ira Rapaport, chief executive of Private Wealth Advisors of Wellesley, Massachusetts.

“In this environment, we are looking for tools and solutions to further diversify a client’s portfolio to have non-correlated investments,” Rapaport said