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Making predictions is a risky business. When a group of Swiss private bankers created the first fund of
hedge funds in the late 1960s, they may have thought of this innovation, like their
sideburns and flared three piece suits, as little more than a passing trend. Few would have dared to imagine
that they had started an industry which nearly 40 years on would have half a trillion dollars in AUM and an ever-growing institutional client base.

Back in the 1960s and 1970s hedge fund investment was limited to a handful of investment styles. Most of the underlying hedge fund managers could be found in or around New York and, for a fund of funds, research and due diligence was more about who, not what, you knew. As the industry has developed there has been little need to reinvent the basic investment model - diversify risk by constructing a portfolio of different managers and styles. Innovation has been largely on the process and delivery side - better due diligence, enhanced risk management, new products, vehicles and distribution channels.

As far as new investment ideas and strategies are concerned, it is the hedge funds themselves that have been the innovators. Where hedge funds have led, funds of hedge funds have tended to follow.

Until recently. Funds of hedge funds now face a competitive threat that may inspire some to rethink their investment model. The threat comes from hedge funds themselves with the rise of large multi-strategy hedge fund groups. These are hedge funds that have grown up and see themselves as institutional asset managers in their own right. They offer style (or strategy) diversification as a one-stop shop with one layer of fees - diversified fund of different strategies managed by a group of internal portfolio managers.

Funds of hedge funds are fighting back: they point out the additional risks that multi-strategy funds can carry (high operational risk, poor liquidity, concentrated positions). The fund of funds model importantly allocates capital to external managers. This detachment enables objective appraisal and diversifies operational risk.

But some funds of hedge funds are also seeing if there is anything they can learn from the multi-strategy managers. The old way of investing for a fund of funds was to look for good managers with track records.

But many established hedge funds are at capacity or have morphed into multi-strategy managers. Funds of hedge funds need to find ever more investment talent and capacity in which to allocate their growing client assets. By targeting emerging or new hedge funds, some funds of funds are not only resolving the capacity problem but also creating an opportunity to have more control over the risks and strategies that the managers employ. They are taking the initiative by researching investment opportunities and then finding the talent to exploit those opportunities. Combine this with increasing transparency and a dynamic approach to risk budgeting and you have a compelling model for the fund of hedge funds firm for the next 40 years.

The fund of hedge funds firm of the future will combine what is best of both multi-strategy managers (responding quickly to new opportunities) and traditional funds of funds (objective, best in class selection and risk management). It will serve primarily institutional clients that want alpha, not disguised beta. It will negotiate terms with the underlying managers and pass the benefits directly to its clients, thus effectively eliminating the additional fee layer.

The fund of funds of the future will have a clear understanding of the manager-specific and aggregate risk in a portfolio of hedge funds. It will develop the capability of identifying and exploiting new investment opportunities. It will take the lead by seeking diversified sources of alpha from a range of external managers that it has seeded without the conflict of shared ownership or use of in-house portfolio managers.

Not all funds of hedge funds will follow this route; the bifurcation between the mainly institutional firms and those that predominantly service private clients will continue, as will the distinction between the independent specialists and the asset gathering, multi-product giants. But a group of funds of hedge funds will increasingly position themselves as the dedicated leaders, not followers, of investment fashion.

Stephen Oxley is a partner at Pacific Alternative Asset Management Company in London

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