Money is flowing into the hedge fund sector again. Globally, hedge fund assets under management reached $2.34 trillion globally. That’s still short of 2008’s peak of $2.94 trillion, but well above the three-year low of $1.73 trillion in early 2009.

Charles Baillie, co-head of alternative investments and global portfolio solutions at Goldman Sachs Asset Management reckons that three-quarters of hedge funds are at or near their high-water marks again.

The recovery has been swift. But the industry has also changed substantially. “The hedge fund industry has matured and moved from the rampant growth phase that we saw in 2006 to 2007,” says Joe McDonnell, head of diversified alternatives at Morgan Stanley Alternative Investment Partners. “The interest has moved from the private client world to the institutional space—which presents its own challenges for hedge fund businesses.”

 The hedge fund world is supposed to be about skill and persistent outperformance—qualities that have always been difficult to pin down in the long-only world.

“Skills are antithetical to scale,” says David Kabiller, founding principal of the quantitative investment manager AQR Kabiller. “There has been a paradigm shift from an asset class with $50 billion under management to one with [more than] $2 trillion.”

Scale has pushed the industry toward less-liquid and more-directional strategies. Furthermore, fund-of-fund managers coping with such large inflows and the fact that many of the best strategies are long closed to new business, are forced to invest more in strategies such as long/short equity, which are not so constrained. Skewed portfolios are the result.

But it does not have to be this way. Lisa Fridman, head of European research at Pacific Alternative Asset Management Company (Paamco), says most new flows have gone to the largest and well-established players, but there are bets on fresh talent too.

“It has been very exciting to see new launches in Europe after a subdued emerging manager activity in 2009,” Fridman says. She expects more new funds as regulatory and shareholder pressure force banks to close proprietary trading desks.

The flipside of the shrinking prop desks is that there might be even less liquidity for many managers’ favourite hedge fund strategies.

Classifying hedge fund opportunities can be done in many ways. They reflect the asset classes used, the instruments traded, and liquidity available for the strategy. Dow Jones Credit Suisse Hedge Fund indices (formerly Credit Suisse/Tremont Hedge Fund) divide the universe into nine sectors: convertible arbitrage, dedicated short bias, emerging markets, equity market neutral, event driven, fixed income arbitrage, global macro, long/short equity, managed futures and multi-strategy.

The most liquid include equity hedged (equity market neutral and long/short equity), managed futures, global macro and low-geared relative value.

The illiquid end of the spectrum includes event-driven relative-value strategies such as distressed debt and convertible arbitrage.

The split among these strategies varies tremendously between different funds of funds. John Angell, chief operating officer of Man Group’s fund-of-fund business, says that its offering is skewed towards equity hedged, global macro and low-geared relative value. Event-driven strategies and managed futures have a lower weight.

By contrast, Omar Kodmani, chief investment officer of the fund-of-fund manager Permal, says its portfolio focuses on broad liquid strategies—which for the firm encompasses macro, fixed income and equity-related strategies.

“This has been our hallmark since we started more than 30 years ago and these are strategies that work through time, unlike others that work only in limited market environments,” he says.

For tailor-made strategies the ratio of demand for liquid versus less-liquid strategies is 90-95% in favour of liquid, says Angell. That preference is no doubt a consequence of the crash: investors found themselves ‘gated’, because funds facing redemption notices had to sell their most liquid assets no matter the price.

The credit crash dislocations will take years to stabilise, which should provide immense opportunities for hedge funds. Global macro strategies have historically done well in the years after major market disturbances. They have the ability to exploit the asset price distortions, central bank actions and exchange rate readjustments that generally follow such events.

In 2008, Permal increased exposures to macro and systematic strategies. But in the past year it shifted towards discretionary macro strategies, believing such managers would be better suited to the uncertain environment. This includes plays on emerging market currencies and commodities, particularly agricultural commodities.

“We still see upside there and we are still positive on metals, where the technical position is still favourable in terms of demand versus supply whilst there is an ongoing arbitrage between gold and gold mining shares,” says Kodmani.

“But the global economy is now in a fragile zone: we put the probability of a double-dip recession at 30% and as a result we have to be balanced, and at the margin favour fixed income and macro strategies over equity-related ones.”

Man Group has a similar outlook. It is most positive on global macro strategies.

“The dislocations mean that there are plenty of opportunities out there,” says Angell. “With emerging markets, for example, there are opportunities with currencies, interest rates and sovereign debt markets giving rise to curve-flattening trades and fixed income arbitrage. Including commodities in global macro introduces another range of opportunities.”

Paamco’s Fridman notes that ‘risk-on/risk-off’ has presented “a difficult environment through which to navigate directional funds”, resulting in a more event driven-tilted portfolio. But its increasing bank loans exposure also illustrates how fund-of-fund players are well positioned to adapt their own portfolios to reflect the changing market environment, as well as short-term opportunities that are still attractive.

Distressed debt may well be a strategy with this kind of potential in the coming years.

Jason Mudrick, chief executive of the debt specialist Mudrick Capital Management points out that while defaults hit a high of 13% in 2010, most leveraged buyouts made at the height of the private equity boom have not yet been restructured.

“The period 2005-08 had the largest in number and value of leveraged buyouts in any three-year period in history, and at historically high leverage multiples averaging eight times EBITDA,” he says.

“Then we saw the most severe contraction since the Great Depression. That should be the cause of many restructurings.” However, these have been delayed because the debt was floating rate, and interest rates have fallen to near zero. With few covenants on the borrowing, companies have so far been able to avoid technical default.

As a result, there are likely to be a further wave of defaults. The first wave has already occurred, with companies that could not meet interest payments because the business environment changed. The next wave is approaching. It will be less correlated with the recession and more with debt maturity—much has to be refinanced over the next few years.

Companies more than six times leveraged will face a problem as capital markets demand interest rates at double-digit spreads over Libor. Restructurings are inevitable.

Some investors are keen to make these top-down decisions themselves—not least because they are no longer sure that a multi-strategy fund-of-funds is the best way to manage conflicting liquidity profiles.

“What we have seen throughout our history is that our investors are becoming more sophisticated in alternatives,” says Fridman at Paamco. “Some are investing directly in the larger hedge funds, while using funds of funds for niche strategies and specific portfolios that can complement their direct allocations.

“At the beginning of 2009, we had requests for a credit-focused fund of funds; more recently we are seeing demand for macro-oriented and event-driven exposure.”

The Madoff fraud had a tremendous impact on pension funds investing in hedge funds.

Most notably, it increased their attention to headline exposure and placed more emphasis on rigorous monitoring of operational, market, liquidity and reputational risks.

“Hedge fund investing has moved away from the more informal network of high net worth individuals, although that still exists, to the more rigorous institutional marketplace,” says Morgan Stanley’s McDonnell.

Attracting investors requires more than the Madoff approach - opacity combined with an aura of cocktail-party exclusivity and access to strategies that may be on the margins of the acceptable.

For institutional investors, the story of hedge fund investment now is of moving beyond simplistic exposures to the asset class through opaque multi-strategy products. The direction is toward more-detailed understanding of underlying exposures and their effect on the portfolio as a whole. They also demand a level of due diligence that should ensure Madoff-type risks are a thing of the past.

“We have a dedicated due diligence team of forensic accountants and we would never invest with anyone who we were not able to meet,” explains Michael Dyer, fund-of-hedge funds portfolio specialist at Morgan Stanley Alternative Investment Partners. This is increasingly the standard demanded by institutional investors.

Will hedge funds will deliver on the promise of double-equity returns at half the volatility over the next decade? Their return to favour seems to suggest that many people believe the promises. But both transparency to help monitor the situation, and liquidity bail out if the hopes turn out to be misplaced are still essential.