When equities markets tanked in 2008 the pain was unprecedented. Big mutual funds like Fidelity Magellan lost 49%. Broad equity indexes fell by a similar order of magnitude. Hedge funds managed to outperform in a manner of speaking: the HFRI Index fell a mere 18%. Since then, however, the investment attractions of hedge funds have been muted. Sure, returns rebounded in 2010 and made a modicum of progress in successive years. Fear among managers and investors has grown with lengthy periods of ‘risk off’ aversion punctuated by brief spells of ‘risk on’ appetite.

Essentially, markets have undergone a secular change. Simply put, the high level of correlation among different asset classes is the new normal. Prior to 2008, single manager hedge funds across the board displayed limited correlation. Today, the figure is rather higher. One hedge fund COO who has charted the data suggests that in 2008 over 50% of managers showed low correlation. In mid-2012, the figure would be only 5% or so.

Investors are realising this. The problem is particularly acute for funds of funds managers: faced with low returns and high correlation, investors are increasingly baulking at the second layer of fees. The Texas Retirement Endowment recently axed three of its five multi-manager providers after finding that around half of the annualised performance of 1.6% over a five year period had gone to the funds of funds. It concluded, not unreasonably, that the performance was too low to justify such fees.

But it is the much greater correlation that is the real threat to hedge funds. Managers inadvertently are protesting this very point when they rail justifiably about trading conditions being ‘impossible’ in risk on, risk off markets. It is not just equities strategies being affected either. Commodities, once lowly correlated, are now highly so.

Diversification, often feted as the one free lunch in investing, has largely ceased to deliver. Not only are many funds of funds underperforming, so are many of the big multi-strategy names, which are among the top global hedge funds. It is becoming clear that size may be the enemy of high performance. Even BridgeWater Pure Alpha saw negative performance in the first half of 2012.

In response, investors have pulled in their horns. Allocations to multi-strategy, distressed and event driven funds are being impeded since investors think they are taking too much risk. Hedge fund investing increasingly resembles a bet on levered beta with the rationale for allocating diminishing the more correlation rises.

What comes next? One solution is to go back to AW Jones and the basics: hedge and get uncorrelated. Then cut management fees radically, making it necessary to perform to get paid. For this approach to work, however, there are likely to be capacity constraints on fund assets.  

For the $10 billion-plus behemoths that dominate the hedge fund business the way forward is probably beta plus alpha. By combining more beta risk with sophisticated alpha techniques leaders like a Bluecrest or Bridgewater can still manage their huge pots of money, while generating something like a less correlated performance. Capital preservation may be the order of the day right now for hedge funds, but generating performance matters too.