In 2007 the whipping boy for alternatives was private equity, and then in 2008 the hatred turned to hedge funds. The candidates for 2009Æs witch burning could be property, commodities, funds of funds, or a return to the ducking stool for private equity.

Funds of hedge funds look like they are winning the dubious accolade of being the figures of opprobrium for 2009.

Debating their double-layer of fees was a skirmish that they were able to counter, pointing out their role as outsourced due diligence providers and the benefits of portfolio diversification.

In bull markets, avoidance of blow ups and flatter returns from diversification gave them an excuse for why their average returns were not beating hedge fund indices. This was at a time when most investors were better served investing in long-only or index products in many Asian regions, which provided similar risk/returns, but with better liquidity, and lower fees.

In the bear market of 2008, funds of hedge funds on average finished nearly 20% down, compared to the hedge fund index down roughly half that level. Even though some funds of hedge funds in bullish times promised to beat average hedge fund returns in bear markets, when they failed to do so, their reply was that it was extremely hard for a fund of hedge funds to ever beat the hedge fund index simply by virtue of the additional layer of fees. Also they claimed that the individual hedge fund indices were flawed and returns over-stated, due to poorly performing funds ceasing to provide their monthly returns to the databases.

At least they could claim they still had the benefits of diversification and avoided blow-ups. That was true until Bernard Madoff came along.

So are there any logical parameters which can indicate whether a fund of hedge fund can add value? Talking to the Street, the following emerge as obvious questions for fund of funds selection:

1) Can you outperform a relevant hedge fund index? (in particular in a bull market, therefore adding value by manager selection)

2) Do you have lower cumulative drawdowns than the chosen hedge fund index? (which in a bear market showcases an ability to add value via risk management)

3) Do you have low correlation to the hedge fund index plus a relevant long-only index (showing that you arenÆt just a camp follower)

4) Time û the 4th dimension. Can you repeat all the above consistently in multiple market environments?

Common sense comparatives can provide reasonable guidelines. Nobody is saying that in a bull market a fund of hedge funds should be able to outperform a stock index, but with good manager selection it should have a fair crack at outperforming a hedge fund index (and most certainly beat a fund of hedge funds index). Even qualifying on three out of four of the above criteria might entitle a fund of hedge funds to merit an investorÆs scrutiny, otherwise, do they really deserve their fees?

What about Madoff though? Several prestigious funds of hedge funds made elementary mistakes. They may or may not survive those mistakes. Every fund of hedge funds claims to be above average at operational due diligence, which of course is statistically impossible.

ôDue diligence is not difficult, itÆs not rocket science,ö says Eric Xu, the managing director of Persistent EdgeÆs Hong Kong office and the chief risk officer. Persistent EdgeÆs funds currently qualify on all four of the points mentioned above. ôIt doesnÆt take a miracle to perform operational due diligence, and one way in which you can discover if a fund of funds is doing it properly or not is to look at their performance numbers. If it isnÆt competent enough to do proper due diligence, then that shortcoming will be reflected in drawdowns.ö

There will still be hedge fund blow-ups, but the diverse portfolios of funds of funds should be able to absorb them and those that can perform well may be able to thrive by virtue of the catharsis. If the current turmoil doesnÆt completely kill alternative investment, then funds of hedge funds may one day emerge stronger.