With steep losses at quant funds and a series of high-profile collapses, hedge funds appeared to be at the heart of the crisis—yet they have weathered the storm surprisingly well.

Hedge funds have received renewed and invigorated attention during the tumult of the past 12 months. With steep losses at quant funds and a series of high-profile collapses, hedge funds appeared to be at the heart of the crisis. But whereas such headline-grabbing cases may suggest otherwise, the industry at large has weathered the storm astonishingly well. Performance data suggest that hedge funds are slowly putting the worst behind them and return to business as usual. Business as usual, however, has changed.

The new stringency in lending by investment banks has forced hedge funds to take on a more humble approach to leverage. This is partly necessity, partly insight. After losing 22.5% of its value in August 2007, Goldman Sachs’ Global Alpha Fund, for instance, promised in a letter to investors that it would be giving greater consideration to leverage as a separate risk factor in constructing portfolios and applying new leverage constraints.

The lending squeeze is also likely to fuel the existing trend of larger hedge funds seeking to achieve greater independence from their prime brokers by raising permanent capital. Citadel Investment Group’s $2 billion bond issue program as well as Fortress Investment Group’s IPO in February 2007 stand as prime examples hereof. As the liquidity crisis shows no sign of abating, we can expect to see more large hedge funds taking advantage of this window in the capital markets.

The year 2008 may not only mark the beginning of the end of excess leverage for some funds, it is also likely to be reflected on as a time when skill-based investing came back to the fore. In the low volatility environment of the past three years everybody could be a winner. The coming 12 months, by contrast, will be about superior asset selection, that is the ability to assemble a portfolio that performs well due to the manager’s skill, not because the directions of the market are predictable.

In other respects, the credit crisis has brought only more of the same. As the competition for alpha continues apace, funds are tapping into ever more sophisticated algorithms with important consequences for the practice of Direct Market Access (DMA). To date, DMA is still largely an equity phenomenon, but with the increasing adoption of multi-asset class algorithms, providers are heading in all directions.

Moreover, hedge funds have become increasingly active participants in the lending business. The credit crunch is a feast for those engaged in providing liquidity, as more cash-strapped companies shunned by commercial banks are hitching themselves to hedge funds. Yet, while the current surge in hedge fund lending is a somewhat opportunistic phenomenon and as such cyclical, lending strategies are no doubt here to stay. Hedge funds have taken to fill part of the void created by consolidation in the banking industry. As banking giants avoid smaller and riskier deals, hedge funds make up for an increasing share of this market.

The current market environment also sets the stage for a trend that is under way for a number of years already: hybrid investing that is, the practice of carving out a discrete amount of capital to be invested in illiquid private investments only. By going hybrid now, funds can capitalize on distressed opportunities in both the hedge fund and the private equity way. By means of these and other branch-outs the versatile industry is bound to rebound. Yet, it would be premature to declare victory. The real challenge is continuous and bears the question: How can hedge funds meet the requirements of their growing institutional clientele with respect to mainstream operations while at the same time remain nimble and deliver on their alpha promise?