After the tumultuous events of 2007, one might think that advisors to affluent investors and their clients should be looking at 2008 with a high degree of caution and a measured amount of risk aversion. One probably should think again.

Times of turbulence, high volatility and leadership transition typically provide the best environment for opportunistic investors and conditions in the financial markets, and today look propitious for many hedge funds. Indeed, the slow, steady, almost complacent market conditions that prevailed from 2004 through early 2007 tended to be more favorable for long-only investors than for many hedge funds. "Affluent families are more cautious and they may want more testing done, but their appetite has not withered," says Amit Choudhury, managing principal of Pinnacle Partners in San Francisco.

Fund flow data bears this out. Despite the brief blowup at many quant-oriented, statistical arbitrage funds in late July and early August and continuing concern about paralysis in the credit markets, the hedge fund business enjoyed net capital inflows of $45 billion in the third quarter of 2007, with half of that amount coming through funds of funds, according to Hedge Fund Research (HFR) in Chicago.

Families with assets of $50 million or less typically invest in funds of funds, according to Jeff Roush, partner at Agile Group in San Francisco. He estimates that families with these wealth parameters will allocate 3% to 5% of their assets to hedge funds, but that percentage tends to rise as their net worth climbs.

Some of the more aggressive investors view periods of transition as opportunities to earn outsized returns. "Market shifts typically begin with a bang, followed by some pain, followed by emerging trends," explains Joseph Nicholas, chairman of HFR Group. "Market changes create inefficiencies, which create opportunities. Right now, the world is making an adjustment and moving to a different type of global positioning."

Yet even high-flying hedge fund managers with doctorates in mathematics and nine-figure incomes relearned some lessons and were reminded of some age-old verities in 2007. "People are a lot more sensitized to the use of leverage," Roush says. "Most affluent investors have certain expectations regarding excessive risk. The smart money sees it as less risky if funds of funds are combined the right way."

Indeed, the strategy of putting a major chunk of a client's money in one or two hedge funds, each of which may require $5 million minimum investments or more, is increasingly suspect. More than a few funds with seeming ly excellent pedigrees, including Amaranth, two Bear Stearns' mortgage-backed securities funds and Sowood, have vanished in the last 15 months. And Goldman Sachs' Global Alpha fund suffered huge losses in August.

For all this, many funds relying on quantitative strategies recovered in late August and professionals don't expect a dramatic diminution of interest. "Quantitative strategies were very hot," Choudhury says. "They will continue to be successful, but investors will be more careful and selective."

Advisors who help their clients invest in hedge funds" understand the niche a hedge fund is involved in and they expect it to react in certain ways," Roush explains. "And they get concerned when it doesn't go up-or down-when it should. They are buying non-correlation and if non-correlation disappears, it's a red flag. Of course, when there is a big enough event, everything becomes correlated."

Winning funds may not have received as much attention as the funds that stumbled this summer, but more than a few hedge funds survived and some-those that anticipated the subprime fiasco and positioned themselves accordingly-even thrived. Most of the winning strategies involved shorting mortgage-backed securities or loading up on such exotic products as credit default swaps, which rose while the subprime vehicles cratered.

Before the blow-up in late July and early August, most hedge fund experts did not think quant strategies were as highly correlated as so many of them turned out to be. Experts are still sorting through the lessons of the recent and brief crisis. "The main lessons learned were: a) know what you are buying when you invest, i.e., no black box, b) view leverage with extreme caution (it can be used to boost return, but if return is only there because of the leverage, better to avoid it) and c) putting all your eggs in one basket can leave you with a lot of broken eggs and no breakfast," says Thomas W. Keesee, principal at CDK Group LLC, in New York and London.

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WINNING FUNDS MAY NOT HAVE RECEIVED AS MUCH ATTENTION AS THE FUNDS THAT STUMBLED THIS SUMMER, BUT MORE THAN A FEW HEDGE FUNDS HAVE THRIVED.

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While cautious about quant strategies, he believes that, at least in early 2008, strategies that depend on higher volatility should present attractive opportunities, including global macro as well as certain arbitrage strategies like convertible and fixed income. Spreads in the credit markets have widened to the point where values have been reestablished and liquidity is gradually returning.

One area that produced sensational returns during the last credit crunch in 2002 and 2003 was distressed securities, which is essentially a long-only strategy. Keesee notes that, while this area has not shown great returns in 2007, it should present attractive opportunities in 2008. "It would be wrong, however, in my opinion to compare those opportunities to those of 2002/2003, or to expect the same level of returns, as prices are unlikely to be as low for assets, unless the default ratios increase substantially and the economy goes into recession," he asserts. "Also there is a lot more organized distressed money (more demand vs. supply) than there was back in 2002, when there were relatively few distressed players and much smaller funds."

In many respects, the experience in the hedge fund universe mirrors that of the rest of the investment world, although leverage can magnify the results. Ken Heinz, president of Hedge Fund Research in Chicago, notes that emerging markets have been "the strongest area of performance for several years." Emerging markets are not only booming but they continue to exhibit high levels of volatility, allowing savvy trader types to capitalize on both sides of the markets.

"We also continue to favor international long/short equity over domestic U.S. markets," Keesee says. "However, some markets should be viewed with more caution given the strong run up recently, although this may be correcting as we speak. At some point, emerging markets are bound to correct as well, although longer term we remain bullish on higher growth non-U.S. economies (e.g., Asia)."

One tactic employed by some market-neutral quant funds and other long-short equity funds that isn't as popular as it was earlier in the decade is buying value stocks and shorting growthier securities. It worked well while value was all the rage, but as higher multiple growth shares rotate back into favor, many long short funds are moving away from it.

Most experts think the markets still have a way to go before we see the full extent of the damage done by the subprime defaults. "I would think we have at least until the second quarter of 2008 before the opportunities created by the crisis will show any signs of diminishing, or perhaps only by then will we see the full extent of the opportunities presented," Keesee says. This is primarily the result of two factors: 1) holders of subprime and related securities coming to grips with and disclosing the full extent of the problems and 2) those same holders being willing and able to take the painful step of getting the assets off their balance sheet at distressed prices and moving on (or being forced into liquidation).

Survival of the fittest remains the rule in the hedge fund universe. Hedge Fund Research's Heinz estimates that funds with $5 billion or more, which manage about 60% of all hedge fund capital, attracted 71% of new assets in 2007's third quarter.

It's a phenomenon Choudhury sees all too clearly. "The bigger get bigger and some of the smaller funds are failing to achieve critical mass," he says. "As the big boys are going upstream [towards institutions], some smaller firms are going downstream, which is not the path of choice."

The wide disparities in hedge fund returns over the last several months demonstrates not so much that hedge funds can be risky-if they weren't, they wouldn't provide outsized returns- but rather that the selection of hedge funds is not for amateurs, Keesee says. "Those who are not fully structured to conduct proper and thorough due diligence, undertake sophisticated portfolio construction including diversification and risk control techniques, and continuously monitor risk" run the risk of larger than market losses, he adds.