For years, funds of funds attracted capital by offering investors access to top-tier hedge fund managers, while providing a layer of diversification by investing in a broad array of funds.

They justified charging extra fees by claiming the diversification and their due diligence process would protect investors from major down drafts. Unfortunately, the financial crisis of 2008 put a bit of a dent in that marketing strategy, as many funds of funds lost even more money than the individual hedge funds themselves, reports Dealbook.

Some fund of funds even failed to ferret out fraud among their holdings, such as Fairfield Greenwich Advisors and Tremont Group Holdings, which lost billions in the Bernie Madoff scandal.

As a result, the fund of funds sector has shrunk by some $130 billion, down to $667 billion, based on data supplied by Hedge Fund Research. That contrasts with the healthy rebound of the hedge fund industry as a whole, now up to near-record highs of roughly $2 trillion.

Ultra-wealthy investors and institutions are shying away from funds of funds, preferring to pay consultants to advise them on asset allocation and selecting the right hedge funds. What’s a fund of funds marketer to do?

In a word, adapt, by changing their strategies and enhancing their service offering. For example, Arden Asset Management, a fund of funds that manages about $8 billion, is now helping clients research other potential alternative investments. Arden gives Investors access to more than 40,000 reports on external hedge funds that the firm has produced over the years. Arden executives also provide consulting services, joining clients for onsite for visits to money managers.

Other firms are tailoring products to the needs of specific investors, rather than offering a one-size-fits-all portfolio. Prisma Capital Partners, a fund of funds started by three former partners at Goldman Sachs, has tailored 70 percent of its assets to customized portfolios that take into account a clients’ risk tolerance, cash needs and the mix of their overall holdings.

Dorset Management, a New York-based asset manager, is planning to start a commodities-focused fund of funds. Other funds of funds are marketing so-called seeding platforms, which buy pieces of hedge funds in their infancy.

Still others, like SkyBridge Capital, are trying to attract assets with a different type of vehicle that has a lower minimum. Clients pay only $50,000 to get access to a portfolio that invests in multibillion-dollar hedge funds such as Third Point and SAC Capital.

The fund of fund community is getting more creative and more aggressive about identifying client needs and trying to expand the category once again.

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