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Funds of hedge funds are changing their ways. For decades, the money managers, which invest across a number of hedge funds, lured big institutions with the promise of diversification. They justified the extra fees by saying their extensive due diligence would help protect investors from major blowups.

Then the financial crisis struck, and the strategy failed. Weighed down by the added expenses, the baskets of funds lost on average more than individual portfolios.

Some failed to detect fraud in their underlying holdings. Fairfield Greenwich Advisors and Tremont Group Holdings lost billions of dollars when Bernard L. Madoff’s fund turned out to be a huge Ponzi scheme.

Since then, the investments have been a tough sell. Assets in funds of funds stand at $667 billion, some $130 billion below their 2007 peak. By contrast, the overall hedge fund industry just reached record highs, with more than $2 trillion, according to Hedge Fund Research. Increasingly, institutional investors are opting to pay consultants to advise them on allocations, or are investing directly into hedge funds themselves. Ultra-wealthy individuals, once major investors in funds of funds, have yet to return full force since 2008.

Amid the wreckage, some funds of funds are adapting their strategies and enhancing their services. They’re also looking to new lines of business, as investors seek out lower fees and greater protection in the aftermath of the crisis.

“The needs of the client have changed and the demands have increased,” said Henry P. Davis, managing director at Arden Asset Management, a fund of funds that manages about $8 billion, down from $12 billion at its peak. “It’s been a pressure that has been constructive, in terms of strengthening and broadening the scope of what you have to offer.”

Arden, for example, is now helping clients vet other potential alternative investments. Investors can access more than 40,000 reports on external hedge funds that the firm has written over its 18-year history. Arden executives also provide consulting services, joining clients for onsite visits at money managers they’re considering.

In the current market, investors are also seeking established firms with heft. Behemoths like the Blackstone Group, which manages $37 billion in its fund of funds business, have had little trouble raising money.

To help gain size, smaller firms are pairing with competitors, giving them new sources of capital and investors. In June, Arden announced an agreement to manage an additional $1.3 billion in assets for another money manager in the space.

Others are tailoring products to the needs of specific investors, rather than creating one-size-fits-all portfolios.

At Prisma Capital Partners, a fund of funds started by three former partners at Goldman Sachs, 70 percent of assets are dedicated to customized portfolios that consider a client’s risk tolerance, cash needs or the mix of their overall holdings.

Niche funds of funds are also in vogue.

Dorset Management, a New York-based asset manager, is planning to start a commodities-focused fund of funds in the coming months, according to a person with knowledge of the matter. Some funds of funds are marketing seeding platforms, which buy pieces of hedge funds in their infancy.

Liongate Capital Management, which runs about $3.2 billion, focuses on hedge funds with $500 million to $2 billion. It allows the firm to distinguish itself from larger rivals, whose asset loads make it difficult to invest in portfolios of that size. Liongate, which has had annualized returns of 9.45 percent since 2004, has pulled in about $2 billion since the financial crisis.

“Fund of funds that are of a midsize like us have to differentiate themselves,” said Jeff Holland, a managing director at Liongate.

SkyBridge Capital, the firm run by Anthony Scaramucci, is 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 like Third Point and SAC Capital. While investors must still earn at least $200,000 a year or have a net worth in excess of $1 million, it is a far cry from the $10 million minimum investment required for many top hedge funds.

Scaramucci says he is trying to broaden the distribution channels for hedge funds, which have historically been reserved for the ultra wealthy and institutions. To do so, he is also charging a fraction atop the hefty hedge fund fees, roughly 1.5 percent of the assets. A typical fund of funds charges 1 percent of assets and takes 10 percent of profit.

Since June of last year, the business has grown to about $1.7 billion in assets under management from about $600 million.

The New York Times