” The End of the 3 and 30 “, from the summer issue ofaiCIO, published today, looks at how hedge funds of funds must adapt or perish, and concludes that a large number will fold regardless of what they do.

aiCIO‘s editor, Kip McDaniel, reports that institutional investors plan to shift from fund of funds towards direct investing in hedge funds. Recent research indicates that 32% of investors currently allocating to funds of funds will invest directly in the next three years — with another 8% poised to follow suit.

“Hedge funds of funds were the Crystal Pepsi of the investment world,” says McDaniel. “They initially attracted considerable attention but users decided they preferred the real thing.”

According to aiCIO, lackluster performance and the inability to avoid a number of high profile hedge fund blowups has convinced many institutional investors that funds of funds cannot justify the extra 1% and 10% they charge on top of the traditional 2% and 20%.

Another reason for the shift is that the central selling point of many funds of funds — access to the most highly-regarded hedge fund managers — is no longer an allure. “The access pitch preyed on insecurities and the seemingly universal desire to be part of an elite,” notes McDaniel. “When it became clear that Madoff built his Ponzi scheme largely out of this human weakness, that pitch died.”

McDaniel reports that the access pitch has been replaced by others that emphasis customization, agglomeration, tactical adjustments and risk management.

Ultimately, this change in strategy is likely for naught, says McDaniel. “Most funds of funds will die a natural death, as the market moves away from them.” He notes that there will still be a market for funds of hedge funds, but it will be dominated by a relatively small group of larger, established players.