The credit crisis and market turbulence are challenging the hedge fund industry, and will unavoidably result in a re-evaluation of the hedge fund model, a new report from Castle Hall Alternatives says.

While hedge funds will likely remain an integral part of diversified institutional portfolios, a contraction of industry capital is expected in the short-term, according to Brossard, Que.-based Castle Hall, a provider of hedge fund operational due diligence.

The report, entitled “Hedge Fund Investing in a New World: Five Questions for Investors and Managers,” explores aspects of the industry that may face changes going forward.

“The structures and conventions accepted in the past may not be the best for the hedge fund industry going forward,” said Chris Addy, Castle Hall’s president and CEO, in a statement. “We have highlighted a number of areas where current practices are weak.”

He added that he expects investors to become more vocal and demanding of greater protection and control when allocating to hedge funds. Investors will also focus more intently on operational, structural and business issues in addition to performance and strategy, Addy said.

The report argues that the typical hedge fund “2 and 20” fee structure — a 2% management fee and 20% incentive fee — is fundamentally flawed. Castle Hall recommends a model that pays hedge fund managers in the same way as private equity managers, which take 20% only of realized gains, rather than 20% annually on the net asset value of the fund.

This change would reduce the risk of hedge fund valuation fraud, the report says, and would remove the problem of paying compensation using estimated, hypothetical values.

The report also calls for better corporate governance in the hedge fund industry, including independent boards that can provide experienced oversight in portfolio valuation and redemption restrictions.

“Effective corporate governance will be critical in the New World, even if this means that investors will have to pay more to attract capable candidates to serve on hedge fund boards,” the report says.

Castle Hall also finds that there is an “expectations gap” between the services administrators provide, and those that investors expect are provided.

Administration servicing must respond to new expectations going forward, including fulfilling a role as an independent watchdog to help prevent fraud among fund managers, the report says.

Castle Hall also argues that hedge fund prospectuses are often written in favour of fund managers at the expense of investors. It says that since the offerings are typically broad and unspecific, they provide managers with freedom of action.

“Investors will need greater specificity in fund offering documents. The terms and obligations related to each investment product should be unambiguous and include detailed guidelines and restrictions,” the report says.

The biggest question facing the hedge fund industry, according to the report, is whether the funds’ open-ended structure is best suited to many of today’s alternative investment strategies.

Castle Hall cites problems with the open-ended structure, including funds having to cut a net asset value monthly, which means pricing assets irrespective of their nature or liquidity. In addition, strategies with investments that are inherently illiquid creates a mismatch between the liquidity of the portfolio and the frequency of the redemption terms in the product sold to investors, the report says.

Ultimately, a stronger hedge fund industry could emerge from the current difficulties, according to Castle Hall.

“The New World will require new choices and the hedge fund industry will impede its success if it does not adapt and learn from the lessons of today’s markets,” the report says.