One of the hallmarks of the markets in the recent financial crisis is the powerlessness of portfolio diversification to preserve capital. It may well be that in the next market cycle different asset classes will indeed behave differently, but in the Lehman-inspired troubles we’re dealing with now, institutions’ moves to alternatives such as private equity and private real estate didn’t help returns much. Hedge funds, however, saved the day for many institutions.

In fact, the hardship spread to the rest of portfolios of endowments that took the alternatives plunge, as private equity and real estate funds not only lost legendary amounts of money themselves, but also imperiled the rest of the portfolio when their capital calls required managers to sell what liquid assets they had.

There are few published indexes for private equity, but two large and previously enthusiastic investors allow us a peek at the results of a diversified portfolio of private equity and real estate funds: the giant CalSTRS reported respective losses of 28% and 43% on its holdings for the year ended June 2009, compared to a drop of 27% for the Russell 3000 stock index. More currently, for the calendar year 2009, the NCREIF national index of high-quality properties fell 17%, in a year when the S&P 500 rose 30%.

The results of both types of alternatives make sense, in a way: the return on private equity is determined by the values in the public market at which managers can sell their transformed companies, and the value of commercial real estate is driven by the health of employment (for office buildings), consumer sales (for retail and warehouse properties), and the rents people can afford (for apartments). Here’s a new rule: “Bad for stocks, bad for alternatives.”

Not so for hedge funds, however. The Hedge Fund Research index of all styles of hedge funds dropped 19% in 2008, compared to the S&P 500’s 37% fall. Moreover, the liquidity of hedge funds allowed some institutions to sacrifice portions of their holdings to meet the capital calls of private equity.

Within the hedge fund universe, long-short equity funds fell 27% in 2008, while dedicated short funds gained 28% for the year, and global macro funds gained 5%. In calendar 2009, hedge funds gained 20%, versus 26% for the S&P 500. In 2010, through April, hedge funds were up about 4% versus a gain of 7% for the broad US stock market, and 3% for bonds. The evil geniuses that run hedge funds may not be such bad guys after all.