By Laurence Fletcher

LONDON (Reuters) - Funds of hedge fund portfolios are battening down the hatches in the current volatile markets by building up cash or steering clear of strategies with too much exposure to market movements.

With returns in the hedge fund industry hard to come by as the credit crisis continues to hit markets, managers who hold portfolios of hedge funds have become wary of strategies that could be caught out by another sharp downturn.

"These are the toughest conditions I've seen in 16 years," said Ken Kinsey-Quick, fund of hedge funds manager at Thames River Capital, who expects billions of dollars more of asset sales by banks.

"We're expecting a big leg down in all financial assets ... We do think in the short-term we don't want much beta." Beta means exposure to overall market movements.

Kinsey-Quick has built up cash balances of 10-15 percent across his portfolios and has hedged out his exposure to market movements by buying index options.

The move comes as the $2.6 trillion hedge fund industry, which is meant to be able to make money in all market conditions, faces one of its toughest challenges to date.

Funds lost 2.11 percent in the first seven months of the year, according to Credit Suisse/Tremont.

July proved a particularly tough month as bank stocks -- which many hedge funds had been betting would fall -- rose and commodities -- which many funds had owned -- fell.