By 2007, after years of dramatic increases, the total assets invested in hedge funds rose to about $2.5 trillion. In 2009, due to losses and redemptions stemming from the current financial crisis, that total is likely to drop to $1 trillion or less. How strongly the industry will bounce back from its annus horribilis is unclear. The global economic environment itself will be a major factor, as will the prospects of additional regulation. But just as important will be whether the hedge-fund sector can heal its own self-inflicted wounds.

Hedge funds are often misrepresented as being risky, secretive, highly leveraged, and unregulated. In fact, most hedge funds are none of those things. They are generally transparent (at least to their investors), subject to significant regulation, and less risky than most other investment options. The high representation of hedge funds in institutional portfolios in recent years has been due not to faddishness or recklessness, but rather to a recognition by sophisticated investors that hedge funds have reliably delivered impressive absolute returns (at least until last year).

Moreover, there is no such thing as a typical hedge fund. Each fund tends to adopt a specific niche for its investments -- long-short equity, currencies, commodities, convertible debt, distressed debt, senior bank or high-yield debt, mortgages, and so forth. Each strategy has its own risk and return characteristics. The funds are referred to as absolute- return vehicles since their mandate is to be profitable in most market environments, performing well even if, say, the stock market is flat or down. This turned out not to be the case in the systemic collapse of the fourth quarter of 2008, but it was true before then and has been true during the first quarter of 2009 (during which the S&P 500 was down almost 12 percent while hedge funds as a whole were positive).         

So what went wrong for hedge funds during the crash of 2008? Two things: what the markets did to them and what they did to themselves.

The markets' influence was primarily due to the unwinding of leverage in the second half of 2008, especially after the collapse of Lehman Brothers in September. Many hedge funds that had relied on various degrees of leverage previously considered reasonably safe awoke to a flock of "black swans," events so unusual that fund managers had barely considered them possible.

The failure of Lehman was critical both on its own, because of the deals it was directly or indirectly involved in, and for the questions it raised about the reliability of other counterparties: If such a major player could simply vanish into thin air, which institution might be next? Credit markets froze and liquidity dried up. Leverage was yanked from the financial system literally overnight, forcing leveraged funds to liquidate their assets in a market with many sellers and few buyers. The ban on short selling securities in the financial sector, imposed by the U.S. Securities and Exchange Commission (SEC) in September, was also important, because it subjected many managers to political risk (something more customary in less developed markets) and caused significant losses in many hedged long-short equity portfolios. As a result of these blows, funds that had been in business for years or even decades were forced out of business in months or even weeks. And the survivors had to record significant losses on many securities as their holdings had to be "marked to market" (valued at the price of a potentially immediate sale).

In December, the revelation of the Bernard Madoff fraud was the straw that broke the back of investor trust. Although Madoff's decades-long Ponzi scheme was technically not a hedge fund -- rather a series of managed accounts at a brokerage firm -- its exposure tainted the entire money-management industry. Investors had already lost faith in the management of the major Wall Street firms and the rating agencies. Now, they also lost faith in the SEC (which, despite many warnings and on-site visits, had failed to detect the fraud) as well as in top-tier accounting firms (including BDO Seidman, PricewaterhouseCoopers, KPMG, and Ernst and Young) that had testified to the existence of billions of dollars of assets supposedly invested with Madoff.                      

Many hedge funds, in turn, compounded their troubles by mistreating their investors. In an attempt to protect remaining assets from forced liquidation, some funds restricted the ability of investors to withdraw their capital. Unlike a typical mutual fund that has shares publicly traded at all times, hedge funds generally allow investors to redeem their assets only at the end of a quarter or a year. Historically, investors have agreed to these restrictions, along with high fees, as the price to be paid for consistent outperformance. But as the crisis unfolded, investors were stunned to find that even this relative liquidity vanished, as some fund managers used clearly unfair methods to suspend redemptions. Many funds refused to let investors take out their money even with adequate notice. Instead, they presented investors with a list of unpalatable options, ranging from accepting unidentified illiquid securities in kind to going into a liquidating trust while continuing to pay managerial fees.

Investors are angry at those hedge funds that refused to meet legitimate redemption requests. As a result, demands for greater liquidity and transparency will confront the industry as a whole from now on, as investors fear getting trapped or duped -- fears that are not unreasonable given recent events. The valuation of illiquid or less liquid assets -- especially debt -- will be another complex and controversial issue. The fees of hedge-fund managers are based in part on the valuation of funds' assets, creating incentives for managers to value assets highly. But what if the assets cannot be readily sold at the prices in question? Are the fees truly justified?

Hedge funds will also face questions about the clawback of performance fees (stipulations that fees paid by investors when funds generate profits be returned in the event of subsequent losses), as well as issues regarding the inadequacy of so-called key-man clauses that require liquidation of a fund if certain individuals are no longer employed there. And increased national or international regulation of the industry as a whole is also a possibility, although how likely such regulation is and what it might involve remains unclear.

Some of the calls for greater regulation are grounded in a sense that hedge funds were part of a broader financial industry run amok, an industry whose culture and practices in recent years were prime causes of the recent crisis. Hedge funds themselves, this argument runs, were material contributors to the broader economic meltdown and need to be reined in to be sure that future catastrophes are prevented.

But this is just not true. The crisis had many causes, the most important of which was the combination of the subprime mortgage meltdown with the securitization of these mortgages into pools that were improperly rated and sold into a highly leveraged global financial market. Although a minority of hedge funds were indeed highly leveraged and had to sell in the deleveraging panic of the last quarter of 2008, they were not central players in how the crisis unfolded. Most hedge funds were unlevered. The speculative excesses of one unit of one financial firm -- AIG -- caused more problems than the entire hedge-fund industry.

Given the concentration of talent at hedge funds, the industry will no doubt survive the crisis, albeit emerging a bit smaller and humbled. However poorly hedge funds performed in 2008, after all, they did much better than regular mutual funds and most buy-and-hold stock portfolios, which were crippled by their long-only bias. It remains a fact that most of the world's greatest investors continue to run hedge funds (which, it is worth noting, is quite different from saying that most hedge funds are run by great investors). And the destruction of many of Wall Street's most venerable institutions, along with a huge collapse in asset prices and a flight of capital from the financial markets, has created a huge opportunity for talented investors to reap outsize returns in the years to come.

When the dust settles, therefore, hedge funds will end up being seen not as some fad of the prior bubble or as illegitimate havens for "malefactors of great wealth," but rather as an integral part of the enduring global financial landscape.

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