Demise of Hedge Funds Has Been Exaggerated

NEW YORK (TheStreet) -- Investors are returning to hedge funds. During the first four months of the year, hedge funds recorded $24 billion of inflows, according to HedgeFund.net.

The inflows represent a big turnaround from the turmoil of 2008. During the downturn, many funds were forced to liquidate, and some analysts predicted that the hedge fund industry was bound to shrink permanently. Hedge fund assets dropped from a peak of nearly $3 trillion in the second quarter of 2008 to $2.3 trillion this year.

The industry continues to face serious hurdles. With memories of the stock-market meltdown still fresh, many individual investors remain wary of hedge funds. In addition, the new Dodd-Frank financial legislation aims to rein in hedge funds, tightening regulations and restricting investments by banks.

Still, the outlook for the industry remains positive. Many pensions and institutions have been increasing their allocations to hedge funds.

The performance of hedge funds in recent years is helping to attract investors. "Hedge funds have outperformed the S&P 500 and done it with a lot less volatility," says Evan Rapoport, principal of Hedgeco.net, a data provider.

Most analysts argue that hedge funds tend to outpace stocks in downturns and produce decent results in bull markets. The funds excel in hard times because they sell short and use other techniques that can produce profits in any market environment. According to Hennessee Group, hedge funds lost 20% of their value in 2008, outpacing the S&P 500 by about 17 percentage points. For the past three years, the funds have stayed in the black, while most mutual funds have suffered sizable losses.

Some critics question the performance figures, arguing that the typical investor actually obtains worse returns than the public databases suggest. The shortfalls occur because of a factor known as survivorship bias, which is connected to the way hedge funds report data. While mutual funds are required to make their returns public, hedge funds only disclose data when they choose. So if a hedge fund collapses and goes out of business, it may not bother to report the final miserable returns. As a result, databases do not include some terrible performers that would bring down the averages.