BOSTON (TheStreet) -- Hedge fund managers, known for risk taking in pursuit of investment gains, have spent more time protecting investors as stocks recorded the steepest declines in three years.

Hedge funds, set up for wealthy individuals and institutions, have fallen 1% from the start of the third quarter through Aug. 12, according to data collected by

Goldman Sachs

analysts. During the same period, the

S&P 500

dropped 5% and the average large-cap "core" mutual fund declined 6%. Goldman Sachs' Hedge Fund Trend Monitor dissects the regulatory filings of 700 hedge funds with $1.28 trillion in equities and exchange traded funds.

John Paulson (Paulson & Co.)

The story of hedge fund returns this year has been split into two chapters. Hedge funds were flat in the first half of 2011, but they have outperformed the market since the beginning of July. Goldman analysts say that as the stock-market correction pushed the S&P 500 down 11% in the third quarter through Aug. 12, the typical hedge fund has decreased only 1%.

After nearly 2,500 hedge funds were liquidated in the last stock-market crash in 2008 and 2009, according to data from Hedge Fund Research, only 181 hedge funds blew up through the first quarter of 2011. Could it be that hedge funds, which have been vilified for aggressive investing, are

actually

hedging risk?

"It's something that has been happening since the end of 2010," says Peter Laurelli, vice president of the research division at Channel Capital Group's HedgeFund.net. His data show that while hedge fund redemptions outpaced allocations in July for the first time in 13 months, performance was positive with a return of 0.8%. By comparison, the S&P 500 Total Return Index fell 2% during July. Data for August aren't yet available.

"It's not as recent as the last month or two," Laurelli adds. "They've noticed the decreasing economic fundamentals globally. We're seeing the net-long exposure decrease over time as a result, and that is likely a more defensive positioning. In reading through some of the reports from funds, we see that net-long exposure has decreased."

Hedge funds have been protected by diverse strategies. As a group, they follow macro, distressed credit, commodity and equity strategies. Long/short equity indices fell 0.3% in July, compared with a 2% drop for the S&P 500, Laurelli says.

"The industry may have been in a more defensive posture throughout the year and that is starting to benefit those on the equity side," Laurelli says. "In aggregate, though, it's the exposure to commodities and credit markets where you've seen the real upside."

Charles Gradante, co-founder of hedge fund advisory firm Hennessee Group, said in a release earlier this month that hedge fund managers were able to generate returns on long and short portfolios in July due to better dispersion and lower correlations among equities.

"However, we have seen a spike in correlation and massive de-risking in early August, which will likely prove challenging for hedge funds in the short term," he said.

Not all fund managers are beating the market. In fact, one of the biggest hedge fund managers in the world is having a year he'd prefer to forget. Several media reports have John Paulson's Paulson & Co. down significantly this year in some of its funds. The leveraged Advantage Plus Fund has slumped 34% through the first two weeks of August, according to a

CNBC

report.

Bets on bank stocks such as

Bank of America

(BAC) - Get Report

and

Citigroup

(C) - Get Report

have turned against investors like Paulson this year after outperforming since the market bottom in March 2009.

Paulson may have also lost millions

on

Hewlett-Packard

(HPQ) - Get Report

shares as well.

On the other hand, Paulson's investments in gold -- most notably the

SPDR Gold Trust ETF

(GLD) - Get Report

-- have kept his gold-related hedge fund in the black, according to several reports. Even so, it's his long exposure that's hurting Paulson. During an investor call in July, Paulson said he plans to cut his net long exposure to 60% from 81% previously, according to a

Reuters

report.

In addition to cutting long exposure, hedge funds are reloading with large-cap stocks. According to Goldman Sachs, large-cap stocks accounted for almost half of hedge fund holdings as of June 30, a trend that has moved higher over the past decade. A divide between the average and aggregate assets of hedge funds in large-cap stocks suggests that the hedge funds with the largest assets under management target large-cap stocks, Goldman analysts write.

Goldman's hedge fund VIP list, a basket of 50 stocks that have the most hedge fund ownership based on 13F filings, is almost exclusively packed with large-cap stocks. But if investors need any more of an indication that hedge funds were getting more defensive ahead of an expected drop in the equity market, several big dividend payers were among the top 50 stocks, including

Pfizer

(PFE) - Get Report

,

BP

(BP) - Get Report

,

Johnson & Johnson

(JNJ) - Get Report

and

Exxon Mobil

(XOM) - Get Report

.

-- Written by Robert Holmes in Boston

.

>To contact the writer of this article, click here:

Robert Holmes

.

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