The Year Hedge Funds Got Hit

The hedge-fund industry's capital base hit an all-time high of $1.93 trillion in June, according to estimates by Hedge Fund Research, which tracks self-reported data from 7,800 funds. By October, that base had declined to $1.56 trillion, with investors withdrawing $70 billion and performance losses accounting for $300 billion.

Industry participants, including some fund managers, said that hedge funds have significantly reduced the amount of debt they have taken on to finance investments, with many now at more modest leverage levels of less than $2 of borrowed money for every $1 put up by investors.

"Hedge funds were . . . an integral part of the bubble," said George Soros, one of the world's wealthiest and most prominent hedge-fund managers, in testimony to Congress last fall. "But the bubble has now burst, and hedge funds will be decimated."

Some say this is a winnowing out of the weak, the reckless or the unlucky. Hedge funds experienced the largest performance spread in their history last year, with the bottom 10 percent losing more than 58 percent and the top 10 percent soaring more than 40 percent, according to Hedge Fund Research.

The industry was founded by legendary traders who set up firms and charged what were then thought to be outrageous fees: 2 percent of assets and 20 percent of investment gains.

And the money rolled in. Because they were mostly unregulated, they did not have to restrict themselves to one type of investment or strategy. So they bet on currencies, commodities and stocks. They could buy long and sell short. They traded in tungsten and titanium, Icelandic ice and weather derivatives.

From a few hundred funds in the early 1990s, the industry -- which caters to wealthy and institutional investors -- ballooned in the past decade, swelling to more than 10,000 funds last June. As TPG-Axon Capital Management's manager Dinakar Singh put it, "hedge funds have grown from being opportunistic investors circling the market for opportunities to actually being a core part of the market itself," moving from "sniper to infantry." The managers, it seemed, minted money.

Hedge funds did not cause the current crisis, analysts said, but they helped amplify it by buying many of the risky mortgage-backed securities that grew the financial-markets bubble.

When the bubble burst, these funds were among the first to experience losses. In late 2006 and early 2007, dozens of large funds began losing money or folding as mortgage defaults rose. In summer 2007, two Bear Stearns hedge funds, which had invested heavily in subprime mortgages, collapsed. That summer, Sowood Capital Management, a hedge fund in Boston, having lost half its capital following losses on bond market investments, was sold to Citadel Investment Group, which runs some of the world's largest hedge funds. Citadel's two largest hedge funds, with about $10 billion in capital, lost 50 percent of their value in 2008.

In recent years, much of the money raised by hedge funds has come from pension and endowment funds, which were seeking high returns with what seemed like low risk.

"The problem with most pension-fund relationships with hedge funds is that they're opaque, and in order to know what to do with the market index and the options, you need to know what is going on in the hedge fund," said H. Sean Mathis, an investment adviser. "What went wrong was you didn't know what the hedge fund was doing.''

In Massachusetts, the $39 billion state pension fund was down 30 percent last year through November; its investments in various hedge-fund strategies declined 18 percent on average in that period. "You can't be an investor if you can't afford losing money at some point," said Michael Travaglini, executive director of the Pension Reserves Investment Management Board, which oversees the state pension fund.