Illustration by Satoshi Kambayashi

HEDGE funds had a brilliant first half of 2008, outperforming Wall Street by 12 percentage points. Hedge funds had an awful six months, producing their worst return on record.

Depending on your point of view, the same statistics can be used to support both those statements. And the dichotomy shows how confused the image of the industry has become.

One leftish British columnist recently described how he believed that hedge funds work. “They set out to make a return of 30% a year any way they can in no-holds-barred, hyper-aggressive financial gambling,” he wrote. By his standards, the average fund's loss of 0.75% in the first six months of the year, according to Hedge Fund Research, was a dismal failure.

But this is not how most hedge funds operate any more. Gone are the days when their main client base was wealthy individuals. Now hedge funds are trying to market themselves to pension funds and endowments. What those clients want is a controlled balance between risk and reward, and a return that is not correlated with conventional stockmarkets. Given that the S&P 500 index lost 12.8% over the first half, hedge-fund managers kept that promise.

In truth, any attempt to analyse the hedge-fund industry as a whole runs into the problem that it is not an asset class but a style of fund management. Hedge Fund Research produces figures for 18 different sectors, from “short bias” (funds that make money from falling share prices) to “merger arbitrage” (funds that exploit movements in bidders' and sellers' share prices). In any given period there are likely to be wide divergences between the returns of the different strategies; the best sector in the first half beat the worst by more than 20 percentage points.

As a result, risk has a lot of different potential meanings for hedge-fund investors. They could opt for a strategy that is out of favour. They could choose a manager on the basis of a track record that has been driven by luck or by the excessive use of borrowed money. At the extreme, they could pick a manager who has relied on fraud.

That helps explain two trends in the industry. The first is concentration: the assets of the 100 largest funds rose from 47% of the industry in 2002 to 66% in 2007, according to GAM, an asset manager. Just as no-one used to get fired for buying IBM computers, no one can be blamed for picking funds run by big managers such as Highbridge or D.E. Shaw.

The second is a reliance on funds-of-funds. It takes an awful lot of due diligence to assess a hedge-fund manager; pension funds and endowments may well feel it is better left to an expert. In the first quarter of the year, the number of individual hedge funds in existence fell slightly (from 7,634 to 7,601); more funds gave up the ghost than were created. But a net 110 funds-of-funds came into existence.

The problem for clients is that the expertise of a fund-of-funds manager requires an extra layer of fees. Those costs turned the net return of a fund-of-funds investor into a loss of 2.3% in the first half. For most institutional clients that use the hedge-fund industry, the real risk is not that they will lose their shirts. It is that the combination of high fees and diversified portfolios will result in mediocre returns.

Clients may slowly be waking up to that reality. Even though the average hedge fund easily beat equities, the flow of money into the sector in the first half of the year was just $29 billion, down from $118 billion in the first six months of 2007.

The headlong growth of the industry, which took it from $39 billion of assets in 1990 to more than $1.9 trillion at the end of June, may be over for a year or two. This is not just down to a lack of enthusiasm among clients. In such difficult markets, traders are less likely to desert the haven of an investment bank for the hard slog of starting their own fund. And the credit crunch means banks are less willing to give hedge funds the kind of leverage they need to create double-digit returns.

Strikingly, the only sector that really drew in the punters in the first half of the year was “global macro”. Such funds take the kind of big bets on currencies and markets that made the names of George Soros and Julian Robertson. Having dominated the industry in the 1980s and the 1990s, global macro funds fell out of favour towards the tail of the dotcom boom. They are now only a small part of the industry.

Astute global macro managers had two great trends to follow in the first half of 2008, betting in favour of commodities and against financials. By and large, they got those trends right. Ironically, the managers thought to be the riskiest have proved to be the best hedges this year.