Hedge funds, in general, had a very difficult time last year. Their overall performance was dismal, investors departed in droves and, to cap it all, the Madoff scandal sapped confidence in the industry.

Of course, the poor average returns included both outstanding and truly awful performances, with bad managers losing clients a bundle of money.

Lately, things have been looking more positive. The pick-up in stock markets since early March and the revival of a degree of risk appetite have helped in boosting returns. And, according to Eurekahedge, the industry has enjoyed two consecutive months of net inflows.

Last year, some investors took a drubbing, as the downturn caught them by surprise. The implicit promise by hedge-fund managers that they offered absolute returns, regardless of market conditions, turned out to be mostly theory and wasn't realised in practice. Hedge funds were not immune in the market turmoil.

The availability of easy credit during the boom years had allowed extraordinary levels of leveraging, goosing up performance that otherwise would have been quite mediocre. In other words, the underlying strategies were far from being innovative or creative. And, it took expert examination of the methods employed to figure this out. Even fairly sophisticated institutional investors often failed to separate the wheat from the chaff.

When performance started crashing last year and investors wanted a fast exit, they found that the doors were being closed abruptly. Fearful fund managers broke their own rules and suspended redemptions, as liquidity dried up.

So, given these awful experiences why are investors returning to the hedge-fund industry once more? Well, it is not so much that memories are short but that risk appetite is reviving and there is the desire to take advantage of rising opportunities.

The shake-up of the industry and the departure of many firms means that there are greater possibilities of finding inefficiencies in the markets, which are readily exploitable. At the same time, leveraging is now practised on a more modest scale, which should limit risk exposure. At the better firms, risk management practices have been tightened. If a manager has an edge in the markets, combining this with a limited degree of leverage and good risk controls can produce quite decent results.

Institutional investors, in particular, are hungry for higher returns. Many face substantial liabilities down the road, and the past year's significant losses have been hard to bear. So they will inevitably be attracted to investing with hedge funds, hoping to experience healthy returns in the future.

But their past experience, which has sometimes been unpleasant, means that they will tread carefully. The search is on for genuine alpha, and not just leveraged beta. Indications are that the bigger institutional investors are shunning the category of hedge fund-of-funds and opting for a variety of individual managers. Some are even trying to employ alpha strategies in-house.

There is room for further rationalisation in the industry. Start-ups will be harder than before and money will flow to some of the bigger fund managers. At the same time, there is definitely a downward pressure on fees. Average fees will fall and only the very best managers will be able to justify high compensation. Some people have argued that the larger hedge funds can move into the space occupied by investment banks, now that there are fewer of the latter. But the surviving investment banks continue to operate in-house hedge funds via their proprietary trading desks. For example, Goldman Sachs has resumed earning substantial profits from its prop desk.

Actually, the firm is no longer just an investment bank but a deposit-taking institution with access to the Fed window. It was helped in a government bailout, along with a host of others, by obtaining debt guarantees and loans. Goldman has already repaid the $10 billion it borrowed, freeing it from the government-imposed cap on employee compensation. One has to marvel at the way they have used government help to restore their finances and resume profit-making activities. No hedge fund has benefited in the same way.

Tighter regulation of hedge funds is in the works. A draft European Union law, principally pushed by France and Germany intends to come down hard on the industry. Unsurprisingly, the UK is fighting to water down the proposed regulatory scheme, and the US won't be happy with it either. London is a principal base for the hedge-fund industry and protecting it from shrinkage has to be a priority. Whatever the outcome of this battle, the end result will be tighter regulations than we have currently. Hedge funds will have to adjust.

Iraj Pouyandeh is a strategist and senior portfolio manager at LOM Asset Management. He manages the LOM Global Equity Fund. For more information on LOM Asset Management please visit www.lomam.com