Scarcely a day goes by without news of more trouble in the hedge-fund world. The industry is downsizing like never before. Hedge funds grew like mushrooms in the years after the 2001-2002 stock market correction. Individual and institutional investors, experiencing lean times, flocked to hedge funds in search of better returns.

The funds' historical performance appeared to promise consistency of returns and protection from capital erosion irrespective of market conditions. However, a significant problem with the data, as many academic studies have revealed, is that some of the securities held by the funds are relatively illiquid, and often priced to model rather than to market. In addition, the dataset is permeated with survivorship bias because so many failed funds simply drop out of the sample used to measure performance. These factors, among others, mean that recorded returns are overstated and risk understated.

The average hedge-fund manager is supposed to follow an absolute-return strategy, enhancing the upside of the portfolio and protecting the downside. This is an asymmetrical approach, as opposed to a symmetrical one where the portfolio swings up and down in broad correlation with the market.

Of course, the industry has never been immune to blowups. And one of the biggest and most famous happened in 1998 when LTCM failed. The collapse of the fund was avoided because the Fed arranged a rescue package that, unfortunately, also introduced moral hazard into the system.

There are a large number of hedge funds around the world, implementing a variety of strategies, models, methods and techniques. It is often difficult for the investor to gauge the quality and worth of the manager's approach. Of course, the manager is unwilling to reveal his methods to individual investors if the methods are at all profitable. The obvious risk is that his techniques will be copied by others and he will lose his edge in the market.

Even institutional investors, who require a lot more transparency than individuals, may not get all the details. They may resort to hiring consultants to pass judgment on the manager's performance. But the experts' assessment may not constitute in-depth knowledge of how well the manager's models will stand up to changes in market conditions and stressful situations.

Indeed, it may be difficult for the potential investor to sort out creative, innovative and flexible managers from ones that are using routine methods that aren't too different from off-the-shelf models used by a horde of others in crowded trades. A long history of outperformance may not be a good guide to how well the fund will do under conditions never previously experienced by the manager.

It is no coincidence that the rapid growth of the industry has occurred during a period of easy access to credit occasioned by loose monetary policy. Ready access to credit allowed the funds to leverage significantly. As a result, otherwise meagre returns were goosed up by an extraordinary degree of leveraging.

Even a novice in this field knows that higher leverage constitutes increased risk. Your prospective returns are boosted upwards but your potential losses are also multiplied in a downward direction. Basic risk management principles mean controlling the degree of leverage according to changing market conditions. But years of easy access to credit bred complacency, and the onset of the credit crunch came as a nasty surprise to many. Inevitably, there was a scramble for liquidity.

With a rise in risk aversion, cash became a preferred asset and investors were increasingly wary of holding positions in hedge funds that normally require notice periods of a month or more. Redemptions rose sharply at the same time that the funds' access to credit tightened, forcing asset sales in falling or illiquid markets. The deleveraging process has been vicious, bringing down many funds.

Some fund managers have been forced to suspend redemptions, thereby undermining the ability of funds-of-hedge-funds to meet investor needs based on the promise of providing the benefits of diversification and liquidity.

The industry's reputation has suffered badly and it is estimated that its total size will decline by thirty to forty percent. Many investors have suffered large losses that will take a long time to recoup. Some managers will leave the industry, while others will close down and start afresh. Of course, throughout the turmoil, there have been many well-managed funds that will now increase their market share.

Tighter regulation of hedge funds is a certainty. The exact form of the regulation will take some time to evolve. It would be unfortunate if governments take a very tough approach because hedge funds play a useful role in the ecology of the marketplace.

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.