London - Deep cracks are starting to show in the love affair between hedge funds and their investors, after another year of paltry returns on expensive investments leaves many feeling cheated and close to bailing out.
An asset class once feted for its ability to make money in all markets is back under the spotlight after the average fund lost 4.4% in the first 11 months of the year, data from Hedge Fund Research shows.
That tepid performance comes just three years after hedge funds lost an average 19% in 2008's market chaos, and raises serious questions about the industry's future growth, particularly in light of the huge fees the managers often earn.
"I'm disappointed at the level of returns," said one large institutional investor who asked not to be named. "The hedge fund industry has once again been underwhelming people's expectations.
"It's an expensive asset class ... They're going to have to have another 2001 or 2003 in the next three-to-five years if they expect the industry to grow," the investor said.
Hedge funds, which made money both in 2001's tumbling markets and 2003's rally, have been caught out this year by whipsawing markets and high volatility amid the eurozone's prolonged and deepening debt crisis.
Equity funds - which often rely on fundamental stock analysis - have been particularly hurt, while macro funds, which bet on stocks, bonds, currencies and commodities, have also left some investors disappointed.
Star managers have suffered, notably John Paulson, whose main Advantage fund was down 47% to the end of November, while Crispin Odey's European fund is down around 15% to end-October, despite big gains in the autumn rally.
"Most hedge funds have a cash benchmark so one really wants to ask - have they been better than cash after fees? My sense is that many have not," said Patrick Rudden, head of blend strategies at AllianceBernstein.
A review of hedge fund performance compiled by HSBC seen by Reuters shows huge variance of more than 80 percentage points across the industry during 2011.
While the Paulson Advantage Plus fund was seen the worst performer this year, the Renaissance Institutional equities fund had advanced 32% by December 9.
"Hedge fund performance figures this year should be seen in the context of exceptionally challenging circumstances for all market participants," one industry source said.
Despite the humble returns, clients faced with volatile equity markets and meagre returns on cash and government bonds markets aren't pulling out wholesale from hedge funds because they do not know where to re-allocate to.
However, Man Group and Polar Capital have both recently reported outflows from their funds and data from BarclayHedge and TrimTabs Investment Research on Monday showed investors asked funds to return $9bn in October, more than three times the amount they pulled in September.
"Obviously investors (across the industry) are not happy with performance ... but many know why (funds have lost money) and they know you're paid to manage risk," Fabrice Cuchet, global head of alternative investments at Dexia Asset Management, told Reuters in a recent interview.
However, dissatisfaction is certainly growing.
Data from research group Preqin show the proportion of investors who say hedge fund returns have fallen short of their expectations has risen to 40%, compared with 28% last year and the 38% recorded in 2008's market chaos.
"In 2008 people were calling the end of the hedge fund industry, but in retrospect people scratched their heads and said, 'the equity market is down 40% and hedge funds are down 20%. Have they done a good job? Yes,'" the large institutional investor said.
"This (year) isn't that. This isn't a 'down 40%' year. It's a totally different situation," he said.
Guy Saintfiet, senior hedge fund researcher at pensions consultant Aon Hewitt, which has $3.8 trillion in assets under advice, said new and existing clients were still allocating to hedge funds but were far more picky about the funds they backed.
"But I think what you have seen is that the average hedge fund out there is probably not a good investment and that is the main lesson, not that the hedge funds our clients are investing in are not doing what they are supposed to be doing," he said.
Nevertheless, one head of hedge funds at a US bank said the overall industry performance has been "unimpressive" since 2007 and a broad shake-up is needed if managers want to hold onto jittery investors chastened by recent volatility.
"Not only is this a second down year in four, but the up years have been in line with the market. So you've had four years that have been in line or horrific," the manager said, speaking anonymously to avoid souring business relationships.
"In the new paradigm they should be aiming for capital protection. They should be trying to minimise down-capture and offer a decent amount of up-capture...I do have a genuine worry for the industry," he said.