Hedge funds can make money in any economic climate, or at least that's what their high-priced managers have always told affluent investors. And year after year, they delivered eye-popping absolute returns. In return, investors typically paid 2% annual fees plus 20% of profits. Eager to get in on these rarefied investments, they met suitability requirements, invested high minimums and promised they would not redeem their shares for a certain number of years.

But something went terribly wrong in 2008. Hedge funds weren't immune to the market collapse, and investors weren't used to losses and limited liquidity. The result: Once the lockups expired, investors deserted hedge funds in droves, angered by the perceived arrogance of managers who weren't holding up their end of the bargain.

Scandals have turned up the heat even more on hedge fund managers. The latest case in point: the Galleon Group, a hedge fund with $7 billion in assets run by billionaire Raj Rajaratnam. In October, he and several of his fund managers and corporate executives were charged with insider trading. The SEC said the scheme generated more than $25 million in illegal profits.

Scandals aside, a closer look at hedge fund performance numbers reveals a surprise. While hedge funds didn't make money in 2008-2009, they performed better than many other asset classes. So while the backlash against hedge funds continues, now may be the time to take a closer look at this alternative asset class.

BY THE NUMBERS

Today, there are more than 6,700 hedge funds on the market, with some $1.5 trillion in assets, according to Hedge Fund Research (HFR) in Chicago. HFR divides them into 18 categories, and the funds within each category may produce widely different returns. In late 2009, Ken Heinz, president of HFR, reported "sharp performance dispersion across funds, strategies and time frames in the last five quarters."

Nevertheless, HFR does compile a weighted composite index, called the HFRI index, that reflects results across the entire industry. From 2004 through 2007, hedge funds generally delivered the absolute returns that some sponsors promised. The HFRI composite index was up from 9% to 13% each calendar year; each year saw losses in only one or two categories.

By comparison, 2008 was a disaster. The HFRI composite index reported losses in eight months out of 12. Two of those months-in September and October-booked losses that exceeded 6%, by far the worst monthly losses in recent times. Fifteen of the 18 categories wound up in the red by year end.

For all of 2008, the HFRI index was down 19%. Although that result was certainly no cause for celebration, it was far better than the S&P 500 and the average domestic stock fund, both of which lost 37% for the year. In that light, hedge funds were absolutely bad but relatively good last year.

In 2009, hedge funds largely rebounded along with the broader stock market. Fifteen of 18 categories were up for the year, through the third quarter, and the HFRI index rose more than 17%.

Of course, a 19% loss in 2008 and a 17% gain in 2009 does not translate into a net loss of 2% for the entire period. "The 2008 to 2009 experience has been a tutorial for the industry on compounding," says Rob Arnott, chairman of Research Affiliates in Newport Beach, Calif.

After a 50% loss, for example, a 100% gain is needed to break even. Still, the HFRI's 19% loss in 2009, followed by a 17.1% gain in the first three quarters of 2009, works out to a total loss of just over 5%-a performance far better than that of stocks, real estate or commodities in that 21-month period.

Given that hedge funds generally had much smaller losses than stocks in 2008 and a solid recovery this year, it is somewhat surprising to see that investors have pulled money from hedge funds in 2009. HFR puts total net outflows at $150 billion in the first half of this year, followed by a bare $1 billion of inflows in the third quarter.

"Some hedge fund outflows resulted from investors' false sense of expectations," says Claude Schwab, who heads the U.S. hedge fund sector at Heidrick & Struggles, an executive search firm based in Chicago. "Some investors thought that hedge funds would always provide absolute returns after so many years of being flat or positive."

From 1990 through 2007, the HFRI composite index had only one down year, when it dropped 1.5% in 2002. When returns fell sharply in 2008, some disappointed investors pulled out. Schwab says the outflows continued in 2009, due at least partly to investors' liquidity needs and "the fact that the gates at some hedge funds were lifted." Some hedge funds erected barriers to redemptions during the worst of the financial crisis, and their opening permitted outflows this year. Disillusionment with steep fees and reports of fraud at some hedge funds might also have spurred redemptions this year.