Lately, being a hedge-fund manager is akin to being the captain of one of those crab boats on the Discovery Channel's hard-bitten reality-television show Deadliest Catch. Battered by stormy market conditions, shifting regulations, and nervous investors, it seems a remarkable feat to simply survive the icy, unforgiving waters, let alone make it out with anything to show for the effort.

Data company Hedge Fund Research estimates that there were more than 10,200 hedge funds managing over $1.93 trillion as of the second quarter of 2008, the latest period for which numbers are available. However, September marked the worst-performing month for hedge funds in a decade. HFR's Global Hedge Fund Index was down nearly 7% in September alone, bringing the year-to-date total to a loss of 13%. Meanwhile, its Equal Weighted Strategies Index was down more than 10% year-to-date.

September 30, the last day of the third quarter, was Redemption Day for many hedge funds, which have 45- to 65-day redemption-notice requirements, according to Richard Wilson, a Boston-based hedge-fund consultant and creator of HedgeFundBlogger.com.

While at press time it was too soon to tell whether there would actually be a run on hedge-fund redemptions due to poor performance, a nervous industry was already holding its breath in anticipation of bad news.

And all of this comes on the heels of a lackluster first half. HFR reports that more than 180 funds closed their doors in the second quarter, pushing the total so far this year to more than 350. At that pace, more than 700 funds, or 7% of the industry, would be closed by year-end. That wouldn't top 2005's record bloodbath of 850 closed funds—but it'd be uncomfortably close.

"If there [were] such a thing as a hedge-fund crisis, then I definitely would say that we were in one right now," Wilson says, comparing this sector's unraveling to the banking sector's slow unwinding of subprimemortgage– linked portfolios.

With such a long and obvious downward trend, investors and advisors need to ask: Is it time to withdraw from the hedge-fund sector, or time to follow conventional market wisdom and get in on funds that are trying to raise cash? Getting to the heart of that answer requires some digging in sands that may well shift in the months ahead.

Battered Funds, Good Investments?

First, it's important to understand some of the challenges that hedge funds have been facing lately. Tight credit markets have made it more difficult and far more expensive for funds that use high leverage. The money simply isn't flowing—and even when the funds can get it, it's more expensive.

"A lot of hedge funds have been getting their big returns because they employ a lot of leverage," says Ann C. Logue, author of Hedge Funds for Dummies. "They borrow a lot of money and their investment strategies are fairly simple. They just have to return the money that they borrow. In the current markets, we've seen some of those trades have not worked out, especially the trades that were made based on mortgage-backed securities or credit derivatives."

Ironically, hedge-fund problems could magnify the overall spiral of decline. Hedge funds have been a source of liquidity in the market. High redemption rates and failing funds could impact the broader market because hedge funds would be less able to provide that liquidity, says Stephen Brown, finance professor at New York University's Stern School of Business. As a result, more businesses could fail because of an inability to raise cash.

Larry Eiben, chief operating officer of TFS Capital, a portfolio management advisory firm in Richmond, Va., theorizes that the funds that are going to survive are the ones that have dialed back their leverage and exposure to financial stocks and other volatile sectors.

"You can't feel great about putting your money to work when there's a ban on short-selling. It's just an ugly environment for the long/short manager," Eiben says."I don't think the long/short manager is so concerned [that] this bank or that brokerage is going to fail. It has more to do with the uncertainty of 'Is the government going to intervene? How are they going to intervene?' And not being able to see that coming."

Uncertain Times and Asset Allocation

With so many challenges, should investors be putting their money elsewhere? John Benevides, president of the Family Office Exchange, a membership-based research advisory firm for ultra-high-net-worth individuals, says his members are long-term investors—they've given no indication that they are panicking and pulling all of their money out of hedge funds.