Hedge funds were supposed to post positive returns in any environment and they charged heavy fees for that consistency. But it didn’t work out that way—they fell in 2008 just like everything else. Still, some investors and advisors are now sniffing around these opaque investments again. And they may indeed deserve a place in your client’s portfolio, but it’s your responsibility to make sure clients understand there’s no such thing as “absolute return.”

Hedge funds, those opaque alternative investments designed to post positive returns regardless of how the overall market performs, created headlines for falling into the red alongside traditional investments in last year's brutal crash. The fall from grace was so sharp that many smaller funds have shuttered, and observers expect more to follow.

Not surprisingly, investors headed for the exits. Some analysts and financial advisors now say that hedge funds overcharge for the service they deliver. They say that last year's mauling showed that this emperor had no clothes.

Still, some investors are considering going back to the surviving funds. Strategists in the wirehouses and elsewhere say hedge funds were wrongly maligned, and that the good funds can still serve the purpose of diversifying a portfolio and reducing risk. Better still, they say hedge funds are positioned to do well in the coming months and years.

Indeed, a few hardy souls are dipping their toes back in the alternative waters. The combined intake of $41.4 billion for May, June and July was the first net inflow for a three-month period since December 2007, according to HedgeFund.net. This fresh cash comes after a drop of 37% from the peak of $2.94 trillion in April 2008.

Despite the recent inflows, the amounts are small enough that some analysts are loath to call it a trend. "Investors are taking a wait-and-see attitude; they are going to wait to see what happens to the money they put in," said Peter Laurelli, head of hedge fund industry research at Channel Capital Group, which runs HedgeFund.net. "Once you go through a difficult situation it's tough to come back with the same intensity," he said. He expects August to post another modest inflow.

It's easy to see the new allure of the funds. HedgeFund.net's aggregate index for all the strategies it tracks shows an increase of 12% for the year through July. The benchmark dropped 15.8% last year.

Many in the industry warn against trying to glean too much from one overall performance statistic because these funds track various investment strategies that are designed to perform differently in different scenarios. (One old saw has it that hedge funds are a billing class rather than an asset class, referring to the 2% management fees and 20% performance fees that most have in common.)

But a deeper look into HedgeFund.net's overall numbers shows that nearly every strategy practiced by the 7,100 funds and funds-of-funds in its database gained ground. Thanks to the rally in equities and commodities, the only losing strategy is practiced by short-based funds, which saw its index drop 12.4% through the end of July. The best performing index so far this year tracks the funds investing is India, which notched gains of 34.7%.

ABSOLUTE RETURNS

The increase in performance this year is a welcome change for investors, but why was last year so bad? Hedge funds certainly did better than the broader market, but whatever happened to the notion that these investments were supposed to be "absolute return vehicles?"

Nadia Papagiannis, hedge fund analyst at Morningstar put it most succinctly: "It's a fallacy. No such strategy makes money in every single market. Theoretically, it's possible... if you can hedge out all market risk in your portfolio and always have positive alpha, then you can have an absolute return strategy," she says. "It's a good theory, but it doesn't work in practice. I've never seen a manager who always profits from stock picking and market timing. And a lot of funds that say their strategy is absolute return aren't [portraying it accurately] because a lot of strategies work well in some environments and not in others. To say that's absolute return is lying," Papagiannis says.

This issue was the subject of a January research report, "Why My 'Absolute Return' Hedge Fund Lost Money 'Absolutely' in 2008" by Gregory Dowling of the Fund Evaluation Group, a consultancy catering to institutional clients.

He pointed out that hedge funds did their job of returning absolutely in the bear market of March 2000 to March 2003. They protected capital and managed to profit as well. And investors expected them to do it again in the next downturn.