Montreal, Canada.

For the first six months of 2009 the Credit Suisse-Tremont Hedge Fund Index gained 7.18% after logging one of its best quarters in almost ten years from April to June. That’s a big reversal from last year’s debacle when hedge funds tanked more than 19% -- their worst year in history.

In a major disappointment, hedge funds failed to protect capital amid carnage in 2008. That’s unlike the 2000-2002 bear market where the group as a whole posted net profits; the difference, of course, was that credit markets went into crash-mode last year severely derailing many strategies. And global long/short equity hedge funds – which never did a good job beating the market in good years – got trashed in 2008. What happened to hedging?

At their peak in late 2007, global hedge fund assets stood at roughly $2.1 trillion dollars – a huge increase from the barely $50 billion under management in 1990. Hedge funds grew widely popular over the last decade as MBAs and hot-shot traders from the biggest banks started their own hedge funds. But the worst bear market since the 1930s last year changed all that.

Hedge funds now manage about $1.5 trillion dollars – a hefty 29% decline in assets from the all-time high. In the fourth quarter of 2008, investors redeemed nearly $150 billion dollars from hedge funds, or around 10% of all hedge fund assets. In 2008, total net outflows were approximately $200 billion dollars or 10% of industry assets; estimates for the first six months of 2009 continue to show more redemptions but at a far slower rate. Still, the damage has been done to the industry and for important reasons.

Bernie Madoff certainly didn’t boost the appeal of hedge funds. The biggest investment fraud in history has damaged the credibility of hedge funds at a time when the industry is shedding assets at a rapid rate.

Restricting client redemptions is probably the worst policy mistake hedge funds made.

As global capital markets began to crash late last year many hedge funds began to impose gates on client redemptions. Most hedge fund prospectuses allow for this clause, which I personally coin a fund’s “death knell” because once you impose restrictions on client capital it ultimately serves to destroy your business. Hedge funds argue that gates are vital in the event of systemic risk – which occurred last fall as counter-party failures grew following Lehman’s bankruptcy in mid-September. Hedge funds need those gates because many strategies are illiquid.

The hedge fund industry will survive. There are many great traders remaining in 2009. But it’s fair to assume that hedge funds will become a greater part of pension fund and large institutional assets because of the illiquid nature of the business. Hedge funds don’t appeal to high net-worth investors anymore; investors and smaller institutions now prize liquidity following the credit crisis and hedge fund models only superimpose high fees and redemption gates – variables that are only suitable for the big fish who can apportion small percentages in alternative investments.

As for me, I closed my hedge fund-of-funds in late 2008 after 12 years of trading. The strategy was conservative and produced an 8% annualized return with low risk – beating the stock market. I closed my fund on September 30 and the timing could not have been better. October and the next several months turned out to be horrendous for all hedge fund strategies, except short-sellers.

The business has changed dramatically, the fees are still too high and redemption clauses are too restrictive. Hedge funds are generally not the right investment product in the age of violent capital markets and rapid liquidity.