Hedge funds, the large private investment pools that have exploded in popularity this decade, have hit their most challenging performance stretch in at least a year, raising questions about whether their growth may be slowing and what that could mean for global stock and bond markets.

Investment returns in the average hedge fund dropped about 1.8% in April, according to Hennessee Group LLC, a New York advisory firm for hedge-fund investors. In all, returns are down 1.6% for the year.

While that doesn't sound like much, it could put pressure on some players in the crowded, lightly regulated arena. Customers including big institutions, pension funds and wealthy investors have flooded hedge funds in recent years seeking outsized returns that aren't necessarily tied to moves in stock and bond markets, unlike the returns of mutual funds and many other investment vehicles.

Hedge-fund managers make most of their profit from their investment gains, typically claiming a hefty 20%. Without any gains, some funds could quickly lose key employees or assets, if investors start demanding their money back.

"The hedge-fund industry has become so large that it has eliminated the very opportunities it was seeking to exploit," says Joe Aaron, of San Francisco-based Wood, Hat & Silver, which invests in hedge funds on behalf of investors but has been pulling out of them lately. "For hedge funds, regression to the mean has been faster than a speeding bullet. The good old days are gone and may be gone forever."

...So far this year, hedge funds have continued to outperform the overall stock market. Compared with the 1.6% drop in return on investment that hedge funds experienced in the first four months of 2005, the Standard & Poor's 500 index of 500 large, publicly traded stocks was down 4.5%. Over the past four years, the average hedge fund gained 6.4% annually, compared with an average annual gain of less than 2% for the S&P 500 and an average annual gain of less than 1% for the Dow Jones Industrial Average.

Over the same period, hedge funds have seen their assets soar to about $1 trillion from about $400 billion, thanks to the influx of new investment and the high returns.

Still, hedge funds are lagging behind bonds, which generally are viewed as safer investments. The Lehman Brothers U.S. Aggregate Bond Index, a broad index tracking bonds, is up 0.7% this year, through April. Some managers say that because hedge funds generally aim for much less volatility, it's unfair to compare them to broad stock and bond indexes.

Among those affected are some of the biggest and best-known funds, including Caxton Associates LLC of New York and Citadel Investment Group in Chicago, each of which has an estimated $12 billion in assets. Each lost more than 2% in April, according to investors. Representatives of Caxton and Citadel declined to comment.

As they have grown, hedge funds, which have the leeway to invest more aggressively than mutual funds and can use borrowed money, or leverage, to amplify their returns, have become much bigger players in trading in stock and bond markets, often through derivatives strategies. Problems at some funds could rebound through global markets if they unwind their positions in stocks and bonds.

Similarly, some funds could seek to increase their leverage (borrowings) to make up for limp returns. Federal Reserve Chairman Alan Greenspan recently warned about keeping an eye on hedge-fund leverage.

A range of causes explain the challenges for hedge funds. The recent drop in oil prices has caused losses at commodity funds, while currency-oriented hedge funds have been hurt by recent resilience in the dollar, which caught some by surprise. As the hedge-fund field becomes more crowded, some managers find their strategies are mimicked by other funds, making it harder to find opportunities.

Some hedge funds have been betting against shares of General Motors Corp., which has been suffering slumping sales and high costs. They took a hit last week when investor Kirk Kerkorian disclosed that he wants to raise his stake in GM to about 9%, helping the stock surge. At the same time, some funds betting against the auto maker's shares also bought GM's bonds, figuring those bonds were safer. But while Standard & Poor's decision to cut its credit rating on GM to "junk" status last week caused the bonds to fall, it didn't affect the stock as much, thanks to Mr. Kerkorian's interest. That hurt funds making this bet.

Another problem area has been convertible bonds, which pay an interest rate, like any other bond, but allow holders to convert them to stock from the issuer at a preset price. By some analyst estimates, hedge funds own more than 75% of all convertible bonds on the market.

Like other bonds, convertibles have been dropping in price amid worries about the health of the economy. That has sparked some investors to pull money out of convertible-bond hedge funds, forcing the funds to sell convertibles to raise cash to pay back their investors and putting even more pressure on the overall market. April was the worst month in more than 15 years for convertible bonds, with convertible hedge funds losing 3.5%, according to Goldman Sachs.

Because of the hedge funds' complicated trading strategies, problems in convertible hedge funds are spreading to other hedge funds that trade corporate debt, as well as to the stock-oriented hedge funds that have been at the core of the hedge-fund boom. Hedge funds known as "equity long/short funds," which buy some shares while betting on others to fall in price, lost about 2.2% on returns in April, according to the Hennessee Group, worse than the S&P drop. They are one of the largest categories of hedge funds.

Many hedge funds increasingly focus on credit-default swaps, or derivative securities that serve as insurance protecting a holder against the default of a company. If hedge funds see big losses they could be tempted to sell these derivative positions, which in turn would weigh on the shares and bonds of the underlying companies.

One of the hallmarks of hedge funds is that investors can't just pull out their money any time they wish to do so. Many funds require investors to exit only at the end of the quarter -- at best. Some worry that at the end of the second quarter in June, there will be significant withdrawals.

"My question is how many hedge funds will pack it in," says Marc Freed, a managing director at Lyster Watson & Co., which invests in dozens of hedge funds on behalf of both individual and institutional clients. Mr. Freed notes that those funds that lost in April may have trouble making up those losses in a challenging market.

That will be a key test. Similar scares appeared in the spring of 2003 and 2004, but were overcome. Some industry experts say the difference now is that interest rates are higher and many hedge funds themselves are relatively newer, with limited experience.

In short, nothing is working at present -- except muni bond floaters and some savings banks paying around 3%. And occasional real estate deals -- if you can find them.

Superfund. Super-expensive. Super-risky: "I'm Christian Baha. I manage Superfund..." Everyone's heard the TV commercials. They scream "Stay away. Stay away." After reading the 137-page prospectus, that's still my conclusion. Superfund does "managed futures," which is a euphemism for trading anything and everything -- except going long stocks (like mutual funds).

Like all managed futures trading, expenses are high, in fact, super-high. If you give Superfund $10,000 to "invest," they charge you a whopping $1,062 in fees. But it could be more. In one footnote, I found "in no instance will the total of all fees computed on a net asset basis exceed 20% per annum..." Which suggests that the fees could be as high as 20%.

The returns are a roller coaster. Not for the faint hearted. Nor do I believe they can continue them as they bring in the huge amounts of money I bet they're getting from their heavy TV advertising. I've had some experience with managed futures funds. Returns have been dropping, as everyone and their uncle jump in. Here's what they show. Look at the monthly ups and down. I don't have the stomach for something like this. I'm doubtful many people do. I don't know what the difference is between Series A and B. And I don't believe these returns will continue.

The prospectus itself lists four potential disadvantages of managed futures fund investments:
1. Lack of diversification. There's only one adviser, namely them.
2. Selection of brokers and clearing firm. You can't compare brokers. You can't choose the ones you want. They choose.
3. Potential higher fees. Tell me about them.
4. Lack of transparency. You don't know what's going on. If you had a separately managed account (which you also don't want), you'd know more and more often.
In short, Superfund is not the perfect investment, except for Mr. Christian Baha, who owns virtually all of it.

I'm getting senile
An elderly man went to his doctor and said, "Doc, I think I'm getting senile. Several times lately, I have forgotten to zip up."
"That's not senility," replied the doctor. "Senility is when you forget to zip down."

How to control the pests
A woman was having a passionate affair with an inspector from a pest-control company. One afternoon they were carrying on in the bedroom together when her husband arrived home unexpectedly.
"Quick," said the woman to her lover," into the closet."
The husband, however, became suspicious and after a search of the bedroom discovered the naked man in the closet.
"Who are you?" he asked him.
"I'm an inspector from Bugs-B-Gone," said the exterminator.
"What are you doing in there?" the husband asked.
"I'm investigating a complaint about an infestation of moths," the man replied.
"And where are your clothes?" asked the husband.
The man looked down at himself and said . . . "Those little bastards."

Harry Newton

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. That money will help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
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