A swamp is sometimes an unsightly thing, but when you drain it, who knows what you find at the bottom.

It's a timely worry because the swamp that's now being drained is an ocean of cheap money that has flooded the financial world, and as the credit ebbs and people stop lending, some 12,000 hedge funds have been caught naked and short (or in some cases, with naked shorts), reeling in their inability to borrow and forced to put up more collateral and liquidate positions both good and bad.

How bad has this year been for hedge funds? In this rarefied and opaque world where formulas for making money are as secret as the formula for Coca-Cola, the best description for the $2 trillion industry this year is probably the one least adorned by hyperbole.

"It's not good," says Brad Alford, the founder of RIA firm Alpha Capital Management in Atlanta and a former director of investments at the Emory University endowment.

It's been said to be the worst year for hedge fund in two decades. The HFRX Global Hedge Fund Index was down 11.6% for the year as of September 30. The HFN Hedge Fund Aggregate was -4.28% for September and -7.69% for the year. Peter Laurelli of HedgeFund.net, which runs the aggregate, had predicted before that September was likely to be the worst month in the modern history of hedge funds.

The Morningstar 1000 Hedge Fund Index was down 13.19% for the year through September 30 and the monthly return for September was negative 7.87%. (These numbers are for funds reporting through October 12 to Morningstar.) Some 550 portfolios had shuttered their doors through August 2008, according to the site. Among firms that have either closed this year or announced they were closing are the $2.8 billion flagship fund of Ospraie Management LLC, Drake Management's $2.5 billion flagship fund and Andor Capital Management, which runs about $2 billion. Other firms that have closed funds are Peloton Partners LLP, which shut down a $2 billion asset-backed portfolio, and Sailfish Capital Partners, which shut down a multistrategy fixed-income fund.

And it could get much worse, especially with the sinking of Lehman Brothers, which is going into bankruptcy and taking a lot of hedge fund trading positions down with it. "I think more [closures] will come to light as the press catches on to the September returns," says Peter Rup, a hedge fund-of-funds manager with Orion Capital Management LLC in New York City. "They're just abysmal."

Hedge funds have preserved capital better than the S&P 500, which was down 20.6% for the year through September. But their vaunted promise of absolute returns and all-weather positive performance has turned out all wet this year-angering the sorts of investors who pay a lot for the privilege of positive performance and dislike cracks in the pool.

"They're not supposed to be measured relative to the market," says Nadia Van Dalen, a hedge fund analyst with Morningstar. "They're supposed to have absolute returns, and the fact that they're doing poorly in a down market might turn people away."

As it turns out, subpar performance is the least of the hedge fund world's problems. The blowups have been loud and harsh, as one fund after another announces it has to close because of the credit freeze.

"The No. 1 thing is the deleveraging of the financial system," says Rup. "A lot of these firms have had credit removed, and worse yet if you were highly leveraged and had these lines of credit removed, you were forced to deleverage yourself and sell at a price that was not optimal."

That doesn't even take into account the possible catastrophe of bank runs by their investors and fund-of-fund managers. The liquidation means a vicious cycle of value decline, and more managers getting out of the business.

If fund managers seem too sensitive to even the slightest attack right now, it might not be guilt so much as a justified fear of mass liquidations by nervous investors, which would make things undeniably worse and drag down the guilty and the innocent alike in a Biblical deluge.

Meanwhile, as fund values shrink, the managers must climb back up to high watermark levels before generating those golden 20% performance returns again. That either kills a lot of managers' incentive to keep going or hinders their ability to woo new talent. Either way, the money freeze keeps them from amping up the returns the way they like and makes some strategies moribund.

And then there is perhaps the unkindest cut of all: A vociferous crowd of pundits, populist politicians and unemployed investment bankers who still blame the hedge funds for a lot of the financial crisis by saying the funds overly shorted firms like Bear Stearns and helped bring them down or ravenously bid for dangerous credit default swaps, which ended up swamping giant insurer AIG.

The hedge fund managers and their partisans, however, say that blaming them for smothering the financial services companies is grossly unfair since it was ultimately overly leveraged banks and insurers that were responsible for their own demise. "Short sellers didn't make Morgan and Lehman and Bear put on 30 to 40 to 1 leverage and create all these toxic instruments," says Alford. "They had nothing to do with that. They are the market equalizer. They make the market more efficient."

Hedge fund managers now are in the difficult position of trying to remind their investors that if they bail, they will miss what will inevitably be a bounce back in the markets. But even though the climate has created opportunity for some, especially those who want to move into the distressed areas and trade on volatility, the market's volatility, its three-sigma events and unanticipated government intervention are giving managers nightmares.

They have spent much of this year building up their cash positions as part of a great unwinding of leverage and battening down the hatches for a feared wave of redemptions. Many funds have frozen redemptions this year (or thrown up "gates"). "They raise cash when there is excess greed or excess fear," says Charles Gradante of hedge fund advisor the Hennessee Group. "And right now there is excess fear. The market is not trading on fundamentals."

Says Alford: "I know some of our hedge funds have just said, 'We can't figure this market out, let's just sit in cash."

Funds Are Crashing, But For Different Reasons
Hedge funds are so diverse it's unfair to tar them with the same brush. But then again, at this point there appears to be an ebbing tide that is sinking all boats.

"The market has taken every sector and asset class-whether it's gold, whether it's oil or whatever-and systematically taken it down," says Alford. "There's really been no diversifier."

There are some strategies, like merger arbitrage and convertible arbitrage, that depend on short selling, and the ban could hit them right where they live. The most common hedge fund structure-long-short equity-has been caught in a whipsaw this year because many of them had bet long on energy and short on financials. The energy and commodities market then tanked in July after a long run-up and soon after that came the ban on financial short selling-squaring the circle and killing the bet utterly.

Rup says that the government intervention also hurt long-short equity because it made the market zigzag, or become discontinuous. When the S&P 500 broke below 1200 (a "technical breakdown"), he says, many managers did what prudent managers usually do and moved to insure their long bets by shorting S&P futures or increasing the short side of portfolio.

"But the problem," he says, "is that they went below 1200 for all of about five hours before the government stepped in and banned the short selling. And the market rallied from 1135 on the S&P to 1290 within 12 hours. That's a 160-point move within the index-an 11% move. If you think about putting insurance on at the 1130, 1140 level and then having to cover it above 1200 at 1240 or 1250, then you've taken a massive hit on your insurance."

This will be another reason September numbers should go on to become as bad as those in July and August, if not much much worse. "It's the uncertainty about how to properly manage that has led to bad numbers," Rup says. "This is not something that anybody could without hindsight know how to manage. Unless you were just lucky, you were hurt."

Knife Swap
Then there is the catastrophe with AIG and Lehman Brothers. Credit default swaps, which act as insurance on a bond's default and spread widening, have in the past couple of years become as popular as Vanilla Coke among hedge funds. According to different reports, hedge funds made up more than 50% of the market for credit default swaps and traded them like baseball cards in a speculative fashion as corporate spreads widened over Treasurys.

The instrument looked like free money to insure bonds with little collateral to risk, and hedge funds became eager buyers of these instruments as spreads started to widen, a move that made them a lot of money in 2007.

But then things went terribly wrong: The defaults started. The most famous victim so far is insurance giant AIG, which came undone by having so much risk on its books it couldn't shore up, though there are some 13 other players, says Gradante. There is some question about how much of this CDS risk the hedge funds ultimately have on their own books as sellers (rather than just buyers).

"That's the million-dollar question," says Rup. However, he personally doubts that many hedge funds would take on that kind of risk. He and Gradante of Hennessee say that the credit default swap market was a much smaller part of the hedge fund market than people realize.

The bigger problem was what hedge fund managers had tied up in Lehman Brothers. When the investment bank went bankrupt, many of its prime brokerage accounts were frozen, and the failure caused a systemic meltdown as funds raced to get the assets out of other banks as well; after that the price of insuring assets went up, requiring even more collateral.

"I don't think anyone in the hedge fund community wanted Lehman to go under," says Alford. "All of our hedge funds are sitting there [trying to decide] what their exposure is and what their percentage is and their assets, and it's surprising. With Bear that never happened. They had the government backing it up. Lehman has just been an absolute disaster. Anyone who thought they were going to go bankrupt would have pulled their assets, but nobody thought they were going to go bankrupt." The result, he says, is that now many hedge funds have assets on their books they can't value, and nobody knows what anything is worth if a client wants to come and get money out. A big mess.

After This, The Deluge
Most will do badly this year, but the optimists say that the market turmoil is simply going to purge the worst tares from the vineyard and that the more rugged strategies, those that are not so dependent on leverage, will survive.
"Will there be as much liquidity and leverage available to hedge funds on an ongoing basis? The answer is definitely not," says Rup. "But that's a good thing, not a bad thing. I can point to any number of hedge funds that were excessively overleveraging their portfolios to generate returns. You know, hedge funds in general should not be looking at 5% expected-rate-of-return investments on their own merit and then leveraging them four times to get to 20%. Hedge funds should be looking at 20% expected rate of return opportunities and then leveraging it slightly."

That begs the question, is anybody doing well? Some are-those who are trading on volatility. Distressed debt will likely be the new hot play, though some say it's still early for this market.

"Another strategy that I've seen pop up is lending," says Morningstar's Van Dalen. "So there are some funds that are taking advantage of this mortgage crisis. I know of one fund that is basically refinancing loans or nonperforming loans of borrowers, taking them off the books of banks and refinancing it for people and they make money off the difference."

Gradante warns that smart investors need to stay in the space and trust in those managers who are less leveraged. "In 2002 we were down 22% for the year, and the following year we were up 16% in 2003," he says. "The media is correct in saying that the market is deleveraging. Too many took that to mean that hedge funds were getting ready to implode.  

"There is a fear that there is too much leverage in the hedge fund arena, but once that fear is alleviated, you'll see more come back. Because institutions and individuals have made more money in hedge funds than anywhere else. You're down 4% this year, but that 4% loss will become a 20% gain when the market turns around."

But there's an even larger question confronting the hedge fund community. How much money will high-net-worth individuals and their advisors want to commit to investing styles that typically carry huge fees and carve out big chunks of investors' profits in the good years? Observers expect many hedge funds to experience major withdrawals at year-end, withdrawals that are likely to force more hedgies to shut their doors.