NEW YORK (CNN/Money) -
Debates about the merits of hedge funds may never end, but one fact remains undisputed: Their coffers are swelling.
In its annual survey of hedge funds with $1 billion or more in assets, the hedge fund industry publication Absolute Return magazine found 196 hedge funds in that group with a combined $743 billion under management -- the vast majority of the industry's estimated $1 trillion in assets.
Westport, Conn.-based Bridgewater Associates topped the list, with $17.7 billion in assets, followed closely by New York-based D.E. Shaw, with $17.1 billion.
Goldman Sachs took third place with $15.3 billion in assets, shattering the notion that hedge funds are strictly entrepreneurial and demonstrating how serious Wall Street's biggest investment banks and brokerage firms are about these funds. Barclays Global Investors also made the list, coming in sixth place at $12.2 billion.
Hedge funds have exploded in recent years, as investors disappointed with traditional funds started looking for new places to invest. Just last year, the hedge fund industry took in $123 billion in new capital, up from $72 billion in 2003, according to Tremont Capital Management, a hedge fund investment and advisory firm.
The growth took place while hedge funds struggled with tough market conditions. The funds this year have produced average returns of 2 to 4 percent, according to various indexes that track these funds. The S&P 500 is up 0.6 percent so far this year while the Dow industrials and Nasdaq are down.
This year also saw a big drop in returns at funds using convertible arbitrage, long considered one of the most popular and stable hedge fund strategies in which a manager buys a company's convertible bonds and bets against the company's stock. Funds employing this strategy have lost a combined $5.1 billion in assets since the beginning of the year.
Activist funds gain big
Despite the tough conditions, Absolute Return found that overall assets grew 9.3 percent since its last survey earlier this year. Several firms, including Glenview Capital, Cantillion Capital Management and Atticus Capital, landed higher up than in previous surveys on the back of strong performance this year.
And some activist hedge funds – the popular style du jour, in which managers seek to effect changes in corporate management to boost share prices – grew dramatically. Daniel Loeb, the manager famous for his scathing letters to corporate executives he feels are underperforming, saw a 52 percent gain in assets at his Third Point Management, from $2.1 billion at the start of the year to more than $3 billion.
Carl Icahn, who is new to the world of hedge funds but not to the world of activism, notched a 31 percent growth in assets in his Icahn Partners fund.
Other funds in the survey's top 10 include Farallon Capital Management, with $13.8 billion; Citadel Investment Group, with $12 billion; Och Ziff Capital, with $12 billion and Maverick Capital, with $11.5 billion.
Tough year overall
The difficult environment meant zero gains for some prominent firms, such as Amaranth and Pequot Capital Management. Angelo, Gordon returned some capital to investors, which reduced the firm's assets by 30 percent, to $8 billion. The firm had ranked No. 4 in the magazine's previous survey.
First coined by Alfred Winslow Jones in 1949, the term "hedge fund" originally referred to a portfolio of stocks with both long positions and short positions. The short positions were included to act as a hedge against losses in the long positions.
Today, the term is a more apt description of a legal structure than an investment style -- the funds are still private, and limited to a certain number of investors, each of whom must have at least $1 million in assets.
Hedge funds today employ a wide variety of styles, including long/short equity, which involves taking long positions in some stocks and selling others short, and distressed investing, which involves buying the securities of troubled companies.
Some hedge funds bet on commodity futures and trade systematically, while others, such as Eddie Lampert's ESL, buy whole companies in the hope of turning them around.
Since their inception, these funds have courted a reputation for big blowups and huge, risky bets, largely because of a small number of managers who made big news.
In 1992, hedge fund maverick George Soros bet against the British pound, a trade that earned him $1 billion and led one newspaper to declare him "The Man who broke the Bank of England."
And in 1998, hedge fund Long Term Capital Management collapsed, nearly sending the financial markets into a tailspin before a consortium of Wall Street firms, encouraged by the New York Fed, raised $3.5 billion and bailed the fund out.
Since then, hedge funds have dramatically scaled down the use of borrowed money to enhance returns, and a growing number of institutional investors, such as the California Public Employees Retirement System, the nation's largest public pension, have put money into hedge funds, alleviating some of the mystique surrounding these funds.
Also, investors have gotten savvier, performing background checks on managers and demanding managers disclose more information about their investment styles.
But that didn't stop some institutional investors from getting burned by Bayou, a Connecticut hedge fund that at its peak told investors it had $440 million in assets. The firm's founders are now being investigated for fraud, and officials are combing records for what's left of the fund's assets.
As of February 2006, hedge funds will be required to register as investment advisers with the Securities and Exchange Commission.
CLARIFICATION: An earlier version of this story reported that Angelo Gordon's assets declined because of a difficult investing environment. Angelo Gordon states that its assets actually declined because the firm voluntarily returned capital to investors. Firms do this when their funds have become too large to effectively manage or when opportunities dry up in a given strategy.