NEW YORK (CNN/Money) - After a solid third quarter, October has been one of the toughest months for hedge funds in recent memory, people in the business said.

October is frequently a tough month, but this year has been particularly brutal due to the drop in energy stocks, corporate deals that fell through, and a tough environment for stock and bond markets, according to people in the industry.

"Outside Japan, most of the major markets are down, the emerging markets got hurt a lot, and macro funds that decided to go long in October are going to get hurt very badly," said Larry Smith, chief investment officer of Third Wave Global Investors, a hedge fund based in Greenwich, Conn., that trades according to broad economic trends around the world, a strategy known as global macro.

While there's still part of a trading day left and most funds won't report numbers to their investors until next month, industry sources said that traditional "long/short" stock funds in particular have taken a beating, with declines as high as 8 to 10 percent for the month in extreme cases.

Long/short equity funds, which buy stocks that fund managers believe will rise and sell short the stocks of companies they believe are overvalued, constitute a good deal of the estimated 8,000 hedge funds worldwide.

It's been a tough month for managers on both sides of the Atlantic.

The Cantillon World Ltd. fund, a global long/short equity fund and generally a top performer, was down about 3 percent for the month through Friday, bringing down its year-to-date gains to about 10 percent. Cantillon has offices in New York and London and is run by former Lazard Asset Management star William von Mueffling.

New York-based Atticus Capital's Atticus Global Ltd. fund lost more than 10 percent through the third week in October, bringing its year- to-date total down to about 11 percent.

British hedge fund manager Gartmore sent a letter to investors saying October had been its worst month ever and that its $1.5 billion AlphaGen Capella fund, traditionally a strong performer, was down 3.5 percent for the first three weeks of the month, according to a report in the Financial Times.

Short selling -- a bet that a company's stock will decline -- involves selling borrowed securities with the hope of buying them back later at a lower price and pocketing the difference. October took a chunk out of the returns of several large, traditionally high-performing funds, according to hedge fund investors.

In particular, funds that held long positions in energy stocks got slammed while the broader market struggled.

The S&P 500 is down 4.1 percent for the month. Small-cap stocks have had a particularly tough month, with the Russell 2000 Index down 6.6 percent. Long/short equity managers are raising their exposure to the U.S. stock market to historically high levels, according to research from Merrill Lynch.

Smith said stocks are rallying virtually everywhere but in the United States, where short-term interest rates have been rising for more than a year. This has acted as a drag on stocks in the short term.

Arbitrage funds, another big piece of the industry, have also had a tough time. Simply put, arbitrage managers seek to profit by simultaneously selling and buying separate but related instruments in order to profit from a difference in price.

Merger arbitrage managers trade the stocks of companies that have announced acquisitions. One person familiar with the matter said that some managers following this strategy got hurt when the family that controls Cablevision dropped its $7.9 billion bid to take the company private.

Also, arbitrageurs who ramped up their exposure to the credit markets likely got hurt due to poor timing, Smith said.

"With volatility down as low as it was, [these funds] probably felt the need to get net exposure to credit and seem to have done it at the wrong time and gotten burned in October," said Smith.

Another event that may have tripped up some hedge funds was the meltdown of commodities brokerage Refco.

Refco went into bankruptcy when customers began withdrawing assets after chief executive Phillip Bennett was charged with securities fraud on Oct. 12 for allegedly hiding a $430 million loan from the company. The company put Bennett on leave on Oct. 10 when it revealed the debt.

According to Chicago-based hedge fund tracker Hedge Fund Research, its index of 1,600 funds gained 5.6 percent in the third quarter, most of the 7.3 percent it estimates hedge funds have returned this year through September.

Hedge funds are having a tough time in comparison to recent years.

Hedge funds produced gains of nearly 10 percent last year; 15.44 percent in 2003; and 3.04 percent in 2002, when the S&P 500 was down more than 23 percent, according to the CSFB/Tremont hedge fund index, which tracks the performance of 400 hedge funds and is distinct from a Tremont's index fund for hedge funds that caters to wealthy investors.

Fund managers cautioned against reading too much into October's results, noting that one bad month does not a year make.

"If you look at the hedge funds that have had a tough month, most of them have had a pretty good year," said Peter Borish, manager of Twinfields Capital, a global macro hedge fund.

"I think we are trying to slice and dice too finely from a performance perspective. The change in performance from Friday to today could be large. A day can be a long time in this business -- it'll be interesting to see some final numbers."

Third Wave's Smith feels that as the Federal Reserve approaches the end of its rate-tightening cycle stocks will rally -- and could even start to rally before the Fed's through.

"Once the equity market sees the end of the economic cycle isn't too far away, people will be more comfortable buying stocks," said Smith. "The market will probably retrace a lot of its lost ground. I think there will be a December rally that will carry through first and second quarters of next year."

This is an updated version of a story that was first published Oct. 28.

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