Trimming The Hedge Funds.

The Silver Surfer : "Surfing in a declining market, I am looking for high rates of attrition."

Before the market downdraft, there were about 10,000 hedge funds with an estimated value of $1 trillion.

Look for about half of them to disappear - but don't worry. It's healthy.

This is a cleansing process. There's a lot of leverage that's being unwound. A lot of funds are liquidating winners to finance sinners.

Investors pulled about $43 billion out of hedge funds in September. Money under management will continue to decline and funds will continue to take hits in a declining market.

Hedge funds appear to be an acceptable casualty in the eyes of government, as well as those of many small investors. But Main Street won't escape the fallout as the sector contracts.

Hedge funds are a mystery to many individual investors, and are often regarded as being volatile and leveraged to the hilt. The reality is more complex. A hedge fund can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and take a position in just about any opportunity in any market.

While strategies vary greatly, many funds hedge against market downturns. The goal: Use a range of techniques to reduce risk, boost returns and limit the correlation with equity and bond markets. In short, the means may be buccaneering but the goal is conservative.

Many fretted that risk-happy hedge funds someday would crash the world's financial markets. Instead, it was thumb-sucking mortgage lenders and established investment banks that gave the world a glimpse of Armageddon.

But that doesn't mean hedge funds are in the clear. In fact, hedge funds may be the next sector to fall.

So far, major funds have taken a hit, but haven't been shattered. One reason: The funds were conservatively managed, contrary to their gunslinging image in the general press. Paradoxically, it looks like most hedge funds took fewer risks than some investment banks.

Here's why: Hedge funds, unlike many mortgage lenders, were playing with their own money and were directly accountable to investors. Any misstep by a hedge-fund manager instantly set off howls, while his investment- and mortgage-bank brethren could make bad decisions until they built to tsunami proportions.

But that's changing. The value of publicly traded hedge funds has taken a hit. Man Group, the world's biggest publicly traded hedge fund, has lost about 41% of its value since July.

And things are likely to get worse. Look for hedge funds to take a hit, because the credit crunch means they can no longer leverage investments. The reason: Credit won't be widely available.

Hedge funds had little to do with the underlying conditions that led to the mortgage crash, but nevertheless will face increased restrictions as part of politicians' need to regulate the markets and do something -- anything -- to address the recent turmoil.

The immediate result of new regulation will be less wiggle room for fund managers. This will almost certainly erode returns, and make hedge funds less attractive to investors.

Big Ben and the central bankers will do their best to prevent future bubbles from building in various markets. This may be good news for the economy - but it will take a bite out of hedge funds, because deft managers were adept at chasing inflated asset classes and knowing when to get out, thereby pocketing a nifty profit.

Buyout funds routinely tapped the debt markets to finance the next acquisition. Such businesses can't thrive if debt markets seize up. What's next? Anyone interested in buying some used office furniture from a hedge fund?

The worldwide economic slowdown will hurt major industries, including those buyout funds routinely trolled, such as retailing and manufacturing. That means there will be few, if any, new deals ahead and existing deals may go bad.

The once saucy financial markets will become increasingly dowdy. That means innovative hedge-fund managers will have few chips to play in a game that has largely disappeared.

There will be rough times ahead, but the sun will continue to rise in the east.