By the end of the year, hedge funds are expected to have returned on average about 7% - the lowest since 2002 and down from 9.5% in 2004 - and unless there is a return to volatility in the markets, analysts expect more of the same in 2006.

"In broad terms hedge funds are going to disappoint again next year," said Hilary Wakefield, a director at EFG private bank, according to Reuters.

"Hedge funds will need a lot of volatility, something to really get things moving, to make good progress," Wakefield added.

To a degree, the hedge fund industry has become a victim of its own success as the value of assets under management in the sector has risen from $500 billion to more than $1 trillion in the space of five years. This has meant an explosion in the amount of money chasing the same profit opportunities ironing out the market inefficiencies that made hedge funds successful in previous years.

However, because hedge funds can be much more flexible in their trading approach than conventional equity fund managers by selling short and investing in all manner of financial instruments from equities to commodity derivatives, their returns have a low correlation to stocks and bonds which means that even when hedge funds are not pulling in big returns, they, by definition, can act as a hedging tool against a possible downturn in the stock markets.

"If there are problems in the world, then hedge funds can reduce the overall volatility of the returns in your portfolio," observed Wakefield.

"That is the attraction for institutions who have become much more concerned about capital preservation," Wakefield added.