They're baa-aack!

Hedge funds, that is. After all the turmoil and trauma of the last three years, hedge funds are rebounding so rapidly that assets could see inflows of $222 billion this year, bringing total assets under management to $1.72 trillion by the end of 2010, according to a Deutsche Bank survey. That's despite the fact that by the end of 2009, there were still more funds closing their doors than opening up.

Now a small cluster of high-profile players, like Pierre-Henri Flamand of Goldman Sachs or, in Asia, Wang Bing and James Tu, alumni from of Deutsche Bank and DKR Oasis Management, are reported to be tiptoeing back into the market. (Even a veteran of scandal-ridden Galleon is said to be trying to raise capital.) And institutional investors—those giant pension funds and endowments—are looking with renewed interest at hedge funds after these go-anywhere, do-anything vehicles posted average returns of 20 percent last year.

That should be good news for Wall Street, for whom the hedge fund industry has been very good, indeed. Not only have investment banks themselves made money directly by managing their own hedge funds, but their trading desks have profited from the high-volume trading strategies of many funds. Hedge funds have also increasingly become consumers of Wall Street products of various kinds, not to mention the prime brokerage revenues and profits hedge funds have generated.

StreetWise wouldn't dream of quibbling with Deutsche Bank's survey results. Without a doubt, institutional investors are more eager than ever to find a new way to capture some returns, and interest in alternatives is, if anything, stronger than it was back in 2006.

And there's no question that the turmoil of 2007 and 2008, however painful it was to endure, ultimately will prove good for the industry. Let's face it, in an industry that relies on finding and capturing above-market returns known as alpha, having 10,000 or so funds chasing around the world in search of the latest new new thing isn't really conducive to alpha sticking around for long. (As one "frontier" investment fund manager recently put it, you have to go to Botswana these days to find great alpha.)

At a recent conference, Cliff Asness, who runs AQR Capital, a quant-based hedge fund and investment group, was heard griping about how rapidly alpha turns into average returns known as beta these days. MIT's big brain, Andrew Lo, also has been making the rounds discussing the phenomenon of the fleeting nature of alpha. So fewer players chasing that elusive stuff can only be a good thing, especially when the ultra-aggressive and high-risk players (not to mention those who have allegedly been building their returns on illegal activity) are removed from the scene.

But…

There are still some issues that the hedge fund community is going to have to reckon with going forward. Here are just a few of them, put forward by some of the managers and other market participants.

1. The shakeout is continuing. Some big hedge fund groups are reporting losses (GLG, Fortress), and others, including some of the biggest names around, are seeing losses. Others are in turmoil. Renaissance Technologies has had three large hedge funds. One, the flagship Medallion fund, is now limited to insiders and has fared well. The two others continue to lag badly.

The two new co-managers, heirs to the legendary and philanthropic James Simons, raised the possibility that they will shut the doors on the two laggards. The Street pretty much considers this to be a done deal. Renaissance will never be what it once was, goes the consensus. Even Goldman Sachs and Citadel continued to shed assets. The new power players on the Street? Well, John Paulson, who made his name and his fortune shorting a panoply of subprime-related investments only to go long the banking sector last year and short Greek debt and other struggling Eurozone securities more recently, has joined the exclusive list (compiled annually by Pensions & Investments) of funds with at least $20 billion in assets.