Hedge funds posted their worst returns in three years in the third quarter, and the fourth quarter appears to be off to an equally rocky start.

For hedge funds around the world, the average loss was 5.02 percent in the three months ended September 28, according to Hedge Fund Monitor, a report compiled by analysts with Bank of America.

Not since the third quarter of 2008, when the global financial system ground to a halt and hedge funds posted an average decline of 9.48 percent, has the $2 trillion industry performed so poorly.

Many savvy money managers were badly bruised by August's vicious market sell-off, and September brought no reprieve. The report said the average hedge fund loss was 2.31 percent last month as concern mounted about the European debt crisis and commodities from gold to corn nose-dived.

Still, hedge funds outperformed the Standard and Poor's 500 index, which lost 5.56 percent in September. Through Monday, the index was down 12.6 percent for the year.

The selling in the stock markets has continued into October, something that could bode poorly for many fund managers heading into the end of the year.

Last month, managers who specialize in going long and short on stocks were hit particularly hard, with those hedge funds registering an average decline of 4.76 percent. Traditional long/short funds make bets on some stocks rising and other falling.

The best performing class of hedge funds in September was Commodity Trading Advisors, which places bets on the futures market and in commodities such as energy and metals. Still, the report said CTAs were only flat for the month.

The relentless volatility that has come to define 2011 has tripped up some of the industry's biggest stars.

John Paulson, manager of the $32.8 billion Paulson & Co, who earned billions with prescient bets on the sub-prime mortgage crisis and gold, miscalculated the timing of a U.S. economic recovery and has paid dearly for it. His flagship Advantage fund has lost about 35 percent this year, investors say.

Other prominent hedge fund managers seeing red this year include Lee Ainslie's Maverick Capital and the world's largest publicly traded hedge fund, Man Group, which last week revealed its investors had withdrawn a net $2.6 billion in the third quarter.

(Reporting by Katya Wachtel, editing by Matthew Goldstein and John Wallace)

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