The hedge fund industry has been forced to contemplate a perplexing contradiction: why is money continuing to pour into its products despite the sector underperforming the S&P 500 for the past four and a half years?

The typical hedge fund gained 3.9% this year through August, compared with 16.2% gains for the S&P 500, according to data provider Hedge Fund Research. Last year, the average hedge fund returned 6.4% versus 16% for the S&P 500, the data provider said.