LONDON (Dow Jones)--Investor demand for hedge funds dropped sharply last year according to data released Monday, with just $40 billion in new money allocated to the asset class.

New York-based consultancy Hennessee Group estimates that hedge fund assets under management swelled by 12% over the year to $1.12 trillion, but that two-thirds of the growth came from performance returns.

Net inflows in 2005 raised total assets by just 4%, down from 19% in 2004 and off a peak of 34% in 2001.

"The hedge fund industry continues to grow as investors diversify their portfolios," E. Lee Hennessee, managing principal of the Hennessee Group said in a statement, though "it is still just a small part of the U.S. equity and bond markets, which combined comprise over $28 trillion."

Hedge fund assets under management have doubled over the past four years as wealthy individuals and institutions sought double-digit returns and portfolio diversification. But modest returns over the past two years and high fees have led some investors to scale back their allocations.

Hennessee found that direct investments by high net wealth individuals and family offices continue to be the largest source of capital for hedge funds, accounting for an estimated 44% of total industry capital.

Funds of hedge funds represent an estimated 28% of assets under management, while corporations and institutions, pension plans and endowments and foundations make up the remainder of investors in hedge funds.

Within hedge fund strategies, Hennessee Group said total assets for arbitrage and event-driven funds were up by about 12.2% in 2005, and that the majority of assets in this area were allocated to multi-strategy arbitrage funds.

According to Hennessee data released two weeks ago, arbitrage and event driven funds tracked by the consultancy gained 5.3% in 2005, indicating that most of their growth in assets came from new capital.

Long/short equity assets under management increased by about 11.5%, with just under 7% of the growth coming from performance gains.

The overall Hennessee Hedge Fund Index climbed 8% in 2005, beating U.S. equity market benchmarks such as the Standard & Poor's 500 and the Nasdaq Composite, which returned 4.9% and 1.4%, respectively.

The average annual return of the Hennessee Hedge Fund Index between 1987 and 2004 was 14.9%.