NEW YORK (Bloomberg) — Hedge-fund managers, Wall Street's best compensated and supposedly smartest investors, are dazed and confused.

Reeling from the worst second-quarter performance in a decade, hedge funds have scaled back trading as they struggle to figure out where markets are headed amid sometimes vicious crosscurrents in stock, commodities and other markets, according to brokers and managers.

"There's a degree of being frozen in the headlights, of not knowing what sectors to emphasise, of what securities to emphasise," said Tim Ghriskey, chief investment officer of Solaris Asset Management LLC, a firm in Bedford Hills, New York, with $2 billion in hedge funds and conventional stock funds.

Hedge-fund managers, who oversee $1.67 trillion in assets, are reluctant to put money to work as they are buffeted by a wide range of often conflicting political and economic forces, from fiscal policy in Europe and the US, to what regulations will be imposed on the financial-services and energy industries, to the growth prospects in China. In turn, smaller and fewer trades may make it harder for funds to rebound from losses incurred since May, when the industry suffered its worst decline in 18 months.

"For many people, it's a frustrating market given the high volatility and low volumes," said Aaron Garvey, portfolio manager at MKP Capital Management LLC, a New York-based hedge fund overseeing $3.5 billion. "We are seeing strong opposing forces in the markets, which makes generating strong convictions difficult for the medium- and long-term."

Prime brokers such as Credit Suisse Group AG and JPMorgan Chase & Co. that service hedge funds report that managers are borrowing less money and are sitting on more cash. Credit Suisse's hedge-fund clients held 24 percent of their assets in cash in June, compared with 19 percent three months earlier, according to the Zurich-based bank's prime brokerage unit. US stock market trading last month had its steepest June decline in at least 13 years. Daily trading volume for the Standard & Poor's 500 Index of the largest US companies averaged 1.09 billion shares in June, 20 percent less than in May. The 15 percent decrease last year was the second-biggest slump between May and June in Bloomberg data going back to 1997.

Hedge funds account for 20 percent of the equities volume in the US, according to Tabb Group LLC, a New York-based adviser to financial-service companies.

Trading of options on stocks, indexes and exchange-traded funds on the eight US exchanges also fell in June, declining two percent from last year to 309 million contracts for the month, according to the Chicago-based Options Clearing Corp. Options are contracts that give the right to buy or sell assets at a set price by a specific date.

"We're trying to reduce risk by downsizing of our trades," said Max Trautman, a former Goldman Sachs Group Inc. proprietary trader and co-founder of Stoneworks Asset Management LLP, a $460 million macro hedge fund based in London. "It's not that we have stopped taking views but we're just putting less risk in them."

Global stocks posted the biggest losses in the second quarter since the bull market began last year, as the sovereign- debt crisis in Greece threatened to spread to other European countries.

Chinese government restrictions on lending and real estate, intended to prevent the world's third-largest economy from overheating, added to concerns global growth may slow. In the US, slowing growth in manufacturing, an unexpected jump in jobless claims and a slump in home sales have fuelled concern the economic recovery is faltering.

Hedge-fund managers say they're also worried about the impact of financial reform being introduced as a result of the Wall Street meltdown, and energy regulation following the BP Plc oil spill in the Gulf of Mexico, the largest in US history.

Among managers sticking to convictions is John Paulson, who is betting on a US economic recovery after making $15 billion with a wager against home mortgages during the financial crisis. Paulson lost 6.9 percent in June in his Advantage Plus hedge fund and 4.4 percent in his Advantage fund, according to two investors briefed on the returns.

The funds were positioned to profit from a jump in stocks including financial-services companies, said the clients, who asked not to be named because the fund is private.

Paulson, who runs the $33 billion New York-based Paulson & Co., hasn't changed his bullish views after the stock market's decline and last week's data showing weaker-than-expected private-sector employment in June, according to the investors. Almost two-thirds of the firm's assets are in his Advantage funds, which invest in corporate events such as bankruptcies and mergers.

Paulson, 54, has told clients he expects inflation to increase over the next three to five years, which is why he has also been buying gold and mining shares, including AngloGold Ashanti Ltd. and Kinross Gold Corp. Gold has risen about 10 percent this year. Paulson's Gold Fund climbed 7.3 percent in June and 13 percent for the year, the investors said.