By CAROLYN CUI and JENNY STRASBURG

The rally in natural-gas prices has caught many hedge funds flatfooted, sparking a string of unexpected losses for top-name players.

Morgan Stanley Smith Barney clients invested in a $640 million group of funds that have emerged as some of the biggest losers in the turmoil. Hedge funds known as "trend followers"—which chase market movements, rather than making fundamental investment decisions —also appear to have been hurt on bad trades.

Earlier this year, traders and portfolio managers across the Street rushed into natural-gas trades, with the "consensus opinion" that prices would continue to languish.

For most of that time, the bet proved a surefire winner—gas prices tumbled 22% in the first five months of 2010—and investors piled in.

The trade was so popular that by May 4, the overall sum of speculators' bets flipped from wagering on a price increase to the opposite, or a "net short" position, according to the Commodity Futures Trading Commission.

Traders believed that an increase in production and mild consumption would continue to weigh on prices. Instead, prices shot up 15% in June amid forecasts for the hottest U.S. summer in 30 years, which would increase demand by power plants that use natural gas to generate electricity. There also were predictions for a flurry of hurricanes, which could cause halts in production.

Trading natural gas has long been considered a game for the strong willed. The commodity fluctuates wildly—for example, last August it lost 40% before jumping 93% in September.

One specific trading favorite, betting on the difference in pricing between a summer and winter contract, is known in the market as the "widow maker" for its perilousness. That particular bet brought down Amaranth Advisors in 2006, one of the biggest hedge-fund collapses in history.

Speculation about another fund collapse hit the market this week, with traders guessing that funds were forced to close out their positions.

"You definitely had a large number of institutional shorts in this market. This rise has caught some of these participants by surprise," said Teri Viswanath, director of commodities research at Credit Suisse.

Five funds housed within Morgan Stanley Smith Barney, investment pools catering to clients of Citigroup Inc. and Morgan Stanley, have lost $120 million or more this year on energy bets, based on assets detailed in public filings.

The Bristol Energy Fund, which as of the end of March held some $500 million in assets, and several smaller funds managed by Houston-based hedge-fund manager SandRidge Capital suffered as natural-gas trades went against them. Big SandRidge funds lost some 15% in the first half of this month, bringing the firm's 2010 decline to about 19%, Reuters reported.

"The manager has experienced a difficult performance this year, and in particular this month, but since we have been working with them, they have generated a positive return for clients," a Morgan Stanley Smith Barney spokeswoman said. She wouldn't comment specifically on the funds' performance. SandRidge couldn't be reached for comment.

Superfund USA, which runs several managed-futures portfolios with $1.25 billion in assets, has been shorting gas this year. The fund lost money on its natural-gas position, which accounts for 1% of its total assets, in April and May, before being forced to close out the position in late May by its technical signal, said Paul Wigdor, chief investment officer.

On June 4, Credit Suisse recommend investors short natural-gas for October delivery, saying the rally had gone too far. The contract was then trading at $4.94 per million British thermal units, and has gained 4.3% since, settling Friday at $5.153.

"In hindsight, we were probably a little bit early," said Ms. Viswanath of Credit Suisse. "Our failure was in underestimating the strength of this particular rally." The Swiss bank still reckons that there will be a correction in gas prices before the end of October. Some funds have profited by chasing the upward momentum.

Tim Pickering, president of Auspice Capital Advisors, said the firm is "doing great on natural gas." Auspice runs a natural-gas exchange-traded fund and a diversified commodity fund. The $232-million Claymore Natural Gas Commodity ETF was up 7.4% since the end of May.

London-based BlueCrest Capital Management LLP was up about 2% this month as of mid-June, and more than 3% for the year, in its $10 billion BlueTrend Fund, helped in part by natural-gas trading gains, a person close to the matter said. That followed a loss of about 8% in the fund for May.

—Christine Buurma contributed to this article.
Write to Carolyn Cui at carolyn.cui@wsj.com and Jenny Strasburg at jenny.strasburg@wsj.com

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