If hedge funds are as bad as the headlines would have us believe, why do sophisticated institutions keep investing in them?

Anyone glimpsing headlines lately knows that hedge funds are accused of causing the Cooper Union college endowment to fail, are underperforming and overcharging, and are riddled with lawbreaking traders. So here’s a puzzle: Why do sophisticated institutions keep adding to the $2 trillion they’ve already invested in hedge funds?

The first big clue lies in the surprising identity of the first “hedged fund” operator: Benjamin Graham, the very father of deep-value stock investing and the spirit-guide of Warren Buffett. Nervous about the heights the market was reaching in the Roaring Twenties, Graham devised a clever way to make money—regardless of whether it continued to rise, or started to fall. The trick? Buy a stock he liked, and simultaneously sell short one he didn’t.

Provided only that his preferred pick did relatively better than the disfavored one, the plan worked beautifully. If share prices rose, the long position would gain more than the short would lose; in a falling market, the long would lose less than the short would make.

Now, naturally, that strategy will trail the overall market performance during long periods of steady upward price movements. (And if you can foretell such stretches and when they will end, you should ignore the idea.) But over the past 30 years of highly volatile markets, a “long/short” approach like Graham’s has returned about five times as much as the indexes have for every dollar invested. So-called underperformance during shorter-term market rallies is the price paid for the protection that the funds provide, and smart investors don’t regret that any more than they do having paid for life insurance but failing to die.

That’s one poorly understood aspect of hedge-fund investing. Another is the widely reported “average hedge fund” performance number. The only common feature of all hedge funds is a specific pooled-investment legal format. They pursue different strategies, in disparate asset classes, with divergent investment goals. Some funds invest in stocks in an attempt to profit on announced corporate mergers. Others invest in futures, to profit from big-picture global trends. Yet others prefer bonds, exploiting tiny price discrepancies between similar issuers. Some hedge funds do shoot for big gains; others aim to grind out slow and steady returns. There are at least a dozen major hedge-fund categories, and hundreds of permutations overall.

Thus, finance articles focusing on a combined-performance statistic for all hedge funds are the equivalent of a sports story that averages the scores of the local baseball, football and basketball teams.

And just as important, the difference in performance between the top and bottom 10% of hedge funds in any given strategy is enormous, much greater than it is in the stock-picking world. Investors don’t invest with a mythical average manager, they invest in an actual one, and the blended performance of others in the field mean nothing for how well the investment performs.

None of this is meant as a valentine to the hedgies. An awful lot of managers do charge Tiffany prices for Kmart merchandise. The common “2 and 20” model, with investors paying an annual 2% management fee and forking over 20% of any profits earned, is tough to justify in today’s return environment. Sure, some managers have the track record to demand it, just as Meryl Streep can name her price for a movie. But most managers, and actors, don’t deserve what the superstars do.

So, agreed: Hedge-fund fees can be excessive, there are some bad funds, and rogue managers do exist. But those sorts of criticisms can be applied to every class of investment throughout the history of finance.

What cannot be said is that the basic logic of investing in hedge funds is flawed. The $2 trillion in the funds tells us that, amid today’s unprecedented financial and political cross currents, many savvy investors don’t want to make all-in, one-way bets on the stock market. They’re voting for downside protection, strategies that tend to zig when markets zag, and broader opportunities for profit. That’s less a puzzle than it is plain common sense.

Mr. Rice, managing partner at Tangent Capital, is the author of “The Alternative Answer: The Nontraditional Investments That Drive the World’s Best-Performing Portfolios,” just out from HarperBusiness.