* Citadel to return cash equal to 2017 gains - letter
* Citadel flagship funds up 11.43 pct to Oct. 31 - source
* Investors add $1.2 bln in first three quarters of 2017 (Updates with graphic link)
By Maiya Keidan and Lawrence Delevingne
LONDON/NEW YORK, Nov 10 (Reuters) - Multi-manager hedge funds, often star performers, have recovered from below-par returns in 2016, with investors adding $1.2 billion to them during the first three quarters of 2017.
Although traditionally they are meant to achieve some of the best returns by running different investment strategies and moving money between them based on their success, many investing approaches used by hedge funds actually lost money in 2016.
As a result, $1.8 billion flowed out of multi-manager funds last year, industry tracker Eurekahedge data shows.
The sector posted returns of 5.1 percent up to the end of September 2016, data from Preqin shows, while the S&P 500 index made gains of 8.6 percent over the same period.
Although these funds have generated returns of 8.14 percent on average so far to Sep. 30 this year, they have again lost out to the S&P 500 index, which was up 12.7 percent.
(Source: multi-strategy gains from Preqin, equities, macro and hedge fund gains from HFR)
Despite this, their improvement over last year is enabling some firms to return profits to investors.
Citadel, one of the largest team-based hedge funds with $28 billion in investment capital, is among the top performers this year, with gains of 11.43 percent in its flagship fund through October, a source close to the firm said.
It is now planning on returning all profits from 2017 to investors, a letter reviewed by Reuters shows.
Traditionally some funds want to keep funds under management below a certain level as it becomes harder to manage assets above that threshold.
A spokesman for Citadel, founded by Chicago billionaire Ken Griffin, said it routinely returns profits, though it did not in 2016 when it made 5 percent, a source close to the firm said.
"We have routinely made profit distributions, in whole or in part, across a number of our funds over the past 20 years,” Citadel spokesman Zia Ahmed said.
Other multi-managers may not be far behind after improved performances. Folger Hill's fund, for example, is up 4.5 percent through end-October, according to a person familiar with the situation, a turnaround from losing 17.5 percent last year.
Millennium Management's International fund is up 5.54 percent in the year to Sept. 30, compared to just 3.38 percent in 2016, according to data compiled by HSBC. Balyasny's Atlas Global Investments fund was up 3.59 percent to Oct. 13, after losing 0.73 percent in 2016, the same data showed.
"Multi-strategy funds are (in general) having a better year so far in 2017 relative to 2016," Russell Barlow, head of hedge fund investments at Aberdeen Standard Investments, said.
Last year saw some firms doing particularly badly, notably Blackstone Group's Senfina Advisors, which lost almost a quarter of assets from performance losses and closed down.
"Security selection based on fundamentals is being rewarded, equity sector dispersion has increased and interest rate divergence has resulted in better opportunities for relative value strategies," Barlow added.
Smaller funds run by Boothbay Absolute Return Strategies and Verition Fund Management are up an estimated 11.8 percent and 9.7 percent through Oct. 31, respectively, both outstripping 2016 returns, people familiar with the situation said.
Multibillion-dollar U.S. investor Schonfeld Strategic Advisors made gains of 14 percent in the year to end-September, a person familiar with the matter said.
However, Citadel appears to be the only multi-manager so far to have performed strongly enough to return profits.
But Citadel has not always performed well and asking to make redemptions has frustrated some investors who have stuck with them, particularly when many firms are already closed to new investment due to their popularity.
"I find this very sad," said one fund-of-fund investor who received a letter to redeem capital. "Especially that we have trusted them in 2009 ...after having had a very difficult 2008."
Citadel's flagship funds lost 55 percent in 2008 and investors asked to withdraw $1.5 billion.
Many investors prefer to keep profits from their initial investment with a manager in order to best generate year-on-year returns and avoid having to find a new home for their cash.
Reporting by Maiya Keidan; additional reporting by Svea Herbst-Bayliss; editing by Alexander Smith