Most Hedge Funds Disappoint

If you shop at Sears, Kmart or JCPenney you have already experienced the disappointment that hedge fund managers bring to the reality of actually running a business, as opposed to theorizing about it.

But if you are an investor, whether a high net worth individual or, increasingly, someone in the middle class who wants in on the action, you are discovering that the genius of asset allocation hasnt been working so well in that sphere either.

The argument that hedge funds have made for themselves is not that they produce higher returns, but that they reduce risk and thus improve returns over the long term. Their exceptional compensation is therefore allegedly based on their ability to steer investors into securities and other 'vehicles' to preserve as well as expand capital. Only even that turns out not to be true. As the following article explains, hedge funds may simply have met the same fate that of other crowded industries: too many people chasing too few good ideas - and some not doing it as well as others. In fact, as offended as the well-educated and well paid may be at the notion, they are not so different from the lower end retailers they appear to covet: those who got in too late or simply havent kept up can not generate the returns of their better-managed competitors. Bummer. JL

Stephen Gandel reports in Fortune:

Funds have underperformed at a time when they are drawing more and more money from middle class retirement accounts.
Hedge funds have been a bust.

That's how Robert Arnott, one of the nation's most successful investment managers, sees it. That's also the conclusion of a piece of research posted on his firm's website this week.

The research, which is titled "The Lure of Hedge Funds," directly refutes one of the key claims hedge funds managers make when they try to attract investors.
"There are some outstanding hedge funds, but they are considerably outnumbered by the multitudes of lousy ones," says Arnott, who heads Research Affiliates.
Hedge funds have traditionally been investment vehicles for the rich and universities. But in the past decade or so, they have drawn more and more money from public pensions and other accounts that hold the retirement funds of the middle class. Assets in hedge funds have more than tripled in the past decade to $2.25 trillion, according to Research Affiliates.
"The results have been a disappointment, and yet asset flows continue at an astronomical rate," says Arnott.
Part of that has to do with the sales pitch.
On the face of it, hedge funds have had a rough go of it recently. The vast majority of funds have done worse than the market for the past four years. To add insult to injury, last year even mutual funds outperformed hedge funds, which charge much higher fees than their rivals.
But hedge fund managers and the industry in general have long contended that those criticizing the funds for not having the highest returns are missing the point. They say hedge funds achieve their investment returns with less risk. You hear of the benefits of diversification, and risk-adjusted-returns. The pro-hedge fund camp argues that when you factor in the lower risk, investing in hedge funds is a better bet than just blindly putting your money in the market.
To prove it, Arnott's colleagues started with a portfolio with a basic mix -- 60% stocks and 40% bonds. They then took a look at what would happen if the portfolio was shifted gradually, 10% at a time, into hedge funds. The result: Returns went down, and risk went up as the exposure to hedge funds increased, which is the opposite of what you want. "Portfolio efficiency didn't improve," says RA's John West, author of the firm's hedge fund study. "In fact, it deteriorates with each additional allocation to hedge funds."
Hedge funds did a little better over the past 15 years. But even over that period, West found that a pension fund would have done better by adding a passively managed mix of commodities, real estate, and other assets, rather than expensive hedge funds.
Arnott's critique of hedge funds comes amid a number of recent high-profile blowups, which have thrown some cold water on the notion that hedge fund managers are masters of some kind of dark magic. John Paulson, who made billions for himself and his hedge fund clients, has reportedly lost $1 billion betting on gold. Bill Ackman, another hedge fund star, has stumbled with his bet to revive department store J.C. Penney (JCP).
And hedge funds and the pension world are starting to clash. On Thursday, the nation's second largest teachers union criticized a number of prominent fund managers for financing organizations that have called for the government to unfund public pensions. Said one union official, "They come to us with their hand out, and then they are stabbing us in the back."