July 1 (Bloomberg) -- Markets sank last year. So too did hedge-fund performance. Markets soared in the just-finished quarter. Hedge funds notched up big wins.

Now remind me why they are called hedge funds.

Bull-market geniuses may be a better moniker. For all the talk of being able to make money whether stocks rise or fall, hedge funds too often look more like index-hugging mutual funds.

Some academic research shows hedge funds are no better at stock picking than the buy-and-hold crowd. Add in the hefty fees hedge funds often charge, and they are “a worse vehicle than mutual funds,” argues an academic research paper entitled, “How Smart Are the Smart Guys?”

Its conclusion: Not very. Or at least not as smart as many hedge-fund guys think, especially now that markets are again giving them a lift.

That isn’t an indictment of the concept of hedge funds. If anything, market turmoil shows there is a huge need for managers who really know specific companies and sectors and can bob and weave with them.

It’s just that few hedge funds live up to this ideal, or justify fees that typically equal 2 percent of assets on top of a 20 percent cut of any profits. That’s partly the result of the incredible surge in hedge funds earlier this decade, when industry assets soared past $2 trillion and rising markets gave even second-rate managers a boost.

Imploding markets have changed that. Almost 1,500 hedge funds went out of business last year, according to Hedge Fund Research Inc., a Chicago-based research outfit. And casualties continue to mount.

Closing Shop

Last month, for instance, James Pallotta said he would shut his Raptor Global hedge funds, while Cantillon Capital Management LLC, an asset management firm run by William von Mueffling, planned to close two hedge funds.

Of course, the hedge-fund news hasn’t been entirely bad. Hedge funds lost 19 percent in 2008, compared with a 38 percent decline for the Standard & Poor’s 500 Index. By the end of May, Hedge Fund Research’s HFRI Fund Weighted Composite Index was up 9.8 percent, compared with a less than 2 percent increase in the S&P 500.

Market gains during the just-ended quarter, the first positive three-month period for many stock indexes since late 2007, have also helped slow investor redemptions, which crippled many hedge funds in late 2008.

Still, hedge funds are meant to do more than simply lose less money than the broader market. They are supposed to protect investors’ capital.

Investors shouldn’t forget that too many hedge funds failed this bear-market test. That’s especially important since rising markets mean investors are likely to again hear the smart-money siren song.

Doubts Raised

A helpful reality check: the “Smart Guys” academic research I cited earlier. The paper, by John Griffin, an associate professor of finance at the University of Texas at Austin, and Jin Xu, of hedge fund Zebra Capital Management LLC, raises doubts about “the ability of hedge-fund management to add value” for investors.

Their conclusions are based on a study of stock picks from 306 hedge-fund companies from 1980 to 2004, as disclosed in Securities and Exchange Commission filings. The findings were initially presented in early 2007 and published this month in the Review of Financial Studies.

While hedge funds invest in all kinds of assets, stock picks are telling because so many funds focus on buying and selling equities. About 42 percent of hedge funds are engaged in stock-picking strategies, according to the paper.

Big Deal

Griffin and Xu found that the stock picks of the hedge funds in the study outperformed mutual-fund performance for the same period by only 1.32 percent a year. This advantage proved insignificant when the impact of the tech-stock boom was excluded.

Fees further erode any hedge-fund advantage, which for Griffin and Wu means these managers didn’t’ “come close to justifying” the standard 20 percent performance levy.

Findings like these fly in the face of much other research that suggests hedge funds demonstrate superior stock-picking skills or the ability to time sectors and markets.

Griffin said this was because his research didn’t include things that can smooth hedge-fund results, like tough-to-verify values of infrequently traded securities or options strategies.

One possible shortcoming: the research didn’t reflect bets that stocks or industry groups will fall in value. These so- called short positions aren’t reported in SEC filings.

Going Short

Over the past two years, funds that heavily shorted the markets, particularly financial stocks, did amazingly well. Yet short positions aren’t likely to skew the results in hedge funds’ favor, Griffin argued, because “if you can’t find evidence that funds are able to pick stocks on the long side, why should they do so much better on the short side?”

The chance that they can’t may help explain why so many hedge funds disappointed so many investors the past two years. In that case, hedge funds’ real genius may have been their ability to use the boom to hype ho-hum skills.

This time around, investors should make sure they are paying for smart performance, not smart talk.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: David Reilly at dreilly14@bloomberg.net

Last Updated: July 1, 2009 00:01 EDT