Hedge Funds are hot. Since 1999, their assets under management have nearly quadrupled, to about $800 billion, as investors have flocked to them in search of superior returns and a refuge from the stock market's gyrations. But evidence is growing that these private pools of capital -- known for using sophisticated strategies off-limits to many mutual funds -- aren't performing as well as they did in the past. Worse, some types of hedge funds aren't delivering much of the diversification that reduces portfolio risk -- one of the big advantages of these pricey investments. Hedge-fund flaws have become more apparent recently, under the microscope of newly developed evaluation techniques. Indeed, although hedge funds are often measured against the returns of the Standard & Poor's 500-stock index or U.S. Treasury bonds, researchers are devising new ways to size up the track record of this relatively young asset class -- which behaves differently from stocks, bonds, and other investments. Using new yardsticks, the investing prowess of hedge-fund managers appears less impressive than previously thought. "People seem to believe the story that with hedge funds, the returns are all attributable to someone's skill," says Laurence Siegel, director of investment policy research at the Ford Foundation. "But we can separate the manager's contribution from the part due to market exposure, and the manager's added value is often smaller than what hedge funds would like you to believe."
At first glance, hedge-fund returns look pretty good. Since 1990 hedge funds have earned an average of 11.9% a year, according to Citigroup (C), which recently published a study on performance. Over the same time, the S&P 500 and the average stock mutual fund have risen 10.5% and 9.2%, respectively. Moreover, when you look at the risk-adjusted returns that many hedge-fund investors care about, hedge funds come out ahead of stocks and bonds. But on a risk-adjusted basis, hedge-fund performance has declined in recent years -- and it isn't expected to rebound anytime soon. Although there's only a short history of data from which to draw conclusions, "the managers are performing less well than they have historically," says Neil Brown, managing director at Citigroup Alternative Investments.
One explanation for the falloff is a decline in trading opportunities. With both stock market volatility and interest rates at low levels, managers have fewer arbitrage plays to exploit, says Charles Gradante, managing principal at Hennessee Group, a New York adviser to hedge fund investors. This common hedge-fund strategy involves betting on price discrepancies between investments. Furthermore, with the explosive growth in hedge funds -- the estimated 7,000 today is double 1999's number -- more managers are chasing fewer profitable potential trades. Because of the lower returns projected for the stock market, Citigroup forecasts that the average annual return to hedge funds will decline to 10.1% for the foreseeable future.
That's no small matter to investors, who pay dearly to invest in these private funds, which are generally open to those with net worths of $1 million or more. A hedge-fund investor can expect to fork over 1% to 2% of the account balance every year to cover management fees. That's not too different from the average mutual fund, which charges about 1.5% a year. But hedge funds typically pocket about 20% of any profits they generate, while regular fund investors keep all the gains after expenses.
Thanks to new methods of evaluating hedge funds, investors can also get a better handle on how much diversification they're likely to get. In the case of some types of hedge funds -- Citigroup tracks 12 styles -- the answer is not much. For example, you can replicate 93% of the movement in returns of "equity nonhedge" funds -- so named because they aren't fully protected, or hedged, against stock market declines. How? You can buy exchange-traded funds (ETFS) and other securities that track indexes, including the Russell 3000 and the MSCI Emerging Markets. Because the hedge funds move with these and other indexes, they offer little diversification to investors whose portfolios are already exposed to investments in the areas the indexes cover.
Other hedge funds that may offer little diversification, given their exposure to such common assets as value and small-cap stocks, include "short-selling" funds that bet against stocks and the "equity hedge" funds that balance exposure to stocks with short positions, according to Citigroup. In contrast, the research indicates that arbitrage funds specializing in both mergers and fixed income largely march to their own beat and so can add diversification.
The new research also answers a key question: What portion of hedge-fund returns is attributable to the widely trumpeted skills of managers, vs. the fortunes of the markets? The good news: On the whole, managers make a difference. The bad: Their skills don't seem as sharp as they were. In recent years, of the 12 styles Citigroup tracks, 11 experienced declining "alpha" -- investment-speak for the return that can't be explained by the market's movements and is assumed to be the result of the manager's hand.
To figure out whether managers are earning their keep, Citigroup researchers examined 12 indexes published by Hedge Fund Research, each covering a different style within the hedge-fund universe. After adjusting the past results -- for instance, by adding back the failed funds deleted from these indexes -- the researchers used statistical methods to estimate what portion of the past returns are attributable to traditional markets, such as commodities, stocks, currencies, and bonds. The rest -- the unexplained portion of the returns -- is the manager's contribution.
The analysis gauges whether a manager delivers more than investors can get with a basket of index funds. "In some cases, you're paying high hedge-fund fees even though markets drive a significant portion of a manager's returns," says Ryan Meredith, quantitative analyst at Citigroup Asset Management and the Citigroup study's lead author. Fund categories that delivered lower "alpha" from 1998 to 2004 are "equity market neutral" and "statistical arbitrage," each of which attempts to minimize market exposure, in part by balancing long and short positions.
Still, despite the recent performance trends, hedge funds on average continue to deliver better risk-adjusted returns than many other asset classes. So if you can afford them, by all means, shop around. But make sure to pick funds with skilled managers that add diversification to your portfolio. Otherwise, you may get very little for those hefty charges.
By Anne Tergesen