Hedge funds are supposed to be the ultimate diversification tool. The idea is that the returns post low/negative correlation with broad measures of conventional investing strategies and yet somehow manage to deliver positive returns when the standard strategies tumble. That’s certainly true some of the time for some of the managers. But expecting hedge funds writ large to deliver satisfaction is too often dashed on the rocks of reality. The notion of a hedge fund beta, in other words, isn’t all that attractive.

The latest bit of evidence comes from news reports today that “hedge funds had their fourth-worst first half since industry performance-tracking began,” according to a story from MarketWatch.com. The article goes on to report:

An index of hedge funds run by Hennessee climbed 0.2% in the first half of 2010. The only years with worse performance in the first six months of the year were 2008, 2002, and 1994, the firm noted. Hennessee has been tracking performance in the industry since 1987.

Those three previous calendar years, by the way, just happened to be losing years for stocks, in case you were wondering. Shocking, isn’t it? Yes, there’s a hedge fund beta, but in broad terms it has a fairly high correlation with the stock market.
What’s the problem now? Jason Bonanca, who runs strategy and research for hedge fund MKP Capital Management, offered an opinion via Reuters today: “The noise quotient in the market has been very high this year, and it is hard to make money when there is that amount of underlying volatility.”
Really? That’s strange, considering that many fans of hedge funds advise that this “nimble” corner of managed money excels in taking advantage of volatility. If you can’t prove yourself (and your high fees) when markets are volatile, when is the right time to own hedge funds? When markets are relatively calm? But isn’t that when conventional plain-vanilla indexing strategies tend to do best? Hmmm.
The problem is that aggregating hedge fund returns into a single benchmark is something akin to herding people off the street onto a stage and expecting to find lots of talent. Sure, you’ll find it, but it’s likely to be rare.
Consider the 12-month trailing returns for long-short mutual funds, according to Morningstar Principia software. For the year through the end of May 2010, returns for the 100-plus funds in this category ranged from a high of nearly 47% down to a loss of more than 20%. For perspective, the S&P 500 was up about 20% over that stretch. For the past 3 years, the top annualized performance for long-short mutual funds was in excess of 12%; the worst roughly -15%. The S&P’s gain during that period was a slight 0.3% annualized return.
The variation is even greater in privately managed hedge funds. But that performance in excess, presumably, is the attraction. Hedge fund strategies reportedly benefit from the fact that managers can do almost anything, in contrast to the highly regulated world of mutual funds and ETFs. But the dark side of that equation is that returns can be all over the map with lightly regulated hedge funds, for good or ill. As such, the risk in pursuing hedge fund beta is that you end up with mush—and that’s before deducting all the hefty fees.
Yes, some hedge funds live up to the hype, but many (most?) don’t. In the end, we’re all swimming in the same waters, trading the same securities and looking at the same data. A few talented managers will be able to beat the odds, but most will deliver mediocrity, or worse. Ditto for conventional investing.
That inspires picking and choosing hedge fund managers as opposed to buying them in the aggregate (or owning the growing array of publicly traded funds that attempt to capture the hedge fund beta). There’s certainly a case for focusing on the best hedge funds .But that opens a new can of worms. Even if you can identify talent, it’s not obvious that the crème de la creme is going to let you into the club.
Meanwhile, even the truly talented managers face more competition over time. “Hedge funds, when they were new, did make a lot of money,” reports MoneyLife.com.

According to Chicago-based data provider Hedge Fund Research between 1990 and 2000 hedge funds were able to achieve an astonishing annual return of 18.74%. They did this by exploiting opportunities in markets. Of course the great thing about competitive markets is that success breeds competition subsequently driving down prices. Over the more recent past, between 2000 and 2007, hedge fund returns have been far more modest, just an 8.61%.

In the end, everything becomes a commodity eventually. The only question is how much you pay for it. Alas, bargains in the land of hedge funds are the exception.