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Another year of lousy returns for hedge funds

Before jumping into how hedge funds fared last year, a story in yesterday's Wall Street Journal caught my eye. The FBI made several arrests of people associated with hedge funds on Wednesday, alleging that the group conspired together by passing insider information among one another. According to investigators, the gains from their activity amounted to $61.8 million.

For me, it served as a reminder of one of the main risks of investing in hedge funds. With their typical compensation structure of 2 percent of assets and 20 percent of profits, hedge-fund managers and associates stand to gain a lot of money when they enjoy excellent returns. Unfortunately, that can cause hedge funds to end up with far more risk than may be appropriate, or worse, to end up leading the professionals handling them to do something illegal in pursuit of profits.

Perhaps most amazing, having a leg up on the competition doesn't seem to help hedge-fund returns beat out comparable indexes. As a group, hedge funds trailed each domestic and bond index in our comparison, though they outperformed each of the international indexes. For the period since 2003 (which is the longest for which we have data), hedge funds have underperformed each major index.

While the HFRX index performed poorly against domestic indexes, it's also important to see how hedge funds fared against diversified portfolios. Using the indexes from the table, an all-stock portfolio (50 percent international/50 percent domestic, equally weighted within those broad categories, rebalanced annually) would have returned -7.0 percent.

The typical allocations of pension plans and many investors is 60 percent stocks and 40 percent bonds. A 60/40 portfolio with those weights (using the all-stock portfolio described above for the stock portion) would have returned -4.0 percent using one-year Treasuries for bonds, -0.4 percent using five-year Treasuries and 7.1 percent using long-term Treasuries. Given the freedom to move across asset classes that hedge funds tout as their big advantage, one would think that "advantage" would show up.

With their high risks and seemingly poor returns, you have to wonder why someone would want to be invested in such vehicles.

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