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Hedge funds disappoint -- again

(MoneyWatch) Considerable academic research demonstrates that there is little to no persistence of performance for actively managed mutual funds. Hedge fund investors only wished they could say the same thing.

The performance of hedge funds has been persistently poor, with 2012 being no exception. The HFRX Global Hedge Fund Index returned just 3.5 percent in 2012. By comparison, the S&P 500 Index returned 16 percent. In fact, there was only one year, 2008, in the past 10 when hedge funds beat the S&P 500. Over the past five years, the S&P 500 returned 1.7 percent per year, producing a cumulative return of 8.6 percent, while the HFRX Index lost 2.9 percent per year, producing a cumulative loss of 13.6 percent.

Last year's performance was so poor that the HFRX Global Hedge Fund Index not only underperformed stocks, but even the Barclays Government/Credit Bond Index, which returned 4.8 percent. That marked the sixth year out of the past 10 that the HRFX underperformed this bond index.

Even worse is that if we compare the return of the HFRX Global Bond Fund Index to the return of a balanced stock/bond portfolio -- 60 percent S&P 500 Index/40 percent Barclays Government/Credit Bond Index -- 2012 marked 10 straight years of underperformance.

Even more devastating is the performance of a subset of hedge funds called "absolute return" funds. These funds are supposed to get positive returns regardless of what the market is doing. That is the "promise," or at least the idea behind them. Unfortunately, the evidence shows that the only thing absolute about them is that they have delivered absolutely abysmal performance. In fact, the HFRX Absolute Return Index actually produced negative returns in three of the past five years.

The cumulative return for the period 2008-2012 was -18.7 percent, or an annualized loss of 4.1 percent per year. By comparison, the BofA Merrill Lynch One-Year Treasury Index (pretty close to a riskless investment) returned 1.4 percent a year, producing a cumulative gain of 7.3 percent, and never had a year with a negative return. The Barclays Government/Credit Bond Index returned 6.1 percent per year, producing a cumulative return of 34.2 percent, and it too did not experience a single year with a loss. For the 10-year period 2003-2012 the Absolute Return Index returned just 0.7 percent a year, underperforming even riskless one-month Treasury bills, which returned 1.8 percent a year.

Given the poor performance of hedge funds, the real puzzle is why investors keep pouring money into them. The only explanations I can think of are that investors have been dazzled by the marketing pitches of Wall Street and are unaware of the evidence.

Finally, some readers will respond with something along these lines: "Who cares what the average fund does? I only buy the top performers." The only problem is that the academic research demonstrates that, just as with actively managed mutual funds, there's no persistence of outperformance of hedge funds beyond the randomly expected.

That's one reason why funds of hedge funds, which tout their ability to identify the future winners, have done so poorly. The other reason is the high costs the industry charges to deliver such poor results.