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Morgan Stanley says hedge funds fail to outperform

Evidence of hedge funds' failure to persistently generate risk-adjusted outperformance is already pretty substantial, so fresh proof on the subject may not be all that surprising. But when a big Wall Street firm that sells hedge fund offerings comes to the same conclusion? Well, that's certainly worth noting.

Morgan Stanley strategist Adam Parker analyzed the performance of hedge funds and concluded that hedge fund alpha (or the returns above proper benchmarks) has disappeared.

Remarkably, the strategist also found that the correlation between hedge fund returns and the S&P 500 has risen to nearly 100 percent in the past couple of years. Thus, any diversification benefit there might have been to hedge funds has vanished as well.

This simply adds to the large body of evidence demonstrating that after appropriately adjusting for risks and biases in the data, hedge funds have had a hard time keeping up with the risk-adjusted returns of Treasury bills. My books, The Only Guide to Alternative Investments You'll Ever Need and The Quest for Alpha, both have chapters that provide details from the many academic papers on the subject. And the picture is a pretty dismal one.

More on funds: Index investing beats active management (again)

Each quarter I also provide an update on the performance of the HFRX Global Hedge Fund Index. The latest data showed that from 2003 through the end of the most recent quarter, the index underperformed every single major equity asset class -- and even virtually riskless one-year Treasury bills. Through November 17, the year-to-date performance of the index was -7.7 percent.

As is the case with mutual funds, not all hedge funds are created equal, and some are actually generating some excess returns. However, the research also shows that just as is the case with mutual funds, there's no persistence of performance beyond the randomly expected.

In other words, there's no way to tell the difference between a good fund manager and a merely lucky one. Thus, we have no way of knowing ahead of time which of the few hedge funds will actually deliver on their promise of alpha going forward.

The bottom line remains unchanged: Hedge funds are the best vehicles ever created in order to transfer wealth from the wallets of the country club set to the wallets of the purveyors.

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