Hedge Funds Go For a Makeover

The Merrill report says that cuts too far into investors' potential alpha -- the measure of a fund's average performance independent of the market. While light regulation makes it hard to know how much money has made its way to hedge funds through funds of funds, the consulting group Van Hedge Fund Advisors International said the average compound annual return for a single-strategy hedge fund was 17.8% between 1988 and 2003, while funds of funds had an average return of only 11.8% during the period.

"Funds of funds fail to show significant alphas in any period reflecting either the burden of the double fee structure or the difficulty in putting together a portfolio of hedge funds that shows persistent positive performance over time, or both reasons simultaneously," the report said.

George Van, founder of Van Hedge, said most investors are aware of the double fees and accept that as the price of venturing into a new asset class. A bigger hurdle is that while fund of funds managers may know which single-strategy funds enjoy good reputations, past performance can never guarantee future results.

"It seems intuitively easy to put together a diverse portfolio of hedge fund and have it perform well over time, but in fact it's difficult," he said. "There is no choice but to use history as a strong indicator of a fund's performance."