Hedge Funds Hit Limits

With large chunks of pensions' assets at risk, big hedge funds tend to manage money more conservatively. It makes sense when one considers the industry's fee structure, which generally charges 1.5% on assets and 20% on returns. A $5 billion hedge fund manager is more likely to be satisfied with a 1.5% management fee on assets than is one managing $50 million.

The dynamic could also be bringing down the industry's overall performance.

"It's very difficult to find funds with 25% returns. Hedge funds are more interested in running a business than running a fund," says Paul Zummo, head of JP Morgan Alternative Asset Management, the fund-of-funds arm of the bank. "The fact that pensions demand consistency of returns is part of the problem." As a result, Zummo says, leading hedge funds have increasingly rolled out multistrategy funds and are taking less risk exposure.

Pabrai predicts that large funds are not going to do as well than in the past. "They have marketed themselves as vehicles that do not lose money because they're hedged. That is a false statement. Even if they hedge perfectly, they charge fees and they have to perform over the cost of those fees in order to look good," he says.

Some say that if hedge fund performance doesn't turn around, the industry's glory days are behind it.

"I will be very surprised if 10 years from now, hedge funds have the size they have today or are still the cocktail party conversation. All of that will die down in the next few years," says Pabrai.