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It's Official: Hedge Funds Had Their Worst Year Since 2008

BOSTON ( TheStreet) -- Hedge funds last year had their worst outing since 2008, underperforming the stock market amid record volatility, Europe's debt woes and a worsening U.S. economy.

Hedge fund managers struggled to generate alpha, or gains above market indices. Hennessee Group, an adviser to hedge fund investors, said today that its Hennessee Hedge Fund Index dropped 4.3% in 2011, compared to a flat performance for the S&P 500. It was the second year in a row that hedge funds failed to beat equity indices.

John Paulson's flagship hedge fund was reportedly down 51% in 2011

Charles Gradante, co-founder of Hennessee Group, said hedge fund managers described 2011 as "more frustrating than 2008," noting that many reduced risk exposure in the fourth quarter that kept them from benefiting from the strong year-end rally.

Hennessee Group noted that equity markets were driven by macro issues in 2011, "which overshadowed strong corporate earnings and an improving economy." The firm said that several hedge funds expressed frustration in long positions of companies, where they beat expectations but still saw share prices decline more than the broader indices. And while stocks rallied sharply higher in October, managers entered the fourth quarter with low exposure levels and were caught off guard by the double-digit rally.

Most famously, hedge fund manager John Paulson of Paulson & Co. had a terrible 2011, watching his flagship fund drop 51% in 2011 after several bets went terribly wrong. By comparison, Paulson's Advantage Plus fund jumped 164% in 2007, according to Bloomberg, thanks to Paulson's bet against the subprime mortgage market.

The Hennessee Group said its Global/Macro Index was among the worst performers, down a whopping 8% last year. The disappointing performance was driven by losses in international and emerging markets. That's no surprise, given the debt crisis that exploded in Europe and the uncertainty over a hard versus soft landing in China.

Among the other big losers, the Hennessee International Index was down 6.4% in 2011, the Hennessee Emerging Markets Index tumbled a massive 12.9%, and the Hennessee Long/Short Equity Index declined 3.6%. The overall Hennessee Macro Index was off 2.1%, faring better than the other hedge fund indices as some funds were positioned conservatively in Treasuries, TIPS and gold.

While the overall performance for 2011 was miserable, there are reasons to be optimistic, says Lee Hennessee, managing principal of Hennessee Group. "While we are seeing some funds liquidate due to poor performance, we are seeing many quality managers closing the door to new capital as they reach capacity limits," he said.

Looking forward, managers told Hennessee Group that stocks look cheap relative to expected earnings and interest rates. However, fund managers expressed concern to Hennessee Group about slowing global economic growth and European sovereign debt issues, which should keep multiples low.

"Despite the performance struggles, we are optimistic on the outlook for the hedge fund industry," Hennessee said. "Hedge funds continue to attract capital due to their historical performance and ability to lower volatility and preserve capital. In addition, most investors understand the challenges for fundamentally-based managers in a macro driven market, and are confident they will not persist."

-- Written by Robert Holmes in Boston.

>To contact the writer of this article, click here: Robert Holmes.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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