Why Hedge Funds Are Lagging

NEW YORK ( TheStreet) -- At a time when stocks are soaring, hedge funds have lagged.

In the past year, exchange-traded funds that aim to replicate hedge funds delivered modest results. IQ Hedge Multi-Strategy Tracker (QAI) returned 1.2%, compared to 13.9% for the S&P 500, according to Morningstar.

But the weak performance has not discouraged some investors. The IQ ETF recorded $132 million inflows in the past year, according to IndexUniverse.com. That is a sizable inflow for a fund with $343 million in assets. Other ETFs that have reported inflows include IQ Hedge Macro Tracker (MCRO) and ProShares Hedge Replication (HDG).

Like the ETFs, the hedge funds themselves have been reporting inflows. In 2012, hedge funds attracted $34 billion in assets, raising the industry's total capital to a record $2.3 trillion, according Hedge Fund Research.

>>>>Also see: 4 Stocks Spiking on Big Volume

What keeps attracting investors? Proponents say that hedge funds provide diversification. The funds can sell short and use other techniques that can limit losses in downturns. Because short selling can hurt results in bull markets, it is not surprising that the funds would trail lately. But critics argue that the spell of uninspiring results could indicate that the hedge fund industry has become bloated.

The stretch of poor performance is a recent development. During the 10 years that began in 2000, many hedge funds excelled. By limiting losses during the big downturns of the decade, hedge funds returned 6.4% annually, compared to a loss of 0.9% for the S&P 500, according to a study by Ineichen Research and Management. But since 2010, the picture has changed. While the S&P has returned 12.4% annually, hedge funds only delivered 4.3%.

>>>>Also see: 6 Surprising Taxes Headed Your Way

The falloff of results has occurred at a time when the hedge fund industry has made dramatic changes. A decade ago, hedge funds catered primarily to wealthy individuals. Many investors came in search of the outsized returns that had been achieved by bold managers such as George Soros.

After suffering big losses in the turmoil of 2008, individuals began fleeing hedge funds and seeking safety in bonds. But institutions moved in the opposite direction, increasing their allocations to hedge funds. Pensions and endowments turned to hedge funds as a way to limit losses in downturns. According to a study by Preqin, institutions now account for 61% of assets in hedge funds, up from 45% in 2008.

1 2 Next › Last »