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Hedge Fund Has-Beens

These lightly regulated investments are more likely to fizzle than blow up.

Is the hedge fund bubble going to end with a bang or a whimper?

Count me in the second camp. In fact, it's already happening. Ever since the collapse of Long Term Capital Management in the fall of 1998, financial pundits have predicted another spectacular blow-up, precipitating another, and even bigger, global financial crisis.

And they're doing it again.

The New York Times

weighed in with a call for greater regulatory scrutiny of the industry.'s

Matthew Gross even seized on the IPO of hedge fund manager



to warn of "the coming hedge-fund apocalypse." Apocalypse, no less.

Are they right?

It's easy to find reasons to worry. These loosely regulated, speculative funds now control well over $1 trillion, according to the most recent estimate by Hedge Fund Research in Chicago. Most of that money has poured in over the last few years. Thousands of new funds have emerged to soak up the money -- each seemingly more amateur than the last.

It's three years since a friend commented, after the Fourth of July weekend, that "you can't go to a cookout these days without meeting someone who's running a hedge fund." It's gotten a lot worse since. Someone I knew at university is now running his own hedge fund. Based on what I observed of him many years ago, I wouldn't hire him to run a bath.

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But there are two problems with the coming-apocalypse theory. The first is that the more hedge funds there are, the smaller the chance of a massive blowup. The people who have the money -- huge pension funds and the super rich -- are scattering their chips more widely across the table, using so-called "funds of funds," which exist for that reason. (The day surely can't be far off when some bright spark launches a "fund of fund of funds".)

The second point, though, is even simpler. We don't need to guess if the bubble is ending with a whimper ... because it already is. Take a look at the most recent industry data. During 2006, the average hedge fund returned between 12.9% and 13.86% -- depending on whether you believe the industry performance index compiled by Hedge Fund Research or the one from Credit Suisse/Tremont.

Over the same period, the most basic mutual fund there is, the

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Vanguard Total Stock Market Index Fund (VTSMX), posted a total gain of ... 15.63%. In other words, the typical hedge fund did two full percentage points worse last year than the simplest index fund open to everybody.

It doesn't end there.

Over the past two years, the average hedge fund gained either 22.5% or 23.4%, according to Credit Suisse/Tremont or HFR. The Vanguard fund: 22.7%. And when you stretch it out over three years, the average hedge fund has gained either 34.3% (CST) or 34.5% (HFR). Vanguard? 38% and change.

So over the last one, two and three years, just as the hedge fund industry has really taken off, those geniuses in designer glasses have done no better, on average, than your typical mom-and-pop investor in a completely passive stock market fund.

Of course many hedge funds did much better. But so, too, did many mutual funds.Forget 2% fees and 20% of the profit, the usual rake charged by the hedge fund crowd. People chasing these overpriced gimmicks could have just handed over 0.20% of their money to Vanguard each year and gone back to their yachts for an early cocktail.Behind all the secrecy and the conspiracy theories, hedge funds have turned out to be ... well, pretty dull.

There is, of course, no mystery to this. Early hedge fund managers were like the first people to take a metal detector to a deserted beach. They turned up all sorts of small buried treasures. Now there are so many treasure-hunters out there you can barely see any sand. What are the chances any Krugerrands remain undiscovered? It's the iron law of diminishing returns: The more people who chase an investment opportunity, the less profitable it becomes.

Another iron law is the ability of investors to forget. So can we rule out a "apocalypse" completely? Of course not. Some sort of financial shock -- whether from a hedge fund or somewhere else -- is bound to happen sooner or later. They always do. Gullibility and disasters are as guaranteed as diminishing returns.

But the hedge fund bubble certainly seems to be coming to an end. With a whimper.

In keeping with TSC's editorial policy, Brett Arends doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Arends takes a critical look inside mutual funds and the personal finance industry in a twice-weekly column that ranges from investment advice for the general reader to the industry's latest scoop. Prior to joining in 2006, he worked for more than two years at the Boston Herald, where he revived the paper's well-known 'On State Street' finance column and was part of a team that won two SABEW awards in 2005. He had previously written for the Daily Telegraph and Daily Mail newspapers in London, the magazine Private Eye, and for Global Agenda, the official magazine of the World Economic Summit in Davos, Switzerland. Arends has also written a book on sports 'futures' betting.