Editors' pick: Originally published July 20.
Many investors clamor to put money in hedge funds, paying "2 + 20" to have these masters of the universe invest all or a sizable portion of their wealth.
But a funny thing happened on the road to riches. It is becoming increasingly evident that, on the whole, hedge funds simply fail to provide either superior returns or diversification benefits to investors.
Alexander Beath and Chris Flynn of CEM Benchmarking performed a comprehensive analysis of asset class returns and found that over the period from 1998 through 2014, hedge funds ranked 11th of 12 asset classes on the basis of net returns, only outperforming other U.S. fixed income, defined as non-investment grade bonds, mortgages and cash.
If that isn't bad enough, risk adjusting the returns makes hedge funds look even worse, as the Sharpe Ratio for hedge funds is the lowest of the asset classes examined.
Warren E. Buffett famously bet Protege Partners that a fund of five hedge funds selected by the firm couldn't beat an S&P 500 index fund over a 10-year period. Eight years into the bet, if it were a prizefight, it would be stopped.
At the time of the Berkshire Hathaway annual meeting in early May, the S&P 500 index fund was up nearly 66%, and the fund of hedge funds was up a scant 22%. A rally reminiscent of the Red Sox in the 2004 American League Championship Series would have to occur to rescue this wager.
Let's dispel one myth. Hedge funds don't represent a true asset class but are simply trading strategies, whether they be long/short, convertible arbitrage, relative value, global macro or a plethora of other variations.
Some defenders of hedge funds contend that they shouldn't be judged solely on the basis of returns and that they provide diversification as part of a larger portfolio of assets.
Alas, there appears to be little validity to that contention, as the Beath-Flynn study showed that hedge funds had the highest pair-wise correlation to U.S. large-capitalization stocks, exhibiting an even higher correlation than between large-cap and small-cap U.S. stocks.
Certainly, some hedge funds do beat the equity market averages, even after fees. For instance, who wouldn't have liked to have been invested in the Medallion fund at Jim Simon's Renaissance Technologies?
From 1994 though mid-2014, the fund's returns were an astounding 71.8% annually before fees, nearly seven times the S&P 500, according to Bloomberg.
Unfortunately, the fund and many other high-performing ones have been closed to new investors for several years.
The situation brings to mind the Groucho Marx quote, "I don't want to belong to any club that will accept me as a member."
Regardless, the hedge fund business doesn't seem to be suffering.
Some 76% of U.S. investors surveyed plan on investing in hedge funds in the second half, according to a recent article in Barron's.
Hedge funds may not provide superior returns to investors, but it is abundantly clear that they do continue to provide superior returns to hedge fund managers.
It looks like PT Barnum was right: "There's a sucker born every minute."
This article is commentary by an independent contributor.
Robert R. Johnson is president and chief executive of the American College of Financial Services in Bryn Mawr, Pa.
At the time of publication, the author held no positions in the stocks mentioned.