Demise of Hedge Funds Has Been Exaggerated

NEW YORK (TheStreet) -- Investors are returning to hedge funds. During the first four months of the year, hedge funds recorded $24 billion of inflows, according to HedgeFund.net.

The inflows represent a big turnaround from the turmoil of 2008. During the downturn, many funds were forced to liquidate, and some analysts predicted that the hedge fund industry was bound to shrink permanently. Hedge fund assets dropped from a peak of nearly $3 trillion in the second quarter of 2008 to $2.3 trillion this year.

The industry continues to face serious hurdles. With memories of the stock-market meltdown still fresh, many individual investors remain wary of hedge funds. In addition, the new Dodd-Frank financial legislation aims to rein in hedge funds, tightening regulations and restricting investments by banks.

Still, the outlook for the industry remains positive. Many pensions and institutions have been increasing their allocations to hedge funds.

The performance of hedge funds in recent years is helping to attract investors. "Hedge funds have outperformed the S&P 500 and done it with a lot less volatility," says Evan Rapoport, principal of Hedgeco.net, a data provider.

Most analysts argue that hedge funds tend to outpace stocks in downturns and produce decent results in bull markets. The funds excel in hard times because they sell short and use other techniques that can produce profits in any market environment. According to Hennessee Group, hedge funds lost 20% of their value in 2008, outpacing the S&P 500 by about 17 percentage points. For the past three years, the funds have stayed in the black, while most mutual funds have suffered sizable losses.

Some critics question the performance figures, arguing that the typical investor actually obtains worse returns than the public databases suggest. The shortfalls occur because of a factor known as survivorship bias, which is connected to the way hedge funds report data. While mutual funds are required to make their returns public, hedge funds only disclose data when they choose. So if a hedge fund collapses and goes out of business, it may not bother to report the final miserable returns. As a result, databases do not include some terrible performers that would bring down the averages.

To get a more accurate idea of average returns, investors should consider the results for funds of hedge funds, says Peter Laurelli, vice president of Channel Capital Group. A typical fund of funds invests in 20 or so hedge funds. If a portfolio holding blows up, the results of the fund of funds will suffer, but it may stay in business and continue disclosing its data.

Laurelli says that since 2001, hedge funds have returned 8.9% annually. Funds of hedge funds have returned 4.4%. That is a healthy figure when compared to the S&P 500, which lost money during the period. "Institutions are continuing to use hedge funds because the performance has been reasonably good," says Laurelli.

Proponents claim that hedge funds have delivered superior returns because they attract top portfolio managers with enormous pay packages. But academic studies suggest that the advantage of hedge funds has been diminishing. A decade ago, hedge funds delivered significant alpha, or excess returns, according to academic studies. Then as more hedge funds appeared, competition increased, and the alpha scores declined.

"Over time, the amount of alpha has been shrinking and is getting closer to zero," says Tom Idzorek, chief investment officer of Ibbotson Associates. "Investors need to be careful because some funds deliver significant amounts of alpha, while others blow up."

Some analysts argue that the relative performance of hedge funds is likely to improve. Now that many funds have fallen by the wayside, the survivors face less competition to find the best opportunities, says Frederick Lake, manager of Aston/Lake Partners LASSO Alternatives ( ALSNX). Lake says profit margins should increase in merger arbitrage and other strategies long favored by hedge funds.

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Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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