“Hedge funds exhibit no ability to time sectors or pick better stock styles. Surprisingly, we find no evidence of consistent differential ability between hedge funds. Overall, our study raises serious questions about the perceived superior skill of hedge fund managers.”

This is a direct quote from the abstract of How Smart are the Smart Guys? A Unique View from Hedge Fund Stock Holdings, by John M. Griffin and Jin Xu and published in the Review of Financial Studies.  A recent a fairly detailed academic study investigating the performance of hedge funds.

This is not surprising as journalist David Reilly points out in a recent article,

“Markets sank last year. So too did hedge-fund performance. Markets soared in the just-finished quarter. Hedge funds notched up big wins.

Now remind me why they are called hedge funds.

Bull-market geniuses may be a better moniker. For all the talk of being able to make money whether stocks rise or fall, hedge funds too often look more like index-hugging mutual funds.”

Many times we are guilty of writing about why we invest a certain way, while not reporting on research that fails to support the inclusion of certain investment strategies. Hedge Fund investing is one of these. Although we have written extensively on this topic in the formal literature, An Alternative Look at Hedge Funds, we have not made a point to consistently convey our views on hedge funds to our clients.

Due to the recent flood of news about hedge funds that are closing and in the spirit of this blog, it seems now is as good a time as any to give a brief eight point list of what we feel are the most significant issues with hedge funds as a viable investment alternative for investors.

1. Hedge funds are not an asset class but a compensation structure.
2. Hedge fund fees have option-like qualities that create an incentive for volatility.
3. The available data on hedge funds are far from perfect.
4. Analyzing the performance of hedge funds is difficult at best.
5. Hidden risks can lurk behind a veil of secrecy.
6. Hedge fund manager selection is no easy task.
7. The scarce resource captures the rents.
8. Hedge fund diversification is not a free lunch.

While I frequently report on the investment underperformance of active mutual fund managers, I have largely left hedge fund managers unscathed. Although hedge funds represent to many the equivalent of an investment status symbol, one should also ask himself if the emperor has any clothing. Hedge funds can be argued are the ultimate in active management because they are free from the constraints of traditional manager guidelines, hedge funds can short securities (they are after all hedge funds!), employ leverage, and trade derivatives.

In 2008, the average Hedge Fund return as measured by the Hedge Fund Research Institute’s Hedge Fund of Fund Composite index fell 21%. Although better than a 100% equity portfolio, this almost matched the 22% loss of a traditional 60/40 (1) stock/bond “balanced portfolio.” Because hedge funds are notoriously tax inefficient, on an after tax basis hedge funds would have faired significantly worse.

Robert Arnott notes: “This invites the question: Where was manager skill, the ability to side step the worst of the equity markets?

1) Using the S&P 500 for stocks and the BarCap Aggregate for Bonds.