It is easy to see why investors are falling out of love with hedge funds. The average fund this year returned the same as 10-year US Treasury bonds. During the past 10 years, a portfolio of 60 per cent US equities and 40 per cent Treasuries outperformed hedge funds (see chart).

Even that overstates hedge fund success. Take account of the selective reporting of new hedge funds and of the bias in favour of survivors (when they lose big money they often stop reporting), and academics estimate returns are 3-5 per cent a year lower than indices suggest.

Look at dollars made by investors, rather than percentage gains, and the situation is even worse: clients tend to buy at the top and sell at the bottom. As Simon Lack put it in The Hedge Fund Mirage: "If all the money that's ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good."


Problems were even greater in the late 1960s, when hedge funds turned out to have been anything but hedged. Just as in the mid-2000s, they had turned in stunning performance by gearing up in a bull market. Just as in 2008, when the bull market ended they crashed, and many managers quit.

After each clear-out, the industry recovered, finding new ways to profit and so convince clients to pay astronomical fees. The same could happen this time. Innovations are hard to predict. But so far there has been little clear-out. Painful times lie ahead.

The real problem is a surfeit of money. This hurts returns, because too much money is chasing each trade. It also lets them get away with fees that are far too high. In an era when an 8 per cent annual return looks good, charges of 2 per cent of assets plus 20 per cent of profits cannot last. Some fees are coming down, but even 1.5 and 15 per cent is too high.


History shows even managers with Nobel prizes sometimes fail spectacularly, and that with hedge funds, just as with mutual funds, past performance is no guarantee of success. Picking between arbitrage, credit or equity funds may add value -- but the same strategies are available passively far more cheaply.

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