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(Reuters) - In theory, last year should have been a great time to be invested in a hedge fund. With markets gobsmacked by U.S. and euro zone crises, what better way to protect your money than to hedge against the market -- the nominal premise behind a hedge fund? Managers can be defensive and pick the sectors or countries that will do well when most of the market is sour. There's a big catch here: Success depends upon whether managers guess which sector won't decline or manage to retreat to bonds at the right time.
And hedge funds definitely got caught in the net in 2011.
Most hedgies guessed wrong last year or stayed their own doomed course. Like most actively managed investments, hedge funds fell victim to the myth that you can predict -- and avoid -- market gyrations on a regular basis. Except for fixed-income funds, every other category of hedge funds lost money in 2011, and all told, the sector lost about 5 percent. Depending upon which hedge fund strategy you bought into, you could've done even worse. Some 75 percent of funds in emerging markets lost money. India and emerging Europe were among the worst categories. Only Brazil was a winner among the developing countries.
Meanwhile, the passive S&P 500 Industrial Index gained about 2 percent on a total return basis, according to the HFN Hedge Fund Aggregate Index (link.reuters.com/mav46s). You also would've been better off holding a portfolio of plain-Jane U.S. Treasury bonds.
Like consistently winning the Super Bowl, it's difficult for a hedge fund manager to beat the market. Because of their fees, they're always starting behind the eight ball. Hedge funds charge up to 20 percent for performance (as a percentage of profits), and up to 2 percent for management -- dwarfing the management fees of passive stock-index funds, which charge as little as 0.07 percent for total annual management.
In a new book entitled "The Hedge Fund Mirage," author Simon Lack said real investor profits were a negative $308 billion from 1998 to 2010. In 2008, when hedge funds should have been protecting investors' funds, they consumed nearly all of the profits earned in previous years.
Ronnie Shah, a research associate with Dimensional Fund Advisors (DFA), a low-cost money manager (www.dfaus.com/),
found that fees usually get in the way of producing superior returns once you subtract all fund expenses -- which is essential math for every investor.
"The arithmetic of active management predicts that, in aggregate, active managers will underperform the market by the fees they charge," Shah wrote in an unpublished DFA paper available to clients. The paper studied portfolio returns from 1927 through 2010.
Of course, this is nothing new to index-fund investors, who have been heeding the mantra of Vanguard Group founder Jack Bogle for decades.
Bogle keeps it simple for every investor. "Costs matter," is his cri de coeur. The man should win a Nobel Prize in economics not only for his good sense and durable mathematical truths, but for inventing the index fund, which has saved and made investors billions over the decades.
Not only do costs matter, but manager risk, transparency and liquidity are still massive stumbling blocks in hedge funds. Managers are constantly guessing which sector is going to be profitable, but are slow to disclose what they hold and lock up investors' money.
Many of these risks are unnecessary. If hedge fund and other active money managers were to adhere to a fiduciary standard and put their clients' interests first, not only would their exorbitant fees plummet, they might well adopt more passive approaches -- in which case they couldn't remotely justify those incredible expenses.
The SEC is working on a fiduciary proposal for brokers, but is chafing under pressure from the financial services industry. Brokers and non-fiduciary advisers are pulling out all stops to kill this new rule, which was mandated by the Dodd-Frank financial reform law. So it's not known exactly when we'll see the rule or if whether it will be diluted (link.reuters.com/sav46s).
As for the $2 trillion hedge fund industry, if you want to spend money on the cachet of having a manager throwing darts -- knowing most of them are unlikely to beat the market -- be my guest.
Just be aware that the "hedging" part of their names is often a money-losing misnomer. Maybe they're just referring to the Versailles-like shrubbery in front of their exquisitely landscaped offices. Guess who's paying for it?
Editing by Beth Pinsker Gladstone and Andrea Evans