LONDON Hedge funds are ending the quarter giving investors less than they would have got from simply buying stocks and hanging on to them, belying their reputation as being at the cutting edge of money-making.
In some cases they have provided less return than from a retail savings account.
It is a reflection both of getting caught by a reversing of investment flows from West to East and of being positioned for rises in financial markets when they suddenly turned choppy.
Investment arms at Wall Street banks look to have been similarly hit, prompting analysts to slash their estimates for first quarter earnings.
Such underperformance does not bode well for the coming quarters if, as many strategists suggest, volatility rather than a set direction for markets is going to be the trend.
Gauging hedge fund success or failure can be notoriously difficult because of the plethora of styles they use. But one of the broadest measures shows at best a flat performance for the first quarter after March losses wiped out early gains.
The HFRX Global Hedge Fund Index shows a year-to-date gain through Tuesday of just 0.03 percent, while its narrower index of equity-focused hedge funds has lost more than 3 percent.
These results compare with a year-to-date gain of around 1.6 percent for the MSCI all-country world index .MIWD00000PUS, over the same period, driven by gains in the region of 2.9 percent on the U.S. S&P 500 .SPX index.
Most of the hedge fund losses -- as well as weakness in
global stock markets -- have come in March, which saw a fall in risk appetite globally compounded by the Japanese earthquake.
But even before this, hedge funds were underperforming, at least when it comes to stock plays.
The broad Dow Jones Credit Suisse Hedge Funds Index -- whose annual average performance since 2004 is 9.45 percent -- was up 2.08 percent for January and February, with its long/short strategy gauge rising 1.99 percent.
MSCI's global stock benchmark was up 4.3 percent for the year at that point. So hedge funds underperformed both on the way up and on the way down.
"You would have been better off buying an (equity) index and doing nothing this quarter," said Nick Bullman, a hedge fund manager and partner of risk advisory group CheckRisk LLP.
Hedge funds are a diverse bunch, so not all strategies have fared poorly.
Equity market neutral funds, which wouldn't have been caught out by a change in market direction, are up 1.7 percent, according to HFRX, while event-driven funds, which bet on events such as mergers and acquisitions, are up nearer 2 percent.
North America-focused funds are still up 2.5 percent, helped by albeit higher gains in U.S. stocks this year, while convertible arbitrage funds, which try to exploit inefficiencies in the convertible bond market, are up 3.01 percent.
The overarching weakness, however, was caused by failing to catch two big shifts in market sentiment, both of which are the kind of events that hedge funds are often expected to protect their high-paying clients from.
First, there was a widespread rotation out of highly popular emerging markets, now seen as a crowded trade, and back into developed markets. Second, after essentially two years of upward momentum, stock markets cooled this month.
Betting on rising markets was a profitable -- and easy -- strategy for hedge funds riding rising optimism about corporate earnings. But, as is the danger with net long positions, many were caught out this month as equity markets tumbled after Japan's earthquake and tsunami and ensuing nuclear crisis.
"The big problem has been that the whole Japan thing was unexpected. Generally speaking, most managers ... had big net long positions," said Ken Kinsey-Quick, fund of hedge funds manager at Thames Rival Capital, part of F&C FCAM.L.
"Unless you were net short you would have lost in this type of environment. We've seen some massive rotation in sectors, it's been brutal," added Kinsey-Quick, who said funds are down between 1 percent and 5 percent so far this month.
Funds have shied away from strategies such as pairs trades -- buying one stock and shorting another in the same sector -- not only because betting on rising markets has been more profitable, but also because stock prices have been so closely correlated, meaning their bets are less likely to work.
However, a drop in correlations since the autumn has encouraged Tim Gascoigne, global head of portfolio management at HSBC Alternative Investments Limited (HAIL), to believe that funds that analyze stocks' valuations, rather than take bets on markets, can now profit.
"Our stockpickers can benefit. We'll see share prices move back toward fair value. We're becoming more constructive on markets and equity long-short. I think it's going to be a strong driver in our portfolios for some time to come," he said at a media briefing earlier this month.
The big question, however, is whether hedge funds can thrive in a climate that promises more emphasis on managing risk.
Some think hedge funds that focus on macroeconomic movements will be among those that do best, playing the volatility as it comes.
But CheckRisk's Bullman says investors in general and hedge funds in particular will have a tough environment to work in.
"Event risk remains very high and therefore has the ability to surprise," he said.
(Editing by Patrick Graham)