* Hedge funds up about 4.5 pct on average, below indexes
* Lack of leverage, choppy markets cited for returns
* Correlation with markets, other funds may spark concern
By Emily Chasan & Laurence Fletcher
NEW YORK/LONDON, Dec 31 (Reuters) - Hedge funds often claim to offer strong returns that are not correlated with broader markets, but in 2010 many failed on both of those counts.
That failure came in large part because hedge funds cannot make as many bets with borrowed money, analysts said.
Hedge funds on average returned just 4.52 percent this year to December 28, according to Hedge Fund Research’s HFRX index.
Those lower returns failed to offer the diversification that hedge fund investors crave, experts said.
Nearly every hedge fund strategy tended to move in synchrony with the markets and with other hedge fund strategies this year, according to hedge fund data tracked by Lipper.
The hedge fund industry’s lackluster performance in 2010 could spur more investors to question whether it is worth paying higher management fees for the funds, experts said.
When an investor gives money to a hedge fund manager, they are looking for returns that do not depend on the broader market, and can therefore improve the performance of the investor’s overall portfolio, said Gabriel Burstein, Global Head of Investment Research for Lipper and Digital Ventures at Thomson Reuters.
“It’s one of the Number One reasons that people invest in alternative investments,” Burstein said.
Even so, investors were forgiving this year. Hedge funds saw net inflows from investors in 2010 for the first time since the credit crisis began, as investors have grown more confident that hedge funds can withstand the markets, according to data from Credit Suisse.
It was a tough year for hedge fund managers for many reasons, including limitations on how much funds can borrow, and difficult-to-analyze changes in the political landscape that spurred sovereign debt crises and new regulations.
Bailouts for Greece and Ireland in particular spooked many funds into reining in their bets.
“Hedge fund managers are significantly more conservative than they were at the beginning of 2008, and I don’t think there are really the mega opportunities, like there were in subprime in ‘07 and ‘08,” said Virginia Parker, chief investment officer at Parker Global Strategies, a firm that advises institutional investors on hedge funds.
Banks are less willing to lend money to hedge fund managers to make big bets, and funds’ investors are also reluctant to magnify their potential losses by allowing managers to take on debt.
“The only way hedge fund managers are going to beat a bull market in equities is if you have leverage ... but investors haven’t wanted leverage,” Parker said.
It is surprising that hedge funds’ performance has so closely tracked the broader markets, Lipper’s Burstein said. In rising markets like 2010’s, the performance of different investment strategies usually diverges.
Returns from different strategies usually converge when markets collapse, like in 2008.
Not every fund has performed poorly.
For example, funds with exposure to credit markets had a strong year.
Louis Gargour’s LNG Europa Credit fund, which bets on corporate credit, rose 76.8 percent in the first 11 months of the year, after making more than 80 percent last year.
Cheyne Capital’s European Event Driven fund rose 19 percent, according to investors in the fund. And at the event driven $3.6 billion fund Third Point, Dan Loeb’s Third Point Offshore fund is up more than 25 percent through Nov. 30. according to numbers compiled by HSBC.
Activist investor Bill Ackman’s biggest Pershing Square International fund, which manages about $3 billion was up about 19.7 percent through the end of November, according to investors. Polygon Investment Partners made around 27 percent in its European Equity Opportunity fund.
Hedge fund managers have become fond of the phrase “Risk on, Risk off”‘ this year to describe the rapid shifts in market behavior as investors fluctuate between riskier commodities and credit bets and a flight to safety in assets like gold and U.S. treasuries.
Investors who proved their strategies were nimble did well, and hedge fund investors went heavily into global macro strategy funds, which are able to invest across many asset classes and adapt quickly to changes in policy.
At $14 billion New Jersey hedge fund Appaloosa Management, David Tepper’s flagship Appaloosa Investment fund was up almost 21 percent after fees in the 10 months through October, after some big bets that the government would continue to support financial firms.
Big U.S. funds had slightly more subdued returns. Israel Englander’s Millennium International was up about 11 percent through Dec. 2, according to figures compiled by HSBC, and Kenneth Griffin’s $11 billion fund Citadel so far this year has seen returns of about 10 percent.
Man Group’s (EMG.L) $22.6 billion AHL fund rose 11.6 percent in the 12 months to December 27 as gains this month helped offset losses in November, while Bluecrest’s BlueTrend fund returned 8.7 percent in the 11 months to end-November, according to figures seen by investors.
Reporting by Emily Chasan and Laurence Fletcher in London; editing by Gunna Dickson