The magic is gone … the infatuation over.
Wealthy investors who thought a few years ago that brainy hedge fund managers would show them the money have shed their rose-colored glasses.
Individuals are no longer enamored with the funds, and for good reason. Last year, hedge funds tracked by Hedge Fund Research gained just 7 percent on average, while the Standard & Poor's 500 provided a 16 percent total return. In 2011, hedge funds lost 8 percent, and as a group they have let individuals down every year since the 2008 financial crisis.
Rather than being the moneymakers investors imagined, in 2008, hedge funds lost 26 percent, according to Hedge Fund Research. That was better than the 38 percent decline in the stock market but a shock for individuals who never expected to lose money after paying tremendous fees for the supposedly elite of the investment industry.
Starting in 2000, hedge funds became the rage as institutions like Yale University's endowment used them to make money when the stock market plummeted 49 percent over a 30-month period. The popular notion was that hedge funds were run by investment managers so talented that they would steer client money through the cruelest of stock markets and beat everyday stock and bond fund managers in good times and bad.
Investors were so eager to be accepted by secretive hedge fund managers, they handed over their money even if managers refused to explain how they'd make money.
"Now, the landscape has totally changed," said Martha Pomerantz, partner at Evercore Wealth Management. In the past, clients asked to be led to the top hedge funds, hoping for a chance to gain along with large endowment and pension funds.
Now, in the aftermath of the Bernie Madoff scandal and lackluster returns from most hedge funds in the unsettling last five years, the allure of the "just trust me" approach to investing has turned into "buyer beware." Before individuals trust hedge funds again, Pomerantz thinks, people will first have to warm to stocks.
The surprising reality of the last year is that the simplest of investing strategies — just investing in a Standard & Poor's 500 index fund — provided investors a return of almost 16 percent. The cost of entry was a mere 0.17 percent in a fund like the Vanguard 500 index, versus the 2 percent that's typical for hedge funds. In addition to the 2 percent upfront, most hedge funds charge an additional 20 percent of any gains.
Such astronomical fees were acceptable amid the hype of the early 2000s, but now that the funds have failed to live up to expectations, individuals are asking, "Is what they are charging commensurate with performance?" said Morningstar hedge fund analyst Nadia Papagiannis.
Of course, some hedge funds invest in bonds and adopt other strategies. They shouldn't be expected to compete with stock investing, so it's not necessarily fair to compare all hedge funds to the Standard & Poor's 500 index. But many individuals haven't appreciated that. They simply assumed, prior to the financial crisis, that hedge fund managers would make sure they didn't lose money.
In fact, research shows that most of the return hedge funds provide comes simply from the type of asset that's selected; not the brilliance of the fund manager — or what's known in the industry as "alpha."
In the early days of hedge funds, in the late '90s, funds were able to provide grandiose returns because they were small and nimble and no one was copying unique strategies. Now, with more than $2 trillion in hedge funds, and thousands employing similar strategies, it's difficult for any to stand out — especially the large ones, said Simon Lack, author of "The Hedge Fund Mirage."
And though there are a handful of hedge funds that are exceptional at times, Lack notes that "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."
While individuals are no longer enamored with hedge funds, institutions such as pension funds remain interested, says Jay Love, partner in Mercer Investment Consulting. Consultants such as Love emphasize that hedge funds should be used because they are supposed to act differently from stocks and provide about a 6 percent average annual return with lower risk than the stock market.
Pension funds are interested now in using hedge funds to provide higher returns than bonds. With bonds paying little interest, and risks of losses rising as interest rates climb, investors are interested in stable returns, said Love.
Still, what investors say they want and what they actually do can be very different, said Love. While Love says hedge funds are supposed to be a conservative strategy, investors have dumped those with conservative approaches and low returns. Market-neutral funds are among the most unpopular. They gained just 3 percent last year and lost 2 percent the prior year as the stock market gained 2 percent.