HEDGE-fund managers are the smartest investors around. With keen eyes and sharp brains, they spot and exploit inefficiencies in the markets. Or at least that is what the industry tells its clients.

There is no doubt that hedge-fund managers have been good at making money for themselves. Many of America’s recently minted billionaires grew rich from hedge clippings. But as a new book* by Simon Lack, who spent many years studying hedge funds at JPMorgan, points out, it is hard to think of any clients that have become rich by investing in hedge funds (whereas Warren Buffett has made millionaires of many of his original investors). Indeed, since 1998, the effective return to hedge-fund clients has only been 2.1% a year, half the return they could have achieved by investing in boring old Treasury bills.

How can that be, when traditional performance measures for the industry show average returns of 7% or so? The problem is a familiar one in fund management and is the equivalent of the “winner’s curse” that occurs with auctions (the successful bidder is doomed to overpay). Take a whole bunch of fund managers and give them an equal amount of money to invest. The managers that perform best initially will tend to attract more investors, and so will gradually become bigger than the moderate or poor performers (who will eventually go out of business).

But the manager will not perform well indefinitely. By the time a bad year occurs, the manager will be running a much larger fund. In cash terms, the loss on the expanded fund may easily outweigh the gains made when the fund was smaller. The return of the average investor will be lower than the average return of the fund.

Read More: http://www.economist.com/node/21542452

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