Hedge funds are designed to succeed in good markets and bad - but in the turmoil of the past few years, investment strategies that had worked in the go-go '90s and early 2000s have proven unsuccessful.
The result is three consecutive years of disappointing returns. In 2009, 2010 and 2011, hedge funds lagged the performance of the U.S. equity market as a whole.
Last year offers a snapshot of the challenges faced by funds in an unpredictable market. In 2011, the hedge fund industry underperformed the S&P 500 by a not-insignificant margin: Hedge Fund Research Composite Index, which tracks the performance of about 2,000 funds, found that the average fund slipped 5 percent. The S&P, by contrast, rose 2 percent.
And, data shows, 60 percent of all hedge funds lost money last year.
A litany of factors are depressing the hedge fund industry's performance. While the ability to short assets is valuable, long-short funds are being stymied by hard-to-predict changes in correlation both between and within asset classes. That factor contributed to a lackluster March for many funds; indeed, investment research firm FRM observed in a recent note, the only funds that generally performed well were those which employ quantitative arbitrage strategies.
Another obstacle to stronger performance is financing availability. Prior to the financial crisis, capital was easy to come by and extreme leverage was quite common. Now, however, gun-shy banks have ratcheted down their lending activity. The average hedge fund, the U.K.'s Financial Services Authority says
, levers its capital by a factor of just 2.5 - a rate that's remained constant for the past three years.
Despite the last few years' challenges, the hedge fund industry is nevertheless a good one to be a part of. In aggregate, the hedge fund community - which is comprised of investors, funds and the brokers with whom the funds execute trades - has generated higher returns
than the market in 12 of the past 13 years.
The fees that funds charge are a big reason for that consistent outperformance. As the New York Times' DealBook blog reported in late March, the top 25 earners in the hedge fund industry raked in $14.4 billion
in 2011, even as most funds generated negative returns.
But hedge funds have historically added real value to the invesment industry: Over the past 13 years, they've produced an average annual return of 7.1 percent for investors.
And FRM, for its part, believes better times are ahead for the hedge fund sector. The firm, news site Opalesque reports this week
, "is confident that hedge funds who provide liquidity will continue to prosper in the relative absence of bank competition."
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