Hedge performed exceptionally well this year (2013), compared with last year’s performance. Since the recent release of a report which put the yield of the average fund at 8.1%, many analysts have been looking at the returns and trying to figure out why managers are doing so poorly, and why people are still attracted to the products.

Hedge Funds

When funds lost, on average, 4.8% in 2011, similar questions were being asked. The S&P 500 lost around 0.2% that year. So why are hedge funds performing so poorly, and why are people investing in them in greater and greater numbers? We can be pretty sure there are more investors, or at least more capital, because hedge fund numbers continue to grow at quite a quick pace.

That growth is the key to the whole puzzle. The more hedge funds there are, and the more investors, the closer to market returns those funds are likely to deliver. This raises questions about what exact market they are conforming to. Hedge funds invest in long and short equities, and every other asset imaginable. The S&P 500 isn’t really a good index to compare their performance to, but it’s a good start.

When you begin to look at hedge funds like this, they become an asset class. If you compare the market’s average return, you are forgetting what these entities invested in and so on. They become the same as an equity, or an ETF, something to be invested in, albeit at a higher cost.

When looking at an index to compare investments with, the most important thing is not to get the asset class right, but to get investor alternatives right. The S&P 500 is used as a default investment portfolio. It’s a pretty arbitrary pick, but its an arbitrary decision. It’s not really important what the index is exactly, what’s important is that there is a common one.

The problem with the overall hedge fund performance is that a large number of funds are not the well trained in the unique operations made famous by Ray Dalio and Bill Ackman. Most of them are, like in any other walk of life, ordinary. To quote Sturgeon’s law, “90% of everything is crap.”

The large percentage of funds, with 90% of them being crap, don’t make  any interesting moves, instead they either following what the bigger funds are doing, at a lag, or following certain indexes; this means that there will always be a risk of underperformance in the market as a whole. Picking a hedge fund out of a hat probably means lower returns than picking a random S&P 500 stock out of a hat.

The hedge fund market’s overall performance will conform closely to a weighted average of all of the markets that the funds participate in. That is a fact. As the hedge fund market gets bigger and bigger, the markets it covers spread out more and more, this means the index they conform to will probably decrease over time.

Hedge funds are, however, personality products. They’re about marketing just as much as they are smart investing, in most cases, smart investing is part of the marketing. Managers are looking to earn fees for holding onto money.

There is probably manager somewhere extolling the benefits of his fund, which gained 13% this year ,beating the average hedge fund return of 8%. David Einhorn only made 8.3% over the top. This hypothetical fund was, of course, indexed to the S&P 500. Investors line up, fees are earned, everybody is happy.

Financial analysts are, as a whole, numbers people, and it would take a miracle to stop their mathematical preoccupations. In certain cases, it makes little sense to pay attention to the data that emerges. Hedge funds are, it would seem, one of those cases.

It is not important to compare the average hedge fund performance to the equities market. Its major use is for comparison to other hedge funds. This index should be used by investors looking to compare funds, but it should not be their only analysis.

People, and institutions, who invest in hedge funds in general, or hedge funds at random, are the laziest of investors. There will always be average hedge funds trying new strategies, some will break the mold and make it to the top, others will get lucky and make it to the top. Most will go bust or chug along in the middle.

An average of hedge funds will always result in a number close to whatever index matches their investments. Most hedge funds still get into the equities business, 75% of those that joined in 2011, so the S&P 500 (INDEXSP:.INX) is good enough. The bigger the market gets, the closer those returns will get to the real thing.

Hedge funds as a whole performed worse than the S&P 500 (INDEXSP:.INX) in 2012. That’s bad news for most of the people who picked a fund out of a hat last January, but probably meaningless to everybody else.