Hedge Funds: Ripping Off Millionaires and Pensions Alike

Hedge funds are a huge rip-off, having lagged the boring old broader market for years now. True, if you’re not a multimillionaire, you probably don’t care. These things aren’t open to mom-and-pop investors, anyway.

But once you realize that hedge funds also suck in a good deal of pension fund money, well, suddenly any schadenfreude becomes a lot less fun.

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The big knock on active management for regular folks is that year in and year out, upwards of 80% of actively managed mutual funds fail to beat their benchmarks. Throw in the fact that active funds charge higher fees than index funds or exchange-traded funds, and you have a situation where investors actually are paying for underperformance.

More amazing is that when it comes to paying for underperformance, well, nothing beats the hedge fund world.�The global hedge fund industry oversees about $2.1 trillion in assets — equivalent to the gross domestic product of Italy — and it charges enormous fees, like the oft-cited “2 and 20.” That is, 2% of assets under management and 20% of all profits.

With that sort of vigorish, a hedge fund has to massively outperform the market to be a worthwhile investment.

So woe unto the�wealthy folks and�pension funds that have entrusted hedge funds to generate outsized returns. In the aggregate, they’re lagging badly not only so far this year, but ever since the latest bull market began.

The HFRX Global Hedge Fund Index has gained just 1.6% so far in 2012. Meanwhile, a boring (and cheap) index fund tracking the S&P 500 — the SPDR S&P 500 ETF (NYSE:SPY) — is up 7.3%. Subtract fees and the hedge-fund investor is left with nothing, but the index investor still has close to a 7% gain.

To get a better sense of the weak year-to-date performance, have a look at the chart below. Courtesy of S&P Capital IQ, it compares the S&P 500 to the IQ Hedge Multi-Strategy Tracker ETF (NYSE:QAI), which we’re using as a proxy for hedge-fund performance:

And it’s not just the wider world of hedge funds that has been lagging. Even the biggest names in the business — the best and the brightest — are doing a pitiful job justifying their fees thus far in 2012. David Einhorn’s flagship fund gained a market-lagging 3.7% for the first half of the year, Reuters reports, citing investors in the fund. Daniel Loeb’s biggest fund rose 3.9%, and Paul Tudor Jones’ flagship fund gained 1.6%.

More shocking, broad-based hedge-fund underperformance is hardly a recent phenomenon. Hedge funds have put together a spotty record of earning their keep for years. Here’s the ignominious scorecard:

• 2009: HFRX Global Hedge Fund Index rose 13.4%, lagging the S&P 500 by a whopping 10 percentage points.
• 2010: HFRX Global Hedge Fund Index gained 5.2%, lagging the broader market by 8.9 percentage points.
• 2011:�HFRX Global Hedge Fund Index lost 8.9%, while the S&P 500 finished flat.

But it gets worse. Hedge funds on average have underperformed even essentially risk-free Treasury�bills, writes Simon Lack in his new book The Hedge Fund Mirage.

Furthermore, the rapacious 2-and-20 fee structure means that the vast majority of returns have flowed to fund managers, not clients. By Lack’s reckoning, 84% of all profits generated by hedge funds since 1998 have gone to the guys running them. Heck, it’s quite possible that the market crash of 2008 wiped out any and all returns hedge funds have ever made for their investors, Lack writes.

We already knew that active management rarely pays in a plain-vanilla 401(k) plan. What’s astonishing is how destructive and expensive it has become for investors with the deepest pockets.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.