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Don’t bet on hedge funds

Date: Sunday, October 8, 2006
Author: Jonathan Clememts, Kansascity.com

Keep up with the Joneses? Maybe you shouldn’t.

Wall Street thrives on envy, and nothing triggers more envy than hedge funds. They are the financial playground of the rich, offering not only cachet, but also the prospect of dazzling returns.

Make no mistake: If you buy a hedge fund, you will get your cachet. The dazzling gains, however, may prove elusive. Many hedge funds have struggled this year, and some — notably Amaranth Advisors — have recently been hit by big losses. Indeed, you could be better off with humdrum mutual funds. Here’s why:

Sluggish returns. Consider a study by Roger Ibbotson, founder of Ibbotson Associates — now a unit of Chicago researchers Morningstar Inc. — and Peng Chen, the firm’s president.

The authors note that hedge funds appear to have clocked an eye-popping 16.5 percent a year between year-end 1994 and April 2006, easily outpacing the 11.6 percent average for the Standard & Poor’s 500-stock index. Yet this 16.5 percent average is mighty misleading, for two reasons.

First, when hedge funds are added to performance databases, they sometimes include earlier results. This “backfill bias” skews the average upward, because only funds with stellar returns typically report their prior performance. Second, when poorly performing hedge funds go out of business, their dismal results are often ignored. What happens if you eliminate these factors? Ibbotson and Chen calculate that hedge funds returned just 9 percent a year, less than the S&P 500’s 11.6 percent.

Risky business. Diversification benefit? Low risk? You might be scratching your head.

Aren’t hedge funds run by swashbuckling money managers who scour the globe for investment opportunities and then aim to magnify their gains with massive amounts of leverage? Sure, those guys exist — and they’re often the folks who end up posting horrendous losses.

But many hedge-fund managers don’t fit the popular image. They aren’t seeking blockbuster returns. Instead, they try to clock moderate gains every year.

Going cheap. There are many intriguing hedge funds out there. But I’m not buying. Remember, we’re aiming to reduce risk — and it strikes me that, for ordinary investors, there are simpler and often cheaper ways of doing that.

“If you want to reduce risk in a traditional balanced strategy, you can add low-correlation assets like real-estate investment trusts, international small-caps and international bonds,” said Nelson Lam, an investment adviser in Lake Oswego, Ore.

Jonathan Clements writes for The Wall Street Journal.