Hedge funds have not done all that well hedging

The endowment of one of the most elite educational institutions in the world, run by some of the best and brightest investment managers, who have been granted privileged access to the innermost insiders in the business world, Wall Street, and Washington, D.C., lost nearly a third of its value in just five months' time.

Even investment newsletter editors, who are sneered at by many on Wall Street, accused of being nothing more than a bunch of lunatic self promoters, have on balance done better than that: The average five-month return through Nov. 30, among the nearly 200 newsletters tracked by the Hulbert Financial Digest, was a loss of "just" 28.9%.

There no doubt are lots of lessons that could be drawn from Harvard's unfortunate experience, but I want to focus on the unfavorable light it sheds on the downside protection that hedge funds were supposed to provide.

Harvard's endowment was run in many ways like a hedge fund, after all. It shunned plain vanilla investments in stocks and bonds, in favor of so-called alternative asset classes that had supposedly low correlations with the U.S. stock market, if not outright inverse correlations. As with the hedge fund industry, in general, their approach held out the promise of being able to make money in any market environment.

It would be one thing if Harvard's recent losses were unique. But they're not.

According to Morningstar, the average hedge fund lost 9.4% in October (the latest month for which data are available), which came on top of an average loss of 7.9% in September. No doubt losses were steep in November, too, but the data aren't yet available.

What's so noteworthy is not just that these monthly losses were the worst in hedge fund history. Perhaps even more so is that these losses came as the U.S. stock market was experiencing some of its worst months.

So much for hedging.

Actually, we shouldn't have been surprised.

Nearly a decade ago, researchers reported that hedge funds were far more correlated with the U.S. equity markets than previously thought. One now-famous study, conducted by Clifford Asness, Robert Krail, and John Liew, all of whom are principals of AQR Capital Management, a firm that itself runs several hedge funds, appeared in the Fall 2001 issue of the Journal of Portfolio Management. Their study was titled, "Do Hedge Funds Really Hedge?"

One of the reasons that hedge funds appeared to have low correlations with the stock market, according to the authors, is that their holdings tend to be illiquid -- and whose prices are updated relatively infrequently. When calculating their net asset value at the end of a given month, therefore, hedge funds often will use stale, out of date, prices for their illiquid investments.

As a result, the researchers found, hedge funds' reported returns often deviate significantly from their true returns. Those deviations have the effect of hiding the extent to which the average hedge fund's returns are correlated with the stock market.

After correcting for the stale prices of illiquid investments, the researchers found a surprisingly high correlation between the typical hedge fund and the stock market.

What's happened over the past three months, shocking as it will be to many, is simply confirmation of what we should have long since realized.

As is too often the case, though, it takes a bear market for us to learn the important investment lessons.