Are your clients prodding you for hedge funds and other alternative investments to diversify their portfolios and boost paltry returns on equities and bonds? They might want to think again. An analysis of hedge funds suggests that they provide neither diversification nor better returns, according to Vanguard research.

Vanguard compares the performance of various categories of hedge funds with that of the broad U.S. equity market, the overall U.S. bond market, and a 60% equity/40% bond portfolio from November 2007 to December 2011. More specifically, Vanguard compares their performance during the market downturn from November 2007 to February 2009 and during the market recovery from March 2009 to December 2011.

Guess what it found? While some of the hedge fund categories outperformed their benchmarks during the market downturn, all of the categories failed to fully participate in the equity market recovery. 

For example, during the market downturn, the U.S. equity market crashed at a cumulative annualized rate of -41.3% and the U.S. bond market returned 4.5%. During this time, the cumulative returns for the various hedge fund categories all exceeded those of equities, ranging from -33.9% to 25.7%.

During the market recovery, however, none of the hedge fund categories were able to exceed the broad equity market’s cumulative return of 24.4%. Some couldn’t even beat the bond market’s overall 7.7% return. A traditional 60% equity/40% bond portfolio would have returned 17.9%, beating all of the hedge funds. 

Even during the downturn, a simple 60% /40% portfolio of stocks and bonds would have cushioned the fall in equities, with a return of -25.4%, ahead of the results of several hedge fund categories.

The analysis also threw a bucket of cold water on the notion that a hedge fund is an alternative investment that can provide portfolio diversification. In fact, many hedge fund categories are positively and strongly correlated with a 60%/40% portfolio of stock and bonds, the study found.

“Hedge funds are not always an ‘alternative’ investment, but, rather, are strongly correlated with the equity and bond markets,” Vanguard writes in the analysis.

To read the research in its entirety, click here. The report is titled “A mixed bag: Performance of hedge fund categories before and after the financial crisis.”