Why hedge funds faltered (and may work again)

Between January 1998 and July 2012, hedge funds had impressive returns of 5.40% annually, with a risk-adjusted “alpha” of 1.8 percentage points, according to financial theorist William Bernstein in Skating Where the Puck Was.

But the return has been awful lately, with the alpha around -4.5% annually between 2008 and 2012. While hedge funds returned a positive 7.4% in 2013, they badly lagged the U.S. stock market return of 33.4% from a total stock index fund.

Hedge fund alpha is going from bad to worse. Why the decline in performance?

Hedge fund assets under management grew $450 billion in the year 2000 to $2.6 trillion by the end of 2013. When more money chases the same market inefficiencies, those market inefficiencies decline substantially and all that is left are the high fees. Those fees are typically 2% annually plus 20% of the profits (known as 2 & 20). Hedge funds had so much money to invest, they started buying stocks like Apple, the most liquid public equity.

To investors, Bernstein’s prime directive is: “Be early to the game.” Your portfolio should not look like everyone else’s. If a strategy has already appeared in the mass media, the ship has sailed. In fact, you are probably too late once it’s in an academic journal. Once every average Joe investor knows about it, it doesn’t work anymore, as correlations increase and returns plummet.

Bernstein illustrates this dynamic by using precious-metals stocks. In the late 1970s, they were hot and their correlations with other stocks were high. In the early 1990s, they went out of favor and began sporting low correlations, which actually would have been the time to jump in.

But be patient, Bernstein advises. Once an asset class falls out of favor, its ownership transfers from the weak, herding hands into stronger and more independently-minded ones. The result is that returns will increase and correlations will decrease.

But with hedge funds still experiencing investor inflows, that time is not yet here.

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.