Bring up the topic of hedge funds at a cocktail party and the first thing to pop into most people's minds may very well be their performance, exclusivity and protection from market downturns. But those impressions may have little to do with reality. Hedge funds, as a group, don't produce better returns than index funds or protect your investment any better than a well-balanced asset allocation. In reality, not having access to this exclusive investment or choosing to avoid it all together is saving you money. Let's dive in and look at exactly what hedge funds are supposed to do and why they just don't live up to the hype of a great investment.

Purpose of a Hedge Fund

The original purpose of a hedge fund was to minimize the risk of long-term investment positions, while at the same time trying to maximize profits. It originally began as a long/short strategy with some leverage added in. This is how they came to have the name hedge funds — they were hedging the risk out of the investment. (For more, see: A Brief History of the Hedge Fund.)

Over the years as the funds produced great profits for those that ran them, more and more money managers were attracted to starting a hedge fund. As more hedge funds were created the emphasis on hedging investment losses became second priority to providing aggressive high returns through illiquid and risky investments. With the move away from the original purpose and the increase in funds, performance began to decline.

Here are some of the reasons these funds are not making the money they should or preserving capital.

High Fees

Most hedge funds charge a 2% management fee plus 20% of the profits that they create, without sharing in the downside when there are losses. While these fees have come down in recent years with increased competition, they are still higher than you would pay in other investments. Even with some funds offering deals where there are clawback provisions, where you get some money back when there is a loss, there are still a lot of fees to overcome. (For more, see: Hedge Funds: Higher Returns or Just High Fees?)

Overcoming fees is one of the hardest thing for any investment to do. The higher that number the harder it is to give your investors returns. If you make 10% and have fees of at least 2% then you really only made 8%. Where this really hurts is when the funds are not doing as good as the indexes. If an index returns the same 10%, you are underperforming by a full 2%.

Replicating Passive Investments

Recent studies have shown that an overwhelming majority of hedge funds are not engaging in real active management to obtain a higher return. They are instead replicating many passive investment strategies such as traditional indexes or smart beta strategies. Australia’s Monash University recently published a paper that showed this phenomenon. It even showed that those hedge funds that were actually using active management to try and outperform indexes were performing worse than the hedge funds that were more passive. So those that were actually running like a hedge fund were bad at it. (For more, see: What's the Difference Between Alpha and Beta?)

Lagging Returns

Now that hedge fund investors are paying for passive returns it becomes even more painful to learn that the hedge funds are doing no better than a standard balanced fund that has an allocation of 60% stocks and 40% bonds at protecting them from risk in the market. Vanguard did a study that showed that hedge funds had the same downside protection of this balanced group of mutual funds during the 2008 market crash.

From November 2007 to February 2009 hedge funds were down from an average monthly rate of -2% to 1.3%. At the same time, a portfolio of 60% stocks and 40% bonds was down 2.3%, while the overall market was down an average monthly rate of 4.2%. When you add in fees, those in the hedge fund have to have a greater return to get back to zero than those in the balanced portfolio. (For more, see: 6 Reasons Hedge Funds Underperform.)

Even after the comeback in the markets, hedge funds are consistently underperforming the S&P 500. The Barclay Hedge Fund Index showed a 2.88% gain in 2014 when the S&P 500 returned 13%. Not exactly the return you think you will be getting.

The Bottom Line

It may sound like a great idea to get into hedge funds, especially when they seem like they are the hot thing to do with your investments. The poor performance of hedge funds are not worth the extra fees you have to pay just to be in them. Your money would be better served finding a good index fund and keeping your asset allocation properly balanced. (For more, see: Hedge Fund Due Diligence.)

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