“Never in the history of Finance was so much charged by so many for so little.” Simon Lack in The Hedge Fund Mirage: Illusion of Big Money and Why it’s Too Good to Be TrueWe often hear that hedge funds are run by the best and the brightest. Their strategies tend to give them ultimate flexibility and of course the highest fees. And most marketing materials claim they can offer investors absolute returns, with lower levels of risk than the market.Unfortunately for many investors this is simply not the case. I don’t want to overgeneralise because there are many excellent hedge funds with great records but as a group they really have not delivered the goods. In fact their performance has been shockingly bad. Here are the findings of some of my research:1) In Simon Lack’s recently released book titled The Hedge Fund Mirage: Illusion of Big Money and Why It’s Too Good to Be True, Lack mentions that hedge funds lost enough money in 2008 to cancel out the entirety of the profits they made in the prior ten years. Many will point out that mutual funds have underperformed as well but I would suggest many people are less upset paying 0.75 percent to 1.75 percent in fees than paying two percent plus 20 percent of returns to have the privilege of losing money.According to Lack, “If all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good.” In analysing funds from 1998 through 2010, Lack adjusted the HFRX Index (an index that tracks hedge funds) by factors such as the “survivor bias” (only surviving hedge funds report returns), and found that fees were $324 billion while real investor’s profits equate to a loss of $308 billion.2) In another study published by the Journal of Financial Economics in 2011 titled “Higher risks, lower returns: What hedge fund investors really earn” researchers compared actual investor returns in hedge funds versus buy-and-hold strategies using dollar-weighted returns (which is just a fancy way of estimating how the actual money people had invested in the strategy performed).Their “main finding is that annualised dollar-weighted returns are on the magnitude of 3 percent to 7 percent lower than corresponding buy-and-hold fund returns.”In fact they suggest “the real alpha of hedge fund investors is close to zero” and that in absolute terms the “dollar-weighted returns are reliably lower than the returns on the S&P 500 index, and are only marginally higher than risk-free rates as of the end of 2008.”3) On the whole Funds of Hedge Funds (FoHFs) have also not been very effective in adding much value according to the 2011 study titled “Assessing the Performance of Funds of Hedge Funds”. The authors suggest that “the vast majority of FoHFs do not exhibit alpha.” Furthermore, “only a small fraction of FoHFs deliver alpha per se, i.e. above the one already delivered by the universe of single-manager hedge funds. This means that the additional layer of fees that FoHFs charge eats away any manager added value”. The key here is fees. Jack Bogle, the founder of Vanguard, once said: “Performance comes and goes, but costs roll on forever”.4) Speaking of Vanguard, a white paper written in 2010 called “Alternative Investments Versus Indexing: An Evaluation of Hedge Fund Performance” concluded that they were unable to “find merit in the argument that hedge funds provide diversification as an alternative asset class. The average returns for hedge funds have been highly correlated with those of long-only indexes. While it is true that hedge funds have been capable of insulating their investors from the worst declines in the broad stocks market, they missed the upturn in the broad market as well.” They also addressed why they felt investors have flocked to this segment and suggest it’s simply “irrational exuberance”, the hope while others might have failed, they could consistently pick winners.5) A Global Asset Allocation note by the research firm BCA titled “Do Hedge Funds Diversify Risk?” on November 30, 2011 suggests that diversification benefits of hedge funds are overstated. Their increasing correlation with the market and each other shows no sign of abating. Style selection is becoming less important.They also conclude that “As an industry, hedge funds have not met their original objective. Positive returns have not been generated in both bull and bear markets.”It may be that 2012 is the year hedge funds return to strong performance and outperform. If not, it’s likely we will see widespread redemptions from the industry when the opportunity arises. In my opinion the comparison between alternatives and traditional asset allocation is very simple.Traditional balanced asset allocation has provided diversification, superior performance, liquidity and much cheaper fees, yet investors continue to shun the traditional approach. (See Chart 1/Source: Bloomberg/Anchor Investment).In 2000 the hedge fund industry was quite small with some $200 billion in assets. It subsequently climbed to around $2 trillion under management by early 2008. In the last two years portfolio allocations to alternatives has jumped from 7 to 17 percent (BCA Research/Scorpio Partnership).Alternatives have underperformed, tend to be much more correlated to other asset classes than advertised, have limited liquidity, and charge much higher fees, so why do investors continue to pile into such investment vehicles? It is concerning to see an increasing allocation to what one many consider to be an inferior and more expensive product compared to a superior less expensive product.Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.