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Common Sense

Hedge Funds Faced a Test in August, and Faltered

A surge in volatility. Plunging global stock markets. A surprise Chinese currency devaluation.

That was August, among the more eventful months for world markets since the collapse of Lehman Brothers and the 2008 financial crisis. In theory, that’s exactly the environment that hedge fund managers have been waiting for. After all, many hedge funds are marketed as helping to smooth out volatility while delivering superior risk-adjusted returns.

So how did hedge funds fare last month?

The results are mixed. The average hedge fund, as measured by the HFRX Global Hedge Fund Index, declined 2.2 percent. In comparison, the benchmark Standard & Poor’s 500-stock index ended down 6.3 percent in August, while another benchmark, a standard mix of 60 percent United States stocks and 40 percent bonds dropped 3.6 percent.

Over the last year, including August, hedge funds lagged far behind, losing on average about 3.5 percent compared with a decline of about 1.6 percent in the S.&P. 500 and a gain of roughly 1 percent in the 60/40 benchmark index. Longer term, hedge funds have underperformed benchmarks over five- and 10-year periods.

“August was a fair test, and many hedge funds had a tough time,” said Simon Lack, founder of the financial consultancy SL Advisors and author of “The Hedge Fund Mirage” and the forthcoming “Wall Street Potholes.” Hedge funds “have failed to beat a 60/40 mix every single year since 2002, and they’re on track to repeat this year.”

Hedge funds come in many varieties, but nearly all of them share two qualities: high fees and the premise that they will counter volatility in stocks while generating high returns.

By charging a percentage of assets under management (often 2 percent) and a cut of any profits (typically 20 percent, though some go as high as 40 percent) hedge funds generate lucrative fees in good times and bad, minting scores of billionaire managers.

Victor Fleischer, a law professor at the University of San Diego, created a stir last month when he estimated that five prominent universities with big hedge fund and private equity portfolios — Yale, Harvard, Princeton, Texas and Stanford — paid their managers more than they gave out in financial aid to students.

Does their performance justify the extraordinary pay? Averages like the HFRX global index mask a wide range of performance by individual hedge funds and the various strategies they deploy. Some prominent funds performed admirably in August. Citadel’s flagship fund was up nearly 1 percent, and Millennium Management was flat.

But few funds have been so nimble. Many funds that did well in August, because they were betting on a market drop, have poor longer-term records. That was the case for liquid alternative mutual funds, which typically offer investors the same strategies as hedge funds, but without the exorbitant fee structures.

Josh Charlson, director of market research for alternative strategies at Morningstar, examined the volatile period of Aug. 17 through 24 and concluded that, on average, liquid alternative funds largely fulfilled their goal of smoothing volatility. Returns ranged from a positive 0.2 percent (for managed futures funds) to a negative 4.8 percent (for equity hedge funds), which is much better than the roughly 9.4 percent drop in the S.&P. 500 for the same period.

But some of the most successful alternative funds during the period have weak longer-term records. The MainStay Marketfield fund, one of the earliest and largest alternative funds, which was singled out by Mr. Charlson for its positive 0.98 percent return during the plunge, has lost more than 13 percent during the last year, according to Morningstar, and has had large investor withdrawals.

“Many people had unrealistic expectations that these funds should gain during severe market downturns,” Mr. Charlson said. “But that’s not how they’re designed; the goal is lower volatility.” At the same time, “Over longer periods, they don’t look very good compared to the market as a whole. “

There are also much cheaper ways to profit from market drops than hedge funds, such as mutual funds and exchange traded funds that bet on market declines. The average bear market fund (funds that bet on market drops) tracked by Morningstar gained 13.4 percent over the last month, far surpassing hedge fund returns. But their longer track records are dismal given the long-running bull market: a negative 19.3 percent over three years and negative 21.8 percent over five.

Just as some of the best-performing funds in August have poor long-term records, some of the most successful hedge funds were hard hit during the downturn. The New York Times reported that the activist investor William Ackman’s Pershing Square Capital Management dropped about 9 percent in August. The article also cited significant losses in funds run by such prominent hedge fund managers as Leon Cooperman, Ray Dalio and David Einhorn.

With such divergent results, picking the right fund is critical. “There will always be a few great funds with happy investors, but it’s a hell of a job figuring out who those are,” Mr. Lack said. “And the more you pick, the more your skill at picking will diminish.”

As a result, he is critical of large state pension funds and endowments that invest with numerous hedge funds. “I don’t think anyone should have more than three or four,” otherwise returns just revert to the average, he said.

Although Calpers, the giant California retirement system, publicly abandoned hedge funds last year, citing their high fees and weak returns, few other large investors have followed. On the contrary, hedge fund assets this year hit a record $3.2 trillion, according to hedge fund data firm Preqin.

Just this week, the California State Teachers’ Retirement System, the nation’s second largest pension fund after Calpers, said it might move as much as $20 billion into alternatives including hedge funds, citing concerns about higher volatility.

That institutions keep pouring money into hedge funds despite their underwhelming track record and steep fees is a tribute to their sales and marketing pitches, which have capitalized on still-vivid memories of the financial crisis and a low interest-rate environment in which the traditional safety of United States Treasury bonds is likely to yield minuscule returns. Moreover, “there are all these highly paid consultants and advisers telling clients to put money in hedge funds,” Mr. Lack said. “You don’t get paid much to tell people to put money in Vanguard.”

A version of this article appears in print on  , Section B, Page 1 of the New York edition with the headline: Hedge Funds Faced a Test This August, and Faltered. Order Reprints | Today’s Paper | Subscribe

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