Hedge fund strategies frequently outperformed the S&P 500 Index from 1992 to 2007, and most pre-2008-financial-crisis academic studies found that hedge funds, on average, generated positive alpha.  But "hedge funds overall didn't perform as well as people would have expected during the crisis," says Mallory Horejs, an alternative investment analyst with Morningstar.

Although some hedge strategies provided significant downside protection at the time, many correlated with the broader market and posted negative returns, defeating one of the main purposes of investing in hedge funds: making money in any market, particularly during down periods.  "The whole concept of absolute, uncorrelated returns really flew out the window," says Horejs. 

Less than stellar performance wasn't the only issue, she adds.  "Many hedge funds imposed gates on their assets, preventing investors from withdrawing their money even as the market continued to drop," she says. Some hedge fund investors got burned as a result.  "They didn't realize the potential was there to lose all their money."

For private wealth advisors, the question is, in the aggregate, do hedge funds presently add value?  In other words, are hedge funds, and especially funds of hedge funds (FoFs), creating enough alpha after fees and taxes to justify the illiquidity and other risks associated with investing in them?

If we go by Figure 1, the quick answer appears to be, "no." The table shows, among other things, that the Morningstar 1000 Hedge Fund Index, a composite of the largest hedge funds in Morningstar's database, has lagged the S&P 500 since 2009, although it has beaten the Barclays Capital U.S. Aggregate Bond Index until recently.

Determining whether this asset class is appropriate for clients begins with a clear understanding of these funds. The word "hedge" might invoke images of investors prudently covering their bets.  But hedge funds can be highly risky and super-volatile. In fact, dozens of hedge funds have suffered serious losses, shut down or filed for bankruptcy in recent years.        
Being relatively unconstrained by SEC regulations that apply to mutual funds, hedge fund managers can and do use leverage, take short positions and invest in derivatives. Overall, hedge fund managers employ an estimated 15 to 20 different types of strategy, which Hedge Fund Research, the largest industry data tracker, groups into four broad categories, as Figure 1 indicates. 

For their vaunted expertise, hedge fund managers typically charge high fees, which industry critics cite as a value detractor.  The industry average is the so-called "two and 20," 2% of AUM and 20% of the profits. In practice, management fees range from 1% to 3% and performance fees can be as high as 40% of the fund's upside.

A fund of funds is even more expensive because investors pay a management fee and a performance fee for each underlying fund, plus the same to the FoF manager.  FoF management fees average 1% per year and incentive fees are typically 10%.  For the extra layer of fees, FoF managers provide investors with asset allocation and perform due diligence on the underlying funds. FoFs often require lower minimum investments than individual funds and can provide clients with access to single funds that may be otherwise closed to new investors.  Multi-fund strategies can also help minimize the risk of an individual fund imploding and wiping out all of an investor's capital.

Historically, FoFs have touted their multiple holdings as a diversification tool, but new academic research demonstrates that once a fund of hedge funds holds more than 20 underlying funds, the benefit of diversification drops sharply. A July 2011 study, by New York University Professor Stephen Brown and two co-authors, available at papers.ssrn.com/sol3/papers.cfm?abstract_id=1436468, found that more than 20 underlying funds increases risk in extreme market conditions.
The increased risk was accompanied by lower returns due to the expense of necessary due diligence, the price of which increases with the number of underlying FoF funds. The study also noted that the majority of FoFs hold more than 20 individual funds.   

Taxes have a further impact on returns. Because some managers trade frequently in an attempt to create outsized returns, their funds generate significant short-term capital gains for investors that are taxed at ordinary rates.