By John Cassidy

The crux of the issue is the industrys two-tiered fee structure, which includes a hefty management fee (two per cent has long been the standard) and a big performance fee (twenty per cent is the standard). Here, again, is the question I posed. Why do investors in hedge fundsthe people whose money is at riskcontinue to allow the managers of the funds to dictate such onerous terms to them? I will consider various theories in order of plausibility, starting with the one that I consider least persuasive. Along the way, Ill deal with some details that I didnt have space for in my previous post.

1. They deliver superior returns. Several commenters said that it wasnt fair to single out last year, when hedge funds generated a return of 7.4 per cent (net of fees), according to Bloomberg, and the S&P 500 produced an over-all return of about thirty-two per cent. Fair enough: lets look at how investors in hedge funds have fared over a longer period.

According to the industrys own figures, over-all returns have been falling steeply over the past decade or so. A study by KPMG, which was commissioned by the Alternative Investment Managers Association, an industry trade group, found that, between 1994 and 2011, hedge funds, on average, generated an average return of nine per cent. But Simon Lack, a financial consultant who used to work for J.P. Morgan and has written a skeptical book about hedge funds. points out that this figure disguises a sharp deterioration in recent years. Between 1994 and 1998, Lack points out in a presentation that is available online. the average return made by hedge funds was twelve per cent; between 2007 and 2011, it was just two per cent.

Even these figures arent necessarily reliable. They are calculated on the basis that each investor buys into a fund, or a range of funds, at the beginning of the period under study and holds on until the end, rebalancing his or her portfolio along the way so that the stake remains constant. But that isnt how things work. Most investors buy in late, deploying and withdrawing big chunks of capital at irregular intervals. To take account of this behavior, Lack and others have redone the figures, calculating dollar-weighted rates of return, which provide a more accurate picture of how hedge-fund investors actually fared than the traditional value-weighted figures.

The difference this makes is quite substantial. According to Lacks figures, between 1994 and 2011, hedge funds generated an annual return of six per cent rather than nine per cent. They did about the same as the stock market, which produced an annual return of 5.8 per cent, but not as well as bonds, which generated an annual return of 7.2 per cent.

An older study by Ilia D. Dichev and Gwen Yu, two academics who were then at the University of Michigan, produced broadly similar results. Dichev and Yu found that, between 1980 and 1992, when the hedge-fund industry was still very small, it generated an annual (value-weighted) return of 19.8 per centa very impressive figure. But, between 1993 and 2006, the annual rate of return fell to 11.1 per cent. These figures are for unadjusted value-weighted returns. When the authors converted them to dollar-weighted numbers, they found that hedge funds produced an annual return of twelve per cent between 1980 and 2006. Thats less than the annual return of 13.5 per cent that the S&P 500 produced over the same period.

The message from both studies is clear: hedge funds, on average, dont outperform the stock market. In what sense, then, can their returns be considered superior? The next theory provides a possible answer.

2. They deliver superior risk-adjusted returns. O.K. an embattled consultant might say, hedge funds dont necessarily beat the stock-market index over the long term, but they are much safer. They do, after all, have the word hedge in their names, and offer, as well as a sense of safety, decent returns.

The short answer to this is 2008, when hedge funds, as an asset class, lost more than twenty per cent of their value. Some individual funds, such as Ray Dalios Bridgewater, which I wrote about at length in 2011, did well, but the industry as a whole did terribly. Just how terribly? According to Lacks figures, hedge-fund losses in 2008 came to about four hundred and fifty billion dollars. That was considerably more than all the profits that the industry had generated in its entire history.

A statistician might argue that this isnt a winning argument because, again, it focusses on one bad year. But that, surely, is the point. If hedge funds really are a hedge, rather than a way of trying to buy above-market returns, they should perform well precisely when everything else is going to pot. But they didnt.

Heres another way to look at it. If somebody offered you a costly investment that combined the promise of safety with the lure of attractive returns, how would you assess it? Well, one way might be to compare it to a hypothetical sixty-forty investment portfoliosixty per cent stocks, forty per cent bondsof the sort that regular investment advisers have been recommending to their cautious clients since the year dot. Lack carried out this exercise, looking at figures going back to 1998. In 2000 and 2001, when the dotcom bubble burst, hedge funds did what they are meant to do, he found: they outperformed the sixty-forty portfolio. But, in every year since 2002, including 2011, when the stock market was flat, the sixty-forty portfolio, which can be constructed very cheaply, did better than the average hedge fund.

3. They deliver uncorrelated returns. This is supposedly the sophisticated defense of hedge funds. By using a variety of techniques unavailable to ordinary folk, such as momentum investing, long/short investing, and betting on global macroeconomic trends or the outcome of mergers, they generate a special type of return, known as alpha, which is quite separate from the gains that can be reaped from more straightforward investments in various markets, known as beta.

Here we get into some complicated, contested, and almost theological debates. Rather than delving into them at length, Ill confine myself to discussing a 2010 study that Roger Ibbotson, a finance professor at Yale, and two of his associates carried out. Defenders of hedge funds often cite it because it concluded that the funds do generate alpha on a consistent basis. The positive hedge fund aggregate alphas for the last eleven years in succession suggest that hedge funds really do produce value, the paper says.

Ibbotson and his colleagues start out by looking at the over-all peformance that hedge funds deliver. They calculate traditional value-weighted returns, rather than dollar-weighted ones, but they adjust them for a couple of other problems that are known to afflict hedge-fund datathe survivorship bias and the backfill bias. When these adjustments are made, it turns out that, between 1995 and 2009, hedge funds produced an annual average return of 7.63 per cent. Over the same period, the S&P 500 generated an annual return of 8.04 per cent.

This confirms that hedge funds dont beat the stock market. How, then, can they be said to generate alpha? Ibbotson and his colleagues use a statistical model that seeks to explain the variability in hedge-fund returns on the basis of several variables, the most important of which are the market returns yielded by stocks, bonds, and cash. Broadly speaking, any returns that these variables cant explain are attributed to alpha, and are thereby assumed to be generated by the skill and expertise of the hedgies.

Rather than discussing the pluses and minuses of this methodology, lets look at the results that it generates, two of which stand out. The first is that most of the returns that hedge funds generate arent alpha at all: theyre beta in disguise. Of that annual average return of 7.63 per cent, 4.62 percentage points come from beta, and just 3.01 percentage points come from alpha, according to Ibbotson and his colleagues. Contrary to their P.R. pitch, hedge funds arent operating oblivious to market conditions. Like ordinary investors, the returns that they receive mostly come from simply being exposed to the market.

The second striking, if unsurprising, finding is that the fees hedge funds charge swallow up much of the alpha they produce. Gross of fees, the annual return to investors over the period from 1995 to 2009 was 11.42 per cent. Management and performance fees reduced this figure by 3.79 percentage points. Even if hedge funds are generating alpha, they are keeping most of it for themselves.

4. Low interest rates. In order to remain solvent, many pension funds need to generate annual returns on their investments of six to eight per cent. With interest rates as low as they have been in the past few years, investing in government bonds and corporate bonds doesnt produce a high enough return. And investing in the stock market is rightly perceived as risky.

This environment has generated a demand for high-yield, low-risk investments, even among investment professionals who understand, on an intuitive level, that the very phrase high-yield, low-risk investment may well be an oxymoron. Hedge funds have seized upon this opportunity to present themselves as the solution to an urgent problem. Even though the industry slipped up badly in 2008 and individual funds have an alarming tendency to blow up or get into legal trouble, it still portrays itself as a safer alternative to the stock market. This marketing strategy may be working: in the first quarter of this year, according to a news release from Hedge Fund Research, the amount of assets that the industry manages hit a new high of $2.7 trillion.

In an article posted at allaboutalpha.com, Dan Steinbrugge, a hedge-fund consultant, explains why this is happening:

Most institutions are currently using a return assumption of between 4% and 7% for a diversified portfolio of hedge funds which compares very favorably to core fixed income, where the expected return is only 2.5% to 3.0%. As long as the expected return is higher for hedge funds than fixed income, we will continue to see money shift from fixed income to hedge funds.

5. Lack of transparency. Hedge funds are secretive for good reason, and it doesnt all have to do with protecting their investment strategies from the competition. The opaqueness of the industry, and the fact that most people dont really understand what it does, adds to its allure, and helps it to maintain its fee structure. Its in part because most investors dont know quite what they are getting, beyond a monthly report outlining the funds over-all performance, that they are willing to pay ultra-premium prices.

Im not joking: at least, I dont think I am. Even after all of the industrys recent troubles, including poor performance and insider-trading charges against some big firms, there is a general feeling that hedge-fund managers are smarter than other people, and that much of what they do is too complicated to be replicated. Generally speaking, neither of these things is true. Obviously, there are a handful of super-smart (or super-lucky) managers who have built up sterling records over the years. (Dalio, of Bridgewater Associates, is one of these people.) But the business of running a hedge fund isnt vastly complicated, and most of the basic investment strategies that funds utilize are well known.

I remember, in 1998, when Long-Term Capital Management, the biggest hedge fund of its time, came close to collapse and had to be rescued by the Fed and a consortium of banks. It was a big shock to see a firm built by Wall Street legends and Nobel-winning economists come a cropper. But it was even more surprising when the trades that had gotten the firm into trouble were revealed. They werent particularly complicated. They were just big and risky. Among longtime observers of the firm, myself included, the general feeling was: Where is the rocket science?

It turned out that L.T.C.M.s real comparative advantage was in marketing itself to journalists and investors. Still, the perception persists that hedge funds are the ultimate luxury goods, hewn together by financial geniuses who necessarily operate in the shadows. Thats a huge advantage for the industry.

6. The price and quality problem. In most businesses, if you want to undercut your competitor, you reduce your prices below theirs. Thats what Amazon did to Borders and other bookstores. Its what Walmart did to the corner store. And its what Southwest did to American Airlines and the other major carriers. Fortunately for the big hedge funds, the same strategy doesnt work in their industry.

Thats because of another information issue that favors incumbents. From the outside, it is very difficult to figure out the quality of an individual fund. Pretty much all you have to go on is a record of its past performance, if you can find a reliable one. But newer funds dont have long track records. In trying to attract investors, they have to rely on their pitch and the reputation of their managers. In theory, part of this pitch could be the promise of lower fees than those charged by, say, Appaloosa Management or Paulson & Co, but what sort of message would that send?

When information about the quality of a good is scarce, buyers all too often interpret its price as a signal of its quality. Andy Warhol silkscreens cost a fortune: he must have been a great artist. Park Avenue surgeons charge more than those in the Bronx or in New Jersey: they must be better. The same thinking applies to hedge-fund managers, and that makes it difficult for anybody to offer lower fees.

7. Investors are sheep. In studying why any human activity becomes popular, it usually pays to consider the possibility that people are copying each other. When money is involved, it is imperative. From Internet stocks to Florida real estate and biotechnology startups, all too many speculative manias have been constructed on this basis.

Could hedge funds be the latest bubble? There certainly seems to be evidence of some signstrend-following and irrational exuberanceamong hedge-fund investors, and that includes ordinary individuals as well as institutional investors. The demand for hedge-fund-like investment vehicles is so large that traditional asset managers, such as Blackrock. are busy launching so-called alternative mutual funds, which mimic some of the characteristics of hedge funds, such as using leverage and selling stocks short. According to the research firm Morningstar, there are more than four hundred of these hybrid funds in existence.

In theory, these alternative mutual funds could emerge as a lower-cost rival to hedge funds, but there doesnt seem to by any sign of that happening. Instead, they are diverting money away from regular mutual funds. Meanwhile, the total amount of capital being directed to all types of alternative investments keeps climbing. In the next ten years, according to a recent study quoted in a research note from JPMorgan, the proportion of mutual-fund assets devoted to alternative funds will quintuple. Meanwhile, hedge-fund executives expect the industrys total assets under management to top three trillion dollars this year, and to keep climbing from there.

8. There is a principal-agent problem. The job of pension-fund managers and other institutional investors is to drive down fees and to get the best terms possible for the people whose money they are managing. In dealing with hedge funds, this hasnt happenedor, rather, the process hasnt been taken nearly as far as it could have been.

In my previous post, I pointed out that fees have fallen a bit recently, particularly those charged by newer funds. But the fact remains that almost all of the profits hedge funds generate go to the managers of the funds rather than to the investors whose capital is at risk. Hedge funds have taken 84% of net real investor profits since 1998, Simon Lack writes. Funds of funds have taken 14%, and only 2% has gone to investors.

These figures surely point to some sort of market failure. On one side are the individual pension-fund managers and managers of charitable endowments, often modestly paid, struggling to meet their actuarial requirements, and looking for assistance. On the other is the hedge-fund industry and its Wall Street enablers, waiting with open arms. It is an amazing disconnect, Lack writes. The entire hedge fund industry is designed to channel assets into hedge funds. Everyoneconsultants, advisers, funds of funds, capital introduction groups of prime brokersrecommends investing in hedge funds. Nobody is providing the opposite view.

Thanks to Lack and a few like-minded heretics, that may finally be changing a bit, and the attitude of some institutional investors may be changing, too. According to a report this week, from the trade publication Pensions Investments. the mighty Californian Public Employees Retirement System is considering cutting in half the amount of money it allocates to hedge funds. Calpers, as its known, is the big dog of the pension-fund world. If it signals to other institutional investors that its had enough of paying hefty fees to overpaid hedge-fund managers for moderate or poor performance, that might actually have some impact.

We shall see. In the meantime, its good to be a hedgie.

Illustration by Tom Bachtell.