Conradde Aenlle

Usually you get what you pay for, but sometimes you get a lot less.

A common raw deal for common investors is the so-called closet index tracker — a fund that’s supposed to be actively managed and charges fees accordingly, yet has a portfolio that varies hardly at all from its benchmark index.

If it’s any consolation, big-time pension plans and wealthy individuals may get an even worse deal. Hedge funds aimed at that uptown clientele charge higher fees than conventional funds, even though the required minimum investment is far greater, and many of these portfolios look like closet index trackers, too.

The one-month correlation between the benchmark Hedge Fund Research Index and the S&P 500 SPX, -0.88%  , meaning the closeness in their price movements, has ranged between 0.6 and 0.9 (the maximum range is -1.0 to 1.0) for most of the last three years, a recent report by Citi Research shows. That’s roughly in line with the S&P 500’s correlation with other U.S. stock indexes. For most of the preceding three years, the range was much wider, between zero and 0.9.

Hilsenrath: Top takeaways from the Fed minutes

Fed minutes reveal Federal Reserve officials have become more concerned about weak growth overseas and the impact of a strengthening U.S. dollar on the domestic economy. Jon Hilsenrath joins the News Hub.

The rise in correlation shows that hedge fund managers are more inclined to mimic the stock market. The U.S. market has been on a tear, so it makes sense they would try that. But there’s a problem: They’re not doing it very well. According to Hedge Fund Research, the average hedge fund returned 5.9% annualized in the five years through August, well below the 16.9% return of the S&P 500.

You may wonder why anyone would own hedge funds when the performance is so poor and they charge on average a management fee of about 1.5% of assets and an incentive fee of 18% of returns, compared to total expenses on a domestic stock index fund of around 0.1% to 0.3%.

Some huge pension plan administrators apparently have been wondering the same thing, and they’re hard pressed to find a good reason.

That explains the recent decision by the California Public Employees’ Retirement System (Calpers) to divest the $4 billion of hedge fund assets in its roughly $300 billion portfolio. Around the same time, the Teacher Retirement System of Texas, with about $126 billion under management, took the more moderate step of reducing its hedge fund exposure from 9% to 8% of its portfolio.

Where to put your money

If you’re a small investor, you probably don’t have access to the hedge funds that institutions and rich individuals do, and the high costs and low returns probably don’t leave you feeling deprived. Still, there are mutual funds that use hedge fund strategies in ways that are more profitable — for shareholders, not managers — and feature far lower expenses and less risk than some of the more high-end versions.

Long/short equity funds, for example, take bets for and against the broad market and try to make money through security or sector selection, buying what looks most attractive and selling short what seems to have the worst prospects. They may be net long or net short, but they’re not trying to beat the market, and because they take positions both ways, they trade with milder swings than conventional stock funds or the typical hedge fund.

Even so, their returns exceed those of hedge funds. The average long/short equity fund rose 8.3% a year in the five years through August, according to investment researcher Morningstar, more than two percentage points better that the average hedge fund.

If you want an investment that can compete with top stock funds on risk-adjusted performance — lower returns but lower volatility, too — and is better than the typical hedge fund, here are some long/short equity funds that have minimum investments of $10,000 or less, below-average expenses and no sales charges, do not appear acutely sensitive to stock market movements and are highly rated by Morningstar (all get four stars under its five-star system):

Catalyst Hedged Insider Buying STVAX, +0.49%  ; Giralda Manager GDAMX, +1.28%  ; Hancock Horizon Quant Long/Short HHQTX, +1.00%  ; Madison Covered Call & Equity Income MENAX, +0.00%  ; Robeco Boston Partners Long/Short Research BPRRX, +0.66%   and Wasatch Long/Short Investor FMLSX, +0.20%

The irony is that these mutual funds are better examples of hedge funds than hedge funds. They reduce risk by taking positions in the stock market in both directions. Many of the vehicles that call themselves hedge funds, meanwhile, resemble conventional stock funds — except when it comes to their fees.