By BRETT ARENDS
BOSTON (MarketWatch) The hedge-fund boys are back in the saddle.
The crisis is over. Bernie Madoff is long since forgotten. And the money is flowing once again.
According to Hedgefund.net, investors pumped another $22 billion into hedge funds of all description last month, the fastest rate in well over a year. The industry's back to managing a thumping $2.5 trillion all but a sixth from the all-time peaks seen in 2008.
Let the good times roll.
The phrase "hedge fund" carries a lot of freight these days. Some people hate them. Others fear them. Others covet them. But most seem to agree these secretive, speculative funds are exciting and dynamic, and somehow contain the secret to eternal wealth.
Investors clamor to get on board. They'll pay through the nose for the privilege: typically 2% of assets a year, plus 20% of the profits, if any. And they'll consider themselves lucky.
Those who can't get in are going to suffer another round of hedge-fund envy.
But how good are hedge funds really? Behind the mystery, what's the reality?
I decided to look at the numbers.
The industry's pretty secretive overall, but Hedgefund.net runs one of the more authoritative databases of performance figures, including thousands of funds.
Over the past five years, the firm says, the average hedge fund made a 55% overall profit for investors.
That covers the gamut of strategies. It includes long-short funds, which play the stock market up and down. It includes global macro funds, which bet on big economic trends. It includes risk arbitrage funds, commodities and managed futures funds, bond funds, and so on.
That sounds pretty good, right?
Well, I decided to compare that to a basic portfolio that any schmuck could have. Like me or, dare I say, you.
What's basic? I wanted to avoid any data mining or back testing. So I decided to go for the most vanilla portfolio I could create: One you would set up if you were completely blind to prices and valuations in the market, and developments in the wider world, and had no view about the future.
I started with 60% stocks, 40% bonds. On the stock side, I allocated the money to the U.S., advanced overseas economies, and emerging markets roughly in line with their 2006 share of the global economy. That meant 15% in the Vanguard Total Stock Market fund fund,
And then I simply rebalanced the fund every quarter, to keep the allocation in line with where it started.
Plain. Simple. No funny stuff. No data mining or backtesting. I ignored gold, even though some people such as Charles de Vaulx at International Value Advisors argue you should include 5% in a basic portfolio.
This is a portfolio anyone could own. Your grandma could create it online tomorrow. No one has to schmooze anyone at the yacht club. Fees are minimal.
I used Lipper Horizon, a service from Thomson Reuters, to track the performance.
Over five years, that vanilla portfolio produced a return of 32%, compared to 55% for the average hedge fund.
So the hedge funds win, right?
Um, not quite.
First, the "average" hedge fund performance figure is heavily skewed by a few big outliers the same way you, me and Bill Gates have an "average" net worth of about $10 billion.
Maybe a better figure is the "median" hedge fund. That's the one you'd get if you lined them up from best to worst and picked the one in the middle. It's the performance of the most typical fund.
Over the past five years, the median hedge fund made a more modest profit of 41%.
That's a long way below 55%.
It's still better than 32%, right?
About two-fifths of the hedge funds actually did worse than the vanilla portfolio. And then there's the really big problem.
Hedge funds come and go. The managers take big gambles. If it pays off, they make big money. If it flops, they close up shop and move on. Heads they win, tails they flip again. There is a lot of churn in the hedge fund industry.
And that churn isn't reflected in the industry performance figures. That's because the ones who flop and fold up shop vanish from the databases. Their performance figures don't count against all the successes.
These great numbers you hear about? They only include the survivors. The ones that lasted.
So, for example, that 41% return is the median performance of about 1,400 funds tracked over the past five years.
But, warns Hedgefund.net, a lot more funds dropped out of the rankings altogether along the way.
How many? Try 3,000.
No kidding. Twice as many. Just completely dropped off the radar screen.
One day a fund is taking big bets with borrowed money. The next Lehman Brothers implodes, markets go haywire, and the fund manager stops returning calls.
Maybe he dropped off the radar screen because he was doing so well. I don't know. Nobody knows. What do you think?
If most of the dropouts did badly, which seems a reasonable guess, the real industry averages turn out to be much worse than people think.
I played with some numbers. By my math, the median dropout fund had to produce a return of at least 21% just to keep the overall industry average in line with that of the plain-vanilla Vanguard portfolio.
Twenty-one percent. This is among the dropouts.
How likely was that? Not very. Even a quarter of the survivors did worse.
Bottom line: The odds have to be overwhelming that the typical hedge fund fared worse, much worse, over the last five years than a plain vanilla portfolio.
So I decided to have a look at the figures over 10 years.
Not many hedge funds have been around for a decade. Hedgefund.net tracks about 500.
How did they do?
The mean performance figure was 204% gain. In other words, the "average" hedge fund tripled your money. But, once again, that's skewed by a few superstars.
The typical, median fund gains 133%.
That's still pretty good. It more than doubled your money. What about plain vanilla portfolio, equivalent to the one above?
Over 10 years it was up a more modest 94%.
I weighted the stocks slightly differently, to reflect the different shares of the global economy in 2001. So the hedge funds won this one, right?
Once again, the devil is in the details.
A third of the hedge funds did worse. And, once again, we are only talking about the performance of the survivors.
According to Hedgefund.net, 75% of the funds that were around in 2001 have vanished along the way. Just 535 made it to the finish line out of 2,229 that started.
By my math, those that dropped out had to produce returns of about 60% to keep the overall numbers level with the plain-vanilla portfolio.
Even a fifth of the survivors failed to do that.
It's time for "hedge funds" to lose their mystique. Naturally there are a few investment geniuses, just as there are among mutual funds and individual stocks. And there are armies of mediocrities charging you high fees.
Hedge fund envy? Hardly worth the time. If you want to make money from hedge funds, there's still only one reliable way to do it.
Move to Greenwich, Conn., and sell real estate.
Brett Arends is a senior columnist for MarketWatch and a personal finance columnist for the Wall Street Journal.