File under obvious - Hedge funds 'fail to deliver'

"In 2008, hedge fund managers generally failed to deliver," Morningstar Hedge Fund Analyst Nadia Papagiannis said yesterday in a press statement. "The average hedge fund may have lost less than the stock market, thanks in part to large cash allocations, but this level of performance was not why investors agreed to pay 2 percent management fees and 20 percent performance fees."

Investors "lost their appetite for hedge funds" as the vehicles intended to deliver absolute returns were forced to resort to relative claims of success.

Since May, hedge funds have been on a steady decline, according to Morningstar Inc. Massive losses in September and October of 7.9 percent and 9.8 percent, respectively, quashed any hope of salvaging the year, even though it ended on a positive note -- December posted a 2.1 percent gain.

Morningstar also calculates hedge fund indexes according to the MSCI methodology. The Morningstar with MSCI Asset Weighted Hedge Fund Composite index, which hedges U.S. dollar exposure, lost 12.9 percent in 2008, while the equally weighted version lost 16.4 percent, reflecting the poorer performance of the smaller funds.

Since August 2007 -- the beginning of the credit crunch -- hedge funds have effectively acted as muted versions of equities, providing positive returns only twice when the MSCI World Stock Index was negative.

Hedge fund inflows peaked in June 2007 and bottomed in October 2008, when more than $21 billion left the industry. In November 2008, another $19.4 billion flowed out of hedge funds, setting the year-to-date outflows at more than $44 billion. Hedge fund investors showed a strong tendency toward performance chasing, investing more after positive months and withdrawing assets after down months. Investors following this strategy ended up losing less than the index, as the markets trended increasingly downward as the year progressed.

High redemptions and little possibility of collecting performance fees in the near future, led hedge funds to shutter in record numbers in 2008. The number of funds dropping out of Morningstar's database increased more than 150 percent in 2008 from 2007 -- 1,158 single-manager funds and 490 funds of funds were removed in 2008 compared to 434 single-manager funds and 208 funds of funds in 2007. (Funds are removed from Morningstar's database if the fund liquidates, if the manager wishes to stop reporting returns, or if funds fail to report returns for six months.)

Emerging market equities proved to be the worst strategy in 2008. Effectively a market-return strategy, these funds are only able to invest in stocks or hold cash, as shorting emerging markets holdings is very difficult. Emerging stock markets performed worse than other markets, as skittish investors pulled capital out of risky assets. Although emerging markets bounced back in December, the MSCI Emerging Markets Index lost almost 55 percent in 2008.

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