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Sad to say, the vast majority of all hedge funds worldwide have well underperformed virtually every major stock or bond index for some four years now. Adding insult to injury, investors in such funds have paid 2% management fees and 20% of (paltry) profits for the privilege of having their money managed by these elite of the investment business. What explains such a fall from grace of even many long-time masters of the financial universe? Have such highly skilled super savvy "best of the best" gone from being "smart" to "dumb?" What went wrong?

Based on many interviews with hedge fund managers, scanning countless e-mail reports, and my long experience in investment management, the simple answer to this vexing question is this: tinkering with exposure. Specifically, the vast majority of hedge fund managers adjusted exposure far too frequently in response to perceived changes in market conditions. Accordingly, much of their prior success in "bottom's up" picking longs and shorts, the historic edge of hedge fund masters, was watered down by such ill-timed changes in long/short ratios and leverage. This activity was little more than "market timing," which most hedge fund managers claim they don't practice, and which once again proved counterproductive for the past four years.

Why did this occur? First, managers paid far too much attention to the mind sets and guidelines of clients, which had become predominantly institutional. Since most allocators of institutional money are agents, not principals, often they are quite averse to volatility, mistaking that pure statistical measure for permanent loss of capital. In reaction to this institutionalization, many managers became obsessed with producing steady Eddie "risk adjusted" returns instead of maximum return on capital. This made good business sense for retaining and growing assets under management, but it hurt bottom line performance. Results were hurt also by the growing practice of reporting returns weekly-another sure way to detract from long term outcomes.

Second, pummeled by the daily drumbeat of seemingly massive economic and geopolitical shifts, many skilled stock and bond jockeys morphed into amateur economists. Previously, most managers paid scant attention to business cycles, overall GDP trends, or the potential effects of political forces. While recognizing that all businesses function within an economic setting, they focused mainly on management prowess, product superiority, marketing clout, and financial strength (or weakness) for holding positions, long or short. But, after the disaster of 2008 and in the following troubled times, managers paid increasing attention to "big picture" trends,believing they could mitigate adverse "macro" forces. This also proved counterproductive.

Despite little success, "risk on risk off"-adjusting exposure-became an almost daily practice in hedge land. Let me repeat: This activity is little more than market timing, which most top managers have claimed they could not do and did not employ. And yet, this combination of "big picture" forecasting and closet market timing continued, causing the vast majority of hedge funds to underperform the Dow, S&P, MSCI, and even Treasury bonds, while charging the highest fees of any service business. So, what should investors in hedge funds do? Quit and go long only?

No, hedge fund managers, who still rank among the smartest people on the planet, will figure it out and get back to basics. In order to promote that change, call your managers and remind them net cash returns, not just "alpha," are required for you and your institution to stay the course. For in most of our world, bottom line money, not abstract concepts, is what really matters.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Why The Vast Majority Of Hedge Funds Underperformed All Major Indexes