Reading through some of the mandates for hedge funds via Bloomberg can provide instant comedic relief…

“Its strict requirement is that funds must have at least three years of 15 percent returns. The ratio of annual returns to maximum drawdown must be at least 1.5.”

“The expected return of the manager is typically between 12 percent to 15 percent on a five year annualized basis. Managers with a maximum drawdown of 20 percent or more will be not considered.”

“Expects a return of 10 percent to 15 percent and drawdowns of no more than 5 percent to 10 percent.”

“The investor has a very “high bar” preference and seeks returns that average over 18 percent. The firm is pedigree sensitive.”

“The expected return on the long-short funds is about 10 percent to 15 percent.”

“Managers should have a strong pedigree and expect a return of at least 12 to 15 percent in the coming quarters.”

“The firm generally targets returns of 15 percent and volatility should be 7 percent.”

“Currently looking for energy hedge fund managers with net returns greater than 20 percent. Managers should have the “right pedigree” and not have a drawdown of greater than 15 percent.”

“The firm is only interested in funds that have track records between six and 18 months with Sharpe ratios of 1.25 or greater. The firm does not wish to review managers that have had drawdowns of greater than 6 percent.”

“The investor is looking for funds with a Sharpe ratio greater than 1, monthly or better liquidity and at least 15 percent annual returns.”

“Looking for managers with a Sharpe ratio of 1.5 with three-year net annualized returns of at least 10 percent.”

“The firm wants to hear from managers with annualized returns of at least 15 percent and a high pedigree.”

Hilarious, I know. There is so much good material in there I don’t even know where to begin. The hedge fund game is so simple. You just pick the funds with a “strong pedigree,” highest past returns, and lowest volatility/drawdowns. Do that and champagne riches and caviar dreams will be yours.

Now keep in mind, these are “institutional” allocators, supposedly the “best of the best” in terms of picking hedge fund investments. They all have impressive “pedigrees” from major investment banks and consulting firms to Ivy League schools. They are not used to being told they can’t do something and so if they want their “high pedigree” fund managers to return 15% with 7% volatility and no drawdowns, that’s what they’ll get.

Right? Wrong.

Since the start of 2005 (10+ years), the HFRX Global Hedge Fund Index and HFRX Equity Hedge Index (two investable indices widely used as benchmarks in the industry) have posted negative returns (-1% and -6.4% respectively). Over that same time period, the Barclays Aggregate Bond Index was up 62.1% and the S&P 500 up 97.6%.

Still dreaming about those 1.5 Sharpe Ratios? Well, how about a negative Sharpe Ratio which is what you get when the numerator of that equation is negative. Does that still work for you?

But it’s not just about return, the hedge fund fanboys will say. It’s about lower volatility, low correlation and absolute return when equities go down. Fair enough.

How have hedge funds done in those areas? They have delivered on lower volatility than equities (as they are not fully exposed to equities in aggregate) but with correlations above 0.7, “absolute return” has been another story.

Since 2005, the S&P 500 has had 48 negative months. While down less on average during these months (because they are not fully exposed to equities in aggregate), the HFRX Global and HFRX Equity Hedge indices have been down 88% and 94% of the time.

With those odds, the notion of “absolute” return for hedge funds in aggregate is beyond absurd. The true believers, though, might still argue that hedge fund exposure was worth it because they were less volatile and lost less in 2008. The only problem with this argument is that there is another asset class that has lower volatility than hedge funds, lower correlation to stocks and on average is up when stocks are down (since 2005, up in 60% of the months that the S&P 500 finished lower).

What is this magical asset class? Simple, boring bonds. The Barclays Aggregate Index was up 5.2% in 2008 and has a negative downside capture ratio (-14.7%) versus the S&P 500 which means on average they are up when stocks are down. They also have a correlation of .01 with stocks, making them much better diversifiers than hedge funds. Oh, and by the way, the two largest U.S. bond ETFs (AGG and BND) have expense ratios less than 0.1%. (For our research on Treasuries, click here).

All of this is not to say Bonds and Stocks are risk-free and don’t have issues of their own (they do: click here for my piece last March explaining why future returns are likely to be lower). It is also not to say there are aren’t unique hedge funds that actually do something different and add value to a diversified portfolio over time. There are.

But the hedge fund myth is that hedge funds as an asset class have been additive to portfolios over the last 10+ years. They clearly have not.

Why? Because at over 10,000 funds (and $2.9 trillion in assets, record highs), many of which pursue similar strategies, there is simply not enough “alpha” to go around. In fact, after fees and trading costs, the only “alpha” that is left is negative alpha. I don’t pretend to know what the right number of hedge funds is, but it’s not 10,000. There probably shouldn’t be more hedge funds than Dunkin Donuts and Burger Kings.

But the mandates, they keep on coming. Demand for hedge funds has never been higher as investors fear “rising rates” and another global financial collapse. Supposedly smart investors with “good pedigrees” remain confident in their ability to pick the next winner. How do they do it? By setting performance standards: choosing the “best” funds, the ones with “high pedigrees” that have the highest performance over the past few years with the lowest volatility, lowest drawdowns, and highest Sharpe Ratios.

Is that an effective investment strategy likely to generate 15% returns with little risk? Read the following paper and you tell me…

“The Harm in Selecting Funds that Have Recently Outperformed”

“In this paper, we empirically investigate the performance of commonly used fund manager selection strategies which involve hiring outperforming managers and firing underperforming managers using U.S. mutual fund data. Based on portfolios constructed using typical 3-year holding and evaluation periods, we find that the excess return to investors who chose funds with poor recent performance is higher than the excess return to investors who chose funds with great recent performance. Our results pose a challenge for asset owners. If the results are accepted at face value, then if past performance is used at all for hiring and firing managers it is the best performing managers that should be replaced with those who have performed more poorly. Despite our findings, a policy of firing successful managers and replacing them with poor performers is not likely to gain widespread acceptance. Instead, the practical implication of our paper is that asset owners should focus on factors other than past performance when selecting managers. We offer possible criteria that could be employed in this context.”