Hedge funds are often touted as absolute performance vehicles, which makes us wonder why they have been getting more and more of the relative performance treatment since their miss in 2008 when they were down alongside stocks. The latest comes from a Dow Jones Credit Suisse press release seen here on Yahoo news:

The Dow Jones Credit Suisse Hedge Fund Index Outperforms Global Equities by More Than Five Percentage Points in August

That’s a cute headline. How about this one? Their hedge fund index was down -2.30% in August.

Now, we’re all for applauding those who manage to lose less than the stock market – and we firmly believe that hedge funds can and will do that consistently. But the problem with saying, “Yes – we were down, but we weren’t down as much as the stock market!” is that you stop being an absolute performance vehicle, and take on a relative performance profile. Absolute performance is supposed to work regardless of the economic environment or whether the stock market is up or down. Relative performance is more a game of trying to beat (slightly) a benchmark.  Absolute performance should not be compared to a benchmark (they set the bar), while relative performance should be at least as good- and never as bad- as the benchmark.

It’s easy to see why hedge funds are trying to say that they’re marginally better than stocks when they’re supposed to be on a totally different level. They want to have their cake and eat it too. They want to market their absolute return profile when making money, yet fall back on their relative performance when losing. Not a bad tactic from a PR perspective, but it doesn’t help the average (sophisticated) investor understand whether the hedge fund he or she is considering will diversify his/her portfolio.  We have made no secret that we don’t believe they will diversify a portfolio. This idea was expanded upon in our newsletter this week. If anything, hedge funds should replace your stock exposure (in our opinion), not try and diversify it.

The astute reader may wonder, How can managed futures talk about “spinning” performance when they’re down for the year, too? AND they’re underperforming hedge funds year to date, as well?

Good question. Yes, managed futures are down for the year, but if you’re trying to determine the diversification value offered by an investment, the better question here is why are managed futures down? They are not down because stocks went down. They are down on their own accord, from doing their own thing. Hedge funds, conversely, are down because stocks are down – making them a beta play (relative performance) instead of and alpha play (absolute performance).

The takeaway here, in our opinion, is clear: hedge funds are not the alternative investments they pretend to be.

If you’re still drooling over the contrast between hedge funds and stocks performance last month, take a minute to think about how managed futures fared in comparison. Managed futures (which we contend is an asset class in its own right), as reported by the same index, generated returns of .25% last month (Disclaimer: Past performance is not necessarily indicative of future results). While the cited press release (which is not a news article, by the way- it’s functionally a piece of marketing designed to make you drool over hedge funds) is quick to point to portions of their industry that performed well last month, isolating Dedicated Short Bias strategy returns in particular, the same could be done for managed futures- with even more drool-worthy results. Barclay Hedge provides the most reflective strategy by strategy break down of any other index, in our opinion, and unlike the hedge fund strategy break down provided by Dow Jones Credit Suisse- where 12 of the 14 strategies, excluding managed futures, had negative returns during August’s roller coaster ride- 5 of the 6 managed futures strategies brought in positive, albeit small, returns for the month.

Before you start calling foul on the mismatch between Barclay Hedge’s numbers and those reported by Dow Jones Credit Suisse, let’s take a moment for a refresher on how these indices work. Each index you see in the financial world, regardless of what asset class it references, is constructed and maintained differently. They’re intended to provide a snapshot of performance- not a panorama- and much like photos taken from different angles with an actual camera, each angle taken by an index is going to provide a slightly different view. However, even with these slight variations, three of the biggest indices in the industry (Dow Jones Credit Suisse, Barclay Hedge, and Newedge- which we recommend) have consistently reported industry performance with a high level of correlation, giving, in our opinion, the average investor confidence in their credibility and utility.

Do they represent the entire world of possible performance within an asset class? Absolutely not- but compiling that information in a consistent and reliable manner would be next to impossible, and as past performance is not necessarily indicative of future results, AND, in our opinion, managed futures exposure is best captured via managed accounts with individual CTAs instead of managed futures index investing (more on that here), such efforts would be a frustrating waste. That being said, investors should always consider the inherent limitations of the specific index they’re looking at. You can learn more about the differences between the indices Attain references here.