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Here Come the Chasing Hedge Funds

According to the folks at Hennessee, the average U.S. hedge fund was up 3.8% through August, compared to 11.9% for the S&P500. Barring a sizable comeback, 2012 will go down as the third consecutive year of under-performance for the nearly $2 trillion hedge fund industry.

With fee structures traditionally consisting of 2% of funds under management and 20% of any gains, fund investors are starting to look for greener pastures. Fund tracking site Hedgeweek.com reports the industry saw $7.4 billion in withdrawals last July. According to the same source, hedge funds as a whole have seen a greater than 23% drop in assets since peaking at $2.4b, just before the housing crash of 2008.

Put yourself in the position of a fund manager. You're competitive, smart and have the quintessentially glitzy, high-flying finance trophy job. There's also a pretty good chance you're getting absolutely crushed by the S&P 500. On weeks such as these, you have investors calling you asking infuriating questions about how much Apple (AAPL) you have and whether or not you were smart enough to buy the dip in Facebook (FB).

Bad and Getting Worse

Even though you take in 2% fees, the way you really make money is by grabbing 20% of the upside. That's a great deal for everyone involved, provided you boot-stomp the S&P500 year after year. As it is, your 3.8% gains work out to 1.7% net of management fees and 1.4% after you take your 20%. The market was beating you by 8:1 at the start of September and it's gotten worse since.

You are the grumpiest Master of the Universe on earth.

As a fund manager, you've got two choices. Choice No. 1 is coming clean with your partners and admitting defeat by writing a letter along the lines of the following:

"Dear Partners,

The Fundamental Return Analytic Unlevered Delta (FRAUD) partnership is up 4% through the first three quarters of the year. Our returns would be better but I refused to take part in this bogus rally based on little more than a possibly corrupt Fed chair dumping money into the system..."

Or you can try to save your business and reputation by catching up to the broader market in the last few months of the year. Doing the latter is impossible unless you chase. You need to buy Amazon (AMZN), Apple and Google (GOOG). You have to take fliers on left-for-dead names like JC Penney (JCP) and, yes, even Facebook.

You don't believe in any of these companies and you hate them at the current prices, but the humiliation of facing massive redemptions and a trashed reputation ("Getting John Paulson-ed") is unspeakably horrible.

There isn't a real choice there. Self-styled Masters of the Universe don't quit just because they're losing going into the fourth quarter. No one starts a year expecting to be reduced to making desperate shots come October, but no football team starts a game with the intent of throwing Hail Marys. When things go pear-shaped, hard decisions must be made.

The most bullish thing about the market is the amount of money bet against it. There are bidders for stocks on every dip. There's big money behind your buys. It's not enough to guarantee a continuation of all the ingredients of a short-squeeze in place.