In the past year, exchange-traded funds that aim to replicate hedge funds delivered modest results. IQ Hedge Multi-Strategy Tracker returned 1.2%, compared to 13.9% for the S&P 500, according to Morningstar.
But the weak performance has not discouraged some investors. The IQ ETF recorded $132 million inflows in the past year, according to IndexUniverse.com. That is a sizable inflow for a fund with $343 million in assets. Other ETFs that have reported inflows include IQ Hedge Macro Tracker and ProShares Hedge Replication .
Like the ETFs, the hedge funds themselves have been reporting inflows. In 2012, hedge funds attracted $34 billion in assets, raising the industry's total capital to a record $2.3 trillion, according Hedge Fund Research.
What keeps attracting investors? Proponents say that hedge funds provide diversification. The funds can sell short and use other techniques that can limit losses in downturns. Because short selling can hurt results in bull markets, it is not surprising that the funds would trail lately. But critics argue that the spell of uninspiring results could indicate that the hedge fund industry has become bloated.
The stretch of poor performance is a recent development. During the 10 years that began in 2000, many hedge funds excelled. By limiting losses during the big downturns of the decade, hedge funds returned 6.4% annually, compared to a loss of 0.9% for the S&P 500, according to a study by Ineichen Research and Management. But since 2010, the picture has changed. While the S&P has returned 12.4% annually, hedge funds only delivered 4.3%.
The falloff of results has occurred at a time when the hedge fund industry has made dramatic changes. A decade ago, hedge funds catered primarily to wealthy individuals. Many investors came in search of the outsized returns that had been achieved by bold managers such as George Soros.
After suffering big losses in the turmoil of 2008, individuals began fleeing hedge funds and seeking safety in bonds. But institutions moved in the opposite direction, increasing their allocations to hedge funds. Pensions and endowments turned to hedge funds as a way to limit losses in downturns. According to a study by Preqin, institutions now account for 61% of assets in hedge funds, up from 45% in 2008.
The arrival of institutions has forced hedge funds to change their strategies. Instead of seeking buccaneers that can deliver big returns, cautious pension funds prefer steady managers who can produce small, consistent gains.
"The institutional hedge funds have taken risk way down because that's what the clients want," says James Dilworth, CEO of Simple Alternatives, which operates S1 Fund , a mutual fund that invests with hedge fund managers.
The institutions have been flocking to a limited number of large hedge funds. Such giants can perform well in downturns, but they cannot trade as nimbly as smaller operators. The sheer size of the funds could be hurting results. Studying returns from 1996 through 2011, consultant PerTrac found that small funds with less than $100 million in assets returned 12.5% annually, while big funds with more than $500 million returned 9.2%.
James Dilworth's S1 Fund aims to overcome the problems of the institutional hedge funds. The mutual fund invests in portfolios managed by five boutique hedge fund managers. The portfolios are small enough to trade nimbly. Each manager owns promising stocks and sells short shares that seem overvalued.
The aim is to outdo typical hedge funds by limiting losses in downturns and delivering decent results in up markets. Lately the fund has been succeeding. In the past year, S1 Fund returned 4.9%, outdoing competing ETFs by a comfortable margin.
It is too soon to know whether the two-year-old mutual fund can succeed over the long term. But by focusing on entrepreneurial managers, the fund could be able to deliver the kind of returns that hedge funds generated in the past.
This article was written by an independent contributor, separate from TheStreet's regular news coverage.