Hedge Funds Beating The Market From The Sidelines

Hedge fund managers have figured out a foolproof way to beat the market: Do nothing. Or more accurately, do very little.

The latest monthly data on the performance of hedge funds again shows relatively flat returns, with losses of 0.8% in February, and a year-to-date gain of 0.12%, according to Hennessee Group LLC, a consultant and adviser to direct investors in hedge funds.

For some observers, such numbers suggest hedge funds deserve a pat on the back. After all, they are beating the pants off of U.S. stock markets, whose indexes were down close to 20% through last month.

"Hedge funds are off to a good start in 2009," commented Charles Gradante, co-founder of Hennessee Group.

But lest we forget, flat returns shouldn't be a signal for celebration. Anyone with a minimum of $5,000 can open a savings account at Bank of America and pull in a 1.5% annual percentage rate on their money. A typical hedge fund may have a billion or more dollars under management.

A savings account, in fact, is probably what many hedge funds increasingly look like. In this always-going-down market, managers say making big bets and parting with cash on hand is the last thing they're willing to do.

As such, they've pulled many of their bets on equities, commodities and other at-risk assets, and have moved into safe havens like cash and U.S. Treasury bonds.

In fact, the average hedge fund has 45% of its assets in cash, according to a Sandler O'Neill & Partners survey conducted in February.

During the boom of 2005 through 2007, most hedge funds had less than 10% of their assets in cash, and were using more borrowed money.

Having that ability to go into cash and Treasurys is a major advantage of hedge funds over mutual funds, which are sometimes required to hold on to certain equity positions even if they know it's a losing proposition. Of course, hedge funds could also short most stocks, but with the Dow now down to its lowest level since 1997, there's fear about a fast-and-furious rebound.

In some cases, it's not that hedge funds are moving all their money to the sidelines, but rather making smaller bets.

Take last Friday, for instance: When positive news caused the stocks of buyout targets Genentech Inc. (DNA) and Rohm & Haas Co. (ROH) to skyrocket, filings show that many of the hedge funds that owned those shares missed out on some of the upside. That's because several firms, like Halcyon Asset Management LLC and Diamondback Capital Management LLC, lowered their exposure to one or both of those stocks, even though they still had shares. Those two firms didn't return messages seeking comment.

Most hedge funds learned their lesson about preserving wealth the hard way. The industry lost an average of 20% in 2008, which led many of its investors - high net worth individuals as well as institutional investors such as pension funds and university endowments - to dump their bets. Hedge funds are hoping to regain their trust.

-By Dan Molinski and Joseph Checkler, Dow Jones Newswires; 201-938-2245; [e-mail]