By Laurence Fletcher
LONDON (Reuters) - A stock market rally has helped hedge funds avoid a nightmare prospect of another year of losses, but their performance raises questions about just how much value managers add through their own skills.
Fund performance over the past year has been closely correlated with equity market gains, suggesting investors may not have got the value-added they pay for in fees.
Hedge funds gained a massive 3.61 percent on average in September, according to Hedge Fund Research, their best monthly performance since May last year, taking year-to-date gains to 4.8 percent.
October has also proved upbeat, with HFR's HFRX index, which tracks daily performance of some hedge funds, showing a gain of 1.12 percent in October.
Funds now look set to shrug off indifferent performance earlier in 2010 and avoid another down year. After 2008's losses of around 20 percent, this would have damaged investor perceptions that these funds can make money in all markets.
"A down year wouldn't be good, it's clearly not the mandate of hedge funds, which is to generate absolute returns whatever the market conditions," said Fabrice Seiman, co-founder of Paris-based hedge fund firm Lutetia Capital.
"Everyone had problems in 2008, but investors would have looked at the asset class in a different way if the industry hadn't made money in '09 and '10," he said.
But the recent gains have come on the back of a stock market rebound that nearly all investors will have enjoyed.
The FTSE 100 <.FTSE> has put on 15 percent since July, amidst growing confidence a 'double dip' recession can be averted, with gains of more than 6 percent in September alone.
Equity hedge funds, one of the biggest categories in the sector, delivered one of the best returns, with gains of 4.83 percent. These funds bet on rising and falling stocks but tend to be oriented to rising markets.
The returns raise the perennial charge that hedge funds are pocketing 2 percent annual fees and 20 percent performance fees for beta -- "low quality" returns produced by market moves -- rather than alpha -- performance due to a manager's skill. This is most prized by clients looking for all-weather returns.
"Most strategies are still correlated with market trends," said Aureliano Gentilini, global head of hedge fund research at Lipper, a Thomson Reuters company.
"Certain strategies have failed to deliver on their promises of uncorrelated returns."
Correlations have in fact increased over the past year, perhaps as managers avoid big bets against the index for fear of missing further stock market gains after last year's rally.
According to HFR president Ken Heinz, the correlation between hedge fund returns and the S&P 500 <.SPX> index over the past 12 months is close to historical highs at 0.94, where 1 indicates perfect correlation, while the correlation of equity hedge funds is 0.96.
In contrast, over the past three years the average hedge fund's correlation is 0.84, while over five years it is 0.81.
Some still argue that hedge funds are doing their job.
"They've benefited from the current rally, but it's unfair to criticize hedge funds for benefiting from the rally when they've also lost a lot less (than the market in the down times)," said Lutetia's Seiman.
"(Whether you should be) paying 2 and 20 is not really the right question -- what counts is what the investor has in their pocket at the end of the day."
(Editing by Sinead Cruise and Jane Merriman)