Hedge funds are frequently promoted as offering positive returns regardless of conditions in the markets. But the recent performance of funds of hedge funds, which offer the additional security of investing across a range of underlying funds, has cast doubt on these claims.

Dollar-denominated funds of hedge funds lost 1.4 per cent in value during the second quarter following the stock market reversal of May while euro, sterling and Swiss franc funds were also hit, according to a review by the fund analysis arm of Standard & Poor’s.

“We suspected that funds of hedge funds might be vulnerable to a correction in equities after portfolios took on a more directional appearance in the previous quarter,” says Randal Goldsmith, author of the review. “We did not expect that they might fare worse than equities but many actually fell more than related equity indices.”

The Cedar Fund, which uses a high degree of borrowing, experienced the most severe decline, of 6.4 per cent, while the GAM Emerging Markets Multi Fund, previously a strong performer, lost 4.2 per cent. Among euro-denominated funds of hedge funds, HDF Global Long-Short Fund fell 3.2 per cent while in sterling the Collins Stewart International Growth Fund fell 5 per cent.

“Funds have not done what it says on the tin,” says Justin Modray at Bestinvest, a retail broker. “Most funds have been launched in the last three years and up to the last quarter they have generally risen. But this has shown that they don’t always produce absolute returns.”

But Modray points out that quoted funds, which are structured like investment trusts, can suffer from the same price volatility. Share price moves can be more extreme than changes in underlying net asset values and funds can swing between trading at a premium and a discount to NAV, exacerbating volatility.

The reason why the funds performed badly was their high exposure to small and mid-cap stocks and their exposure to commodities and emerging market equities which also suffered setbacks, says Goldsmith.

The sell-off in equity markets was prompted by moves by central banks to raise interest rates. Hedge funds of funds have greater difficulty adjusting to this sort of liquidity squeeze – which also hit them in 1994 and 1998 – than they did when markets corrected the extreme over-valuation of technology and media stocks in 2000-03, Goldsmith says.

“Given this, investors may need to think carefully about market conditions despite hedge funds’ general aim for absolute returns at all times,” he adds.

Fund managers may have also been caught out by the long-term strong performance of the underlying markets before the May correction. “As markets have done well, hedge funds have focused on beta [market-related] returns,” says Odi Lahav, director of investment consulting at Allenbridge Investment Consultants. “They suffer when there is a correction.”

“The fact that some equity funds may have lost a few per cent is not relevant to their long-term aim of providing a superior risk-adjusted return,” says Tim Bell, managing director for hedge funds at UBS Wealth Management in the UK.

“Some have produced annual compound returns of 15-20 per cent while equity markets have been flat relative to March 2000.”

Funds of hedge funds are unable to react as quickly to changes in market sentiment as mainstream long-only funds because they often have to give notice of planned redemptions – 90 days is a common period – or are restricted by lock-up agreements, the S&P review notes.

“You want the manager to be able to shift their allocation and move with the market,” says Lahav.

“Managers of growing funds who are taking in new money can reallocate their funds more quickly than those who are fully invested.”

Many funds have performed poorly in recent months but some have lived up to their claims. The funds that did best were those with a bias towards arbitrage, trading and fixed-income related strategies, says S&P. Those that bet on stock market volatility also did well.

Investing in the hedge fund sector has traditionally been the preserve of the very wealthy and many funds set high minimum entry levels.

“We see them very much as a niche,” says Modray. “We tend to use them in the larger discretionary portfolios. They should never dominate a portfolio.”

At Allenbridge, only the largest portfolios are invested in single managed hedge funds. Funds of hedge funds are seen as being more appropriate for the smaller accounts and may account for between 5 and 40 per cent of a portfolio, depending on the risk profile of the investor.

“We view funds of hedge funds as a capital preservation vehicle rather than as an investment for growth,” says Lahav.