Hedge fund returns rose in September, but a muted performance this year after the triumphs of 2000-2003 has raised doubts about the durability of future earnings.
In September returns were just over 1 percent, the best monthly performance since February, according to the Credit Suisse First Boston Tremont Index. But in the nine months to end-September returns were only 3.0-3.5 percent compared with 5.6 percent for the UK FTSE all-share index and 13.3 percent for British commercial property.
This year could be the worst since 1994, when the Federal Reserve rapidly and unexpectedly hiked interest rates in the United States, sending stocks, bonds and the dollar crashing.
In 2000-2002 hedge fund returns averaged more than 10 percent a year, while traditional investment funds saw the value of their portfolios deteriorate sharply as stocks collapsed.
Hedge funds did better because they can use derivatives to limit downside risks or gear up investments, they can borrow to take bigger stakes and they can short sell - gamble on a lower price for a security in the future.
Last year too, as equity markets recovered, hedge funds returned more than 10 percent on average.
But this year's lacklustre performance has prompted some to ask if heavy flows of money into hedge funds over the past four years have created a bubble.
"Typically a bubble is asset price inflation, when prices overshoot fair value," Alex Ineichen, head of alternative investment strategies at UBS Investment Research said.
"Hedge funds are simply a way of managing money. The bubble characteristics are that return expectations may be too high ... It's not a disaster scenario, but reality is kicking in."
Assets managed by hedge funds have doubled to around $1 trillion from 4 years ago, with much of that new money invested by institutions looking for ways to diversify away from traditional markets after the equity bear market.
Stock and bond markets were range-bound between April and August with a downward bias and very little volatility. Hedge funds are supposed to be able make money even when markets are trending down, but without volatility that was difficult.
"Post-summer, there has been a little more volatility," Graham Martin, business development director at fund manager Gartmore said. "Markets are being driven more by fundamentals now, something hedge funds can make money from."
But the Chicago Board Options Exchange's Market Volatility Index - a benchmark measure of stock market volatility - has held below the key 20 level for most of this year.
Hedge fund returns picked up in September as volatility and stock markets picked up. But on October 1 the Market Volatility Index fell to 12.75, its lowest level since January 1996, and anxiety about hedge fund investments has flooded back.
"Hedge funds need volatility to make money. There hasn't been very much of that recently," Gavin Rankin, Europe Product Manager at Citigroup Private Bank said.
"It's not a bubble, it's a reflection of where markets have been over the past few months ... Even in convertibles it's difficult to isolate the impact of higher money flows because the strategy is extremely dependent on volatility."
Hedge funds that trade the equity, bond and derivatives components of convertible bonds have seen their returns slip because the volatility that spawns mispricing opportunities has been lacking and a dearth of new issues has piled on the pain.
Relative value strategies - where traders look for cheap assets to buy and expensive assets to sell and which account for half the $1 trillion of assets under management - have also dampened industry returns.
"Pricing imperfections in these areas have disappeared. We're starting to see some redemptions," said Arie Assayag, global head of hedge funds at Societe Generale Asset Management said.
"But there are innovations, I don't think we are in a bubble ... If money leaves the industry some of these opportunities may return.
The question is, is this a cycle like the one we see in traditional assets or are some of these strategies finished?"
Many hedge fund managers in the relative value area have redeployed their skills and are looking for profit possibilities in corporate bonds and company capital structures - playing off stocks and bonds a firm has issued against each other.
"Hedge funds are very dynamic. It's an area where investor and manager interests are aligned, where the innovations are," Citigroup's Rankin said.
"We're seeing managers turn to different strategies to produce higher returns."
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