Were Hedge Funds Ever Hot? After correcting for hedge funds that die early or never reach the public eye, returns average 10.5 percent, close to the S&P 500 average.

Byline: Henry Blodget (Aaron Blodget, a former securities analyst, is president of Cherry Hill Research, an industry-research firm.)

Enthusiasm about the world's hottest investment vehicle--the hedge fund--has sagged of late, thanks to recent mediocre industry-wide performance and blow-ups at Amaranth Advisors and others. Recently the toast of Wall Street, hedge funds seemed like the answer to investors' prayers: a way to make big money in any market and diversify any portfolio. Alas, as with other investment tools, there's no free lunch.

Recent academic research, in fact, suggests that hedge funds are not only riskier than they are commonly thought to be, but provide lower returns and less diversification benefit. The advantages of funds of funds, meanwhile, a convenient (if mind-bogglingly expensive) way for institutions and wealthy individuals to own multiple hedge funds, appear to be similarly overstated.

The conventional story is that after five years of amazing growth, the hedge-fund industry is being slowed by its own growing weight. There is more than $1 trillion in hedge funds today, up from some $40 billion in 1990--and thus too much money chasing too few opportunities. Although this is true, greater scrutiny of past performance has also revealed that the average hedge fund's returns weren't all that spectacular to begin with. A handful of funds have posted extraordinary results, and awestruck coverage in the financial press has served as an advertisement for the industry as a whole. But the average fund's results have been distinctly ordinary.

The major databases of hedge-fund performance suffer from severe report-ing biases, which most researchers believe have significantly overstated the industry's results. According to a recent study by Profs. William Fung of London Business School and David A. Hsieh of Duke University, for example, the TASS database reports that from 1994 to 2004, the average annual hedge-fund return was an impressive 14.4 percent, after fees. However, after adjusting for "survival bias" (the tendency for underperforming funds to shut down and drop out of the database) and "incubation bias" (hedge-fund managers often launch several funds internally but only market the ones that do well), Fung and Hsieh concluded that the true average performance was only ...