Hedge funds lag the market, again by Stephen Gandel @FortuneMagazine April 10, 2012, 10:18 AM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons Hedgie Eddie Lampert rebounded in 2012 Hedge funds have rebounded in 2012, but the funds’ highly paid managers are still lagging the market. Fortune — The smart money got outwitted again. So far in 2012 investors would have done better putting their money in a low-cost stock index fund than the average hedge fund. In the first three months of year, the average hedge fund returned 4.6%, after fees, according to the Hennessee Hedge Fund Index. That was considerably better than last year, when the average hedge fund lost money, but it was still a lot lower than the Standard & Poor’s 500, which was up 12% in the same time. Charles Gradante, who follows hedge funds for advisory firm Hennessee Group, says most managers of the private funds were caught off guard by the recent spike in stock prices. Coming into the year, Gradante says, many managers were still expecting stocks to drop. “Many of the managers seemed to have the opinion that the market was overbought,” says Gradante. Instead, the market had one of the best first three months of the year in history. But it wasn’t only the funds that regularly bet against the market, or put their money in bonds, that underperformed. Even the funds that generally invested in stocks did worse than the market, gaining just 10.4%, according to fund tracker BarclayHedge. Part of the reason has to do with fees. Hedge funds have long been able to charge large fees – typically 1% of overall assets and 20% of fund gains – because of a perception that the funds often outperformed the market. But that hasn’t been the case in the past few years. The last time hedge funds outperformed the market was in 2008. Even then the average fund fell just over 20%. That beat out the S&P 500, which dropped 37%. Hedge funds, though, have lagged the market for the past three years. Last year nearly 60% of all hedge funds lost money, even as the market overall was flat. Despite the lackluster average performance, a number of funds appear to be having a good year. Eddie Lampert‘s hedge fund ESL Investments rebounded in 2012, after losing money in 2011. The stock of Sears Holdings SHLD , one of Lampert’s biggest positions, has been one of the market’s best performers this year. According to Insider Monkey , the eight largest holdings of Lampert’s largest fund are up a combined 40% in the first quarter. Another top performer in the quarter was value investor Whitney Tilson, whose T2 fund was reportedly up 23% in the first three months of the year. Daniel Loeb, who has recently been pushing for changes at Yahoo!, also appears to have had a better than average quarter, though still not enough to beat the market. His main fund at Third Point Partners was up a reported 10%. Still, the recent poor performance in general of hedge funds has caused some people to rethink whether the private investment vehicles are worth what the managers charge. A recent study by former hedge fund investor Simon Lack found that in the 12 years ending in 2010, the average investor got only 3% of the average gain of hedge funds. The rest of the gains paid for the management fees. The conclusion is that something will have to change in the hedge fund business. Disappointing results and sky-high fees can only go on for so long, even on Wall Street.