A typical hedge fund invests or goes long in stocks and other securities, and simultaneously bets against or shorts those overvalued securities. In theory, this means hedge funds are supposed to deliver an absolute return in all markets while protecting your capital. They’re also supposed to reduce your risk and hopefully, outpace stock benchmarks.

This strategy doesn’t come cheap. If you’re a hedge fund investor, you’re expected to fork over big bucks in management fees. And that’s not all. You could be subjected to 12-month lock-in periods (or more) and then hand over a 1% annual management fee and a slick 15% performance or incentive fee on new net profits. What a deal!

This pales in comparison to plain indexing or investing in active mutual funds, that don’t lock-in your capital and or charge obscene annual fees. Also, mutual funds rarely blow-up like some hedge funds…but hey, that’s not even worth mentioning right?

What Happened to Hedging?

Seriously, to be fair, hedge funds did protect investor capital in the last bear market from 2000 to 2002. So for two years, investors were satisfied with their hedge funds.

But, if you take a closer look, you’ll notice most so-called “hedge” funds simply failed to do that during the severe market dislocations in history. For example, most hedge funds lost a pile of dough during the fall of Long-Term Capital Management in August 1998, the aggressive rate hikes of 1994 and during the October crash of ‘87.

This is how hedge funds work. Hedge funds function properly and make money as long as there are a series of established trends in their respective sphere of trading. But once markets dive sharply, most hedge funds fall just as hard as everything else.

The Markets Have NOT Been Kind to Hedge Funds This Year

So far, 2008 has been one of the toughest years for global investors since 2002. As you might guess, the average hedge fund is losing money. In fact, some hedge fund categories are faring worse than the S&P 500 Index.

Go back a little farther and the hedge fund story just gets worse. Since 2007, a record number of hedge funds have either closed or collapsed. This market volatility has drawn the final curtain on some of the more inexperienced and highly leveraged operators.

According to the Credit Suisse Tremont Hedge Fund Index, those amazing Wall Street and London trading wizards are down an average 2.1% this year through March 31. Even worse, out of the 12 sub-indices that make up this database, only three are profitable.

The best-performing hedge fund sector this year is the short-selling category. That’s an obvious place to make money for any short-only focused hedge fund. But others, including distressed debt, event-driven, convertible arbitrage, and long/short equity are all suffering losses through March (latest data available).

So far in 2008, most hedge funds have failed to make the grade. Investor cash flows have tumbled more than 50% compared to 12 months ago as redemptions surge. Many investors have also grown concerned about prime-broker counterparty risk whereby investment banks like Bear Stearns conducted trading on behalf of large hedge funds.

Too Popular?

Back in the ‘80s and ‘90s, hedge fund managers only marketed these products to the super wealthy. But now, hedge funds are marketed to mainstream investors through publicly listed companies and retail hedge funds offshore. Pension funds, endowments and even sovereign wealth funds (SWFs) are climbing aboard hedge funds this decade for higher inflation-adjusted returns in this sluggish stock market environment.

Hedge funds grew so popular heading into the mid-2000s that several high-profile managers went public. Fortress Investment Group (FIG-NYSE) is no doubt one of the better hedge funds in the world. But even being one of the “better ones,” this hedge fund has still gotten slammed since going public in 2007 following a dismal first quarter as leveraged loans soured.

“Fortress” Doesn’t Live Up to its Name

Unfortunately, too many hedge funds fail to earn their stripes. They simply don’t deserve their fat 15% incentive fees. Many managers disguise themselves as long/short products. But in reality, they’re just glorified mutual funds that fail to properly hedge while levying huge fees.

Despite their ongoing issues, a small handful of hedge funds do belong in a large globally diversified portfolio. From a universe of more than 6,000 products, some are still worth your dollars. These managers have earned top performance accolades over the years, successfully protected investor capital and have a large portion of their net wealth invested in their funds.

But now, more than ever, you must conduct careful due diligence on any hedge fund product. Make sure you understand any potential hedge fund’s liquidity provisions, underlying leverage, lock-ups (if any) and the fund’s prime brokerage relationship.

Also, a true-blue hedge fund should be able to make money in most markets, including bear markets and crashes. Investors beware.

ERIC ROSEMAN, Investment Director