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Treacherous Times for Hedge Funds

The stock rally, low fixed-income yields, plateauing commodities and legal pressures have mired hedge funds in uncertainty, raising questions about handling the ever-shifting market environment amid growing frustration by many investors.

Investor unrest stems from a slew of issues, ranging from high fees to a feeling that many professional investors are largely missing the historic equities rally that began in 2009. During the first two months of the year, the average hedge fund was up 2.67 percent, according to HFR, whereas the Standard & Poor's 500-stock index rose 6.2 percent. Returns for specialized hedge funds, such as commodities funds, have been relatively poor, with long-biased funds and some event-driven funds two of the bright spots.

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Unsurprisingly, hedge fund managers like Omega Advisors' Leon Cooperman, who has been bullish on the stock market for well over a year, and Appaloosa Management's David Tepper, whose championing of the so-called Bernanke put, which suggested that the Federal Reserve's program of quantitative easing would poise the stock market for huge returns, have performed exceedingly well.

Tepper remains bullish, according to someone familiar with his thinking, and predicts an upsurge of 20 percent or more this year if economic improvements continue. "We are still constructive the market," he told CNBC of his outlook.

Other hedge fund managers, though hoping to capitalize on the market's froth, are less secure about the S&P's trajectory, worrying that a hiccup in March or April could interrupt their gains or that an overbought market could lead to precipitous losses this summer.

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"I think there's a lot of trepidation of the market, even though we're making new highs," said one major New York hedge fund manager, noting that for the last three years, a market-rattling event—tsunami, Fed action or European tumult—had interrupted a stock runup during the second quarter, leaving buy-side traders some scar tissue. "There are a lot of hedge funds probably reducing their long exposure or adding hedges," the manager said.

Such questions have become more urgent as other asset classes, notably government and corporate bonds, deliver sagging yields. Some hedge fund managers believe that if other large money managers, such as pension funds, rotate investments out of fixed-income products and into equity, the stock rally could prove more sustainable. When that will happen remains unclear, however.

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In the meantime, investors are antsy. Redemption requests for February—during which fell the standard deadline for hedge funds with quarterly return policies—were slightly higher than a year earlier, following a December that marked a two-year redemption high. Some investors and brokers have said they were rebelling against what they considered overly restrictive redemption policies and relatively high fees.

Others cited more tailored concerns, such as the possibility of additional legal pain at the $15 billion hedge fund SAC Capital, whose founder was recently implicated in a federal lawsuit charging a former trader with insider trading. (The firm and its founder, Steve Cohen, have insisted they behaved properly.)

Instability in 2013 is an extension of what played out last year. The S&P was up more than 13 percent in 2012, but the average hedge fund less than half that, turning off investors. Redemptions in December hit a two-year high, according to figures from SS&C Technologies.

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