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Smart Money? Hedge Funds Now Worse Than Mutual Funds

Hedge fund managers don't have much to be thankful for these holidays, as failure to beat low-fee index funds will likely infuriate investors shelling out hefty fees for their services.

John Lund | Blend Images | Getty Images

Just 13 percent of the so-called smartest money on the Street are outperforming the S&P 500, and a fifth of all hedge funds are actually in the red during 2012, according to Goldman Sachs data.

To make matters worse, hedge fund managers have crowded into the same trades, with turnover at a record low, according to Goldman.

Translation: Hedge fund investors are paying 2 percent fees up front and 20 percent of profits thereafter to managers delivering poor performance and apparently doing little about it.

"Many hedge funds turned into mutual funds — but with higher fees and worse performance — this year," said Mike Murphy, who runs hedge fund Rosecliff Capital. "Hedge funds have underperformed because they have been hedging against a massive market correction as the memory of 2008 is still fresh in every one's mind."

"It's been a tough year, but better times are ahead," added Murphy.

The S&P 500 was up 14 percent through November, while the average hedge fund posted just a 6 percent return over the same time period, according to Goldman. Meanwhile, the average large-cap mutual fund has returned 13 percent.

"Hedge fund returns are highly dependent on the performance of just a few key stocks," wrote Amanda Sneider, author of the report for Goldman. Examples given include Apple, Google, AIG, Microsoft and Priceline.com .

"Turnover of all hedge fund positions averaged a record low of 29 percent during 3Q 2012, well below the 10-year average of 35 percent," wrote Sneider and the rest of the strategy team at Goldman.

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It's not just closet indexing leading to this underperformance. Record low interest rates globally have led to high correlations between stocks, bonds, gold and currencies, making it difficult for hedge fund managers to separate themselves from the rest of the pack.

"Correlation between assets is so high, it is just a difficult environment to create alpha and still provide low-volatility returns," said Brad Lamensdorf, co-manager of the Active Bear ETF .

Goldman's analysis is based on a rather large sample size, using the latest available public filings from nearly 700 hedge funds with $1.3 trillion under management.

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