“Ask no questions, and you’ll be told no lies.” – Charles Dickens, Great Expectations

A typical conversation between a hedge fund allocator and a hedge fund manager…

Hedge fund allocator: “What are your expected returns and volatility over the next few years?”

Hedge fund manager: “15-20% annualized with very low volatility.”

Hedge fund allocator: “Great. That’s exactly what we’re looking for.”

I’m using some hyperbole here, but not as much as you might think. As I outlined in “The Hedge Fund Myth” earlier this year, the lofty expectations among hedge fund allocators borders on absurd. That hedge fund managers promise the world is understandable (they are selling a luxury item in decline); that investors put any weight on said promises boggles the mind.

The $178 billion New York State Pension fund (3rd largest in the U.S.) is a recent example. After undoubtedly having the above conversation years ago, they are not happy with the results (negative returns in their most recent fiscal year).

Their solution: demand a minimum return of 10% per year.

Will that work?

No. Not unless we are to believe that simply demanding a higher return from an investment manager can effectuate that outcome. Does saying “I want a return of x%” get you that return? No. When it comes to investing, where there’s a will, there isn’t necessarily a way.

Besides, almost all allocators already demand high performance from their hedge funds, selling the poor performers and buying the best performers, over and over again. Hedge fund performance should be exceptional based on this survival of the fittest model, but as we know it has been anything but.

Since 2005, the S&P 500 is up 129% versus a gain of 4.7% for the HFRX Global Hedge Fund Index and a gain of 0.1% for the HFRX Equity Hedge Index. Keep in mind – these are cumulative returns.