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NEW YORK (CNN/Money) -
Hedge funds, which have had a tough year so far and a particularly nasty October, could be headed for a spectacular fall.
People in the business say traditional stock hedge funds are looking more and more like plain old stock funds these days, since they're buying more stocks outright rather than hedging their positions.
If hedge funds keep dialing up their exposure to stocks and don't make adjustments, some fund managers and investors say, the funds could be in for a very unpleasant surprise the next time the market produces a year like 2002, when the S&P 500 tumbled 23.4 percent.
That year, hedge funds were far less correlated to the stock market, and ended up rising 3.04 percent, according to the CSFB/Tremont hedge fund index, which tracks the performance of 400 funds.
In October, the average equity hedge fund lost 1.55 percent, according to Chicago-based hedge fund tracker Hedge Fund Research, while the S&P 500 declined 1.78 percent.
Investors and fund managers note, of course, that it's impossible to say when stocks will have a big down year.
But growing signs that managers are just aping the performance of the broader market are disturbing to some in the business, who note that investors are paying eye-popping fees for the expertise of hedge fund managers.
"Investors will recognize that when a manager isn't adding value and doing their job it's not worth the fees that they are paying them and they will move on," said Russell Lundeberg, the chief investment officer of Barrett Capital Management, a fund that invests in hedge funds.
Hedge funds were originally designed to produce positive results in up or down markets -- in large part by using investments to offset risk, or hedge, against market declines.
The theory was that when stocks rose, so-called absolute return funds would rise, but not as much as the broader market. And when stocks sank, the funds would fall less.
Analysts noted several factors that have pushed hedge funds away from their original direction.
Investors are demanding bigger returns, a "gold rush" mentality has led less experienced managers into the business, and more managers have come from mutual funds where a classic hedging technique, short-selling, or betting against certain stocks, is less widely used.
"It's a result of investor demand and the type of managers coming into long/short and where they cut their teeth," said Justin Dew, senior hedge fund analyst at Standard & Poor's, referring to the traditional stock hedge funds that both buy (go long) and bet against (go short) certain stocks or sectors.
What it means to you
Why would a rough year for hedge funds matter to the average investor?
The hedge fund industry has doubled in size since 2001, according to Tremont Capital Management, and these funds now manage an estimated $1.3 trillion worldwide and can have a big effect on some markets.
Perhaps more important is that more average Americans are exposed to hedge funds than ever before through their pension plans. After years such as 2002, when hedge funds dramatically outperformed the broader stock market, pensions began investing in hedge funds to boost their performance.
Shortly after the Sept. 11 attacks, many long/short equity hedge funds stepped up their hedging to reduce their exposure to the stock market.
But in the intervening years, from 2003 to 2005, these funds appear to have drifted away from more aggressively hedging their portfolios. From 2003 to today, hedge funds have doubled their net long exposure, according to research prepared for CNN/Money by Markov Processes, a New York-based financial services consulting firm.
Markov CEO and founder Michael Markov analyzed the returns for long/short hedge funds using both the CSFB/Tremont index and Hedge Fund Research's index and compared them to returns from the S&P 500. The research found that the levels of net long exposure in the funds studied are now back to pre-Sept. 11 levels.
"One may conclude that it took about two years of solid market gains for hedge fund managers to become more optimistic and increase their net exposure in 2004-2005," Markov wrote.
Why are managers dialing up their exposure to the market?
Barrett Capital's Lundeberg believes that the explosion in the number of hedge funds worldwide in recent years has created a surfeit of new managers who aren't experienced and don't know how to hedge effectively.
"With all the new entrants into the hedge fund world, there are a lot of people that are coming ... that unfortunately are no more than mutual funds with hedge fund fees," he said.
Do your homework
And one investor noted that long/short managers are not as contrarian as they used to be and often just follow the herd, and end up owning many of the same stocks.
This investor noted that it's getting harder and more expensive to short stocks, and that many long/short equity managers are gaining short exposure not through stocks but through derivatives. A typical example is a hedge fund that takes long positions in stocks but shorts ETFs, this person said.
Dew said he believes that rising net exposures in long/short equity funds are not necessarily a bad thing -- as long as these managers apprise their investors of the types of risks their investment style carries.
"As long as managers do what they say and say what they do, I don't think it's an issue. If the manager deviates from that, that's when you get into style drift, and that's a big problem," he said, referring to managers who deviate from their stated strategy.
"If I were invested with a manager and all of a sudden the market was down 20 percent and my manager was only down 2 percent, I'd question that," Dew said.
"No matter what the direction of the inconsistency, it should be questioned," he added, because it could indicate that the manager took on bigger risks than advertised.
(Correction: An earlier version of a chart inadvertently switched the names of two hedge fund indexes. CNN/Money regrets the error).
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The world of hedge funds is still a boy's club: Click here.
October one of the industry's toughest months in memory: More here.
How the growing market for complex investments called derivatives could affect you.
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