HEDGE-fund managers are the smartest investors around. With keen eyes and sharp brains, they spot and exploit inefficiencies in the markets. Or at least that is what the industry tells its clients.

There is no doubt that hedge-fund managers have been good at making money for themselves. Many of America's recently minted billionaires grew rich from hedge clippings. But as a new book* by Simon Lack, who spent many years studying hedge funds at JPMorgan, points out, it is hard to think of any clients that have become rich by investing in hedge funds (whereas Warren Buffett has made millionaires of many of his original investors). Indeed, since 1998, the effective return to hedge-fund clients has only been 2.1% a year, half the return they could have achieved by investing in boring old Treasury bills.

How can that be, when traditional performance measures for the industry show average returns of 7% or so? The problem is a familiar one in fund management and is the equivalent of the “winner's curse” that occurs with auctions (the successful bidder is doomed to overpay). Take a whole bunch of fund managers and give them an equal amount of money to invest. The managers that perform best initially will tend to attract more investors, and so will gradually become bigger than the moderate or poor performers (who will eventually go out of business).

But the manager will not perform well indefinitely. By the time a bad year occurs, the manager will be running a much larger fund. In cash terms, the loss on the expanded fund may easily outweigh the gains made when the fund was smaller. The return of the average investor will be lower than the average return of the fund.

What is true for individual funds also turns out to be true for the industry as a whole. Between 1998 and 2003 the average hedge fund earned positive returns every year, ranging from 5% in 2002 to 27% in 1999. Back then, however, the industry was quite small: overall assets only passed $200 billion in 2000.

That strong performance attracted the attention of pension funds, charities and university endowments at a time when their portfolios had been clobbered by the bursting of the dotcom bubble. They duly piled into “alternative assets” like hedge funds and private equity. By early 2008 the hedge-fund industry had around $2 trillion under management.

But that year turned out to be the annus horribilis for the hedge-fund sector. The average performance was a loss of 23%. In cash terms the loss for that single year was more than double the industry's total assets under management in 2000, when it was still doing well. Mr Lack reckons that the industry may have lost enough money in 2008 to cancel out all the profits it made in the previous ten years.

At this point, hedge-fund managers might cry foul. The losses suffered in 2008 make a huge impact on the way Mr Lack calculates his figures. If you use the same methodology on stockmarkets, hedge funds outperformed the S&P 500 between 2001 and the end of 2010.

But private-equity managers are judged on a similar basis (the internal rate of return) to Mr Lack's calculations. And his numbers probably flatter the hedge-fund industry. Indices of hedge-fund returns overstate the numbers because of factors such as “survivor bias” (poor performers stop reporting their numbers) and “backfill bias” (only successful newcomers start to report). These effects could add 3-5 percentage points a year to average returns. Many investors invest in the sector through funds of funds, which charge an additional layer of fees.

Even if you allow for the rebound in markets (and hedge-fund returns) in 2009 and 2010, investors have still got the short end of the stick. They have yet to recover the losses suffered in 2008. But hedge-fund managers took home almost $100 billion in fees between 2008 and 2010 (and an aggregate haul of $379 billion between 1998 and 2010).

Mr Lack's book suggests the blind faith displayed by many institutional investors in hedge funds needs to be reconsidered. Individual managers may be brilliant but it is hard to spot them in advance. John Paulson was not particularly well-regarded before he made a fortune betting against subprime bonds—and his performance has slumped since. Investing in hedge funds will enable some lucky managers to enjoy an early retirement on their yachts. It will not enable pension funds to eliminate their deficits.

* “The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True”, published by John Wiley & Sons, January 2012

Economist.com/blogs/buttonwood