The Tragedy of the "Smart" Money

Imagine a PGA Tour where the average player is no better at golf than the viewers at home. Or an NBA where most players never make a basket throughout their careers. Or a NASCAR where most drivers can't top the 65 mph speed limit of public freeways.

You'd be insulted and would never pay attention to these "pros." But this is essentially what the universe of professional hedge fund managers looks like.

The average hedge fund is up 2.15% year to date, according to Hedge Fund Research. A basic S&P 500 (INDEX: ^GSPC  ) index fund gained 12.5% during that time. That isn't a fluke, either:

Year

HFR Global Hedge Fund Index Return

S&P 500 Total Return

2012 (YTD)

2.2%

12.5%

2011

(8.8%)

2.5%

2010

5.2%

14.9%

2009

13.4%

27.1%

2008

(23.3%)

(37%)

2007

4.2%

5.5%

2006

9.3%

15.7%

2005

2.7%

4.8%

Source: Hedge Fund Research; Robert Shiller; author's calculations. Dividends reinvested for S&P 500.

A thousand dollars invested in HFR's group of global hedge funds in 2005 would be worth $997 today, while the same amount invested in a simple S&P 500 index fund would be worth $1,346. This is comparable to a group of NBA teams playing a local high-school basketball team for seven years straight and scoring a third fewer points. It's impressively bad.

To be fair, the S&P 500 might not be the best benchmark for global hedge funds, which dabble in bonds, derivatives, real estate, and even fine art. But the rationale for measuring hedge funds against an alternative benchmark -- that is, they focus on "absolute" returns that perform in any market environment, rather than "relative" returns against the crowd -- fades when the industry has lost money in two of the last seven years. There is no way to rationalize hedge funds' recent returns. Professional investors, many with Ph.D.s and decades of experience, tend to underperform your grandmother's passive index fund. That's reality.

Of course, hedge funds can be measured as a group, but there are individual standouts. John Paulson and Kyle Bass bet against the housing bubble and made fortunes. David Tepper bet on bank stocks and made several billion dollars. Ray Dalio has emerged as one of the best investors of all time. These investors are true stars, but they are also true exceptions. In aggregate, professional hedge fund managers severely lag the market.

Why?

To start, the hedge fund industry has grown so large that it's nearly impossible to outperform as a group. With $2.3 trillion under management -- up 11-fold in the last 15 years -- hedge funds struggle to beat the market because they effectively are the market.

Then add in nosebleed fees. The typical hedge fund charges a 2% annual "management" fee off the top, plus 20% of profits. These fees may be justified for a handful of exceptional funds. But the exception has become the norm, and market-lagging funds now charge fees totally inconsistent with performance. Blogger Josh Brown was once asked what a hedge fund is. He replied, "A vehicle that turns investor capital into Greenwich real estate." One Fool commenter quipped that if pay were fair, most money managers would receive a bill at the end of the year, rather than a paycheck.

There is progress here as investors stomp their feet and demand that fees be reined in. But there's a long way to go -- and as long as an index fund charges total fees of 0.06% a year and trounces most hedge funds, there will continue to be.

A third limiting factor is a culture of "short-termism." Most hedge funds are measured quarterly, but stories abound of investors demanding monthly, weekly, and even daily trading reports. That creates all kinds of distortions. When you are measured by short-term performance, you manage for short-term performance, which means forgoing long-term opportunities.

The big takeaway, as Warren Buffett says, is that "Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ." Many hedge fund managers are truly brilliant. But the market doesn't care how many Ivy League degrees you have, how complex your model is, or how you did on the SATs. Successful investing is mostly about having control over your emotions. That's why the index fund, which knows no emotion, tends to win.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.


Read/Post Comments (7) | Recommend This Article (42)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 07, 2012, at 5:58 PM, ynotc wrote:

    This is a good article. If this is true, and I agree that generally it is, then why does the "smart money" continue to seek alpha with these people?

  • Report this Comment On November 07, 2012, at 6:02 PM, TMFMorgan wrote:

    ^ Stories of a dozen or so epic hedge fund managers is enough for investors to gamble on another 10,000 mediocre ones.

  • Report this Comment On November 08, 2012, at 4:28 AM, TimTomson wrote:

    Morgan,

    Thanks for a good writing.

    Agree with your most points.

    If one can predict S&P500 behavior,

    there is no need for hedge fund managers.

    Good article regarding

    S&P500 2013 forecast published on Seeking Alpha:

    http://seekingalpha.com/article/926141-2-s-p-500-forecasts-f...

    Good Trading!

  • Report this Comment On November 08, 2012, at 12:44 PM, eibe wrote:

    It is easy to understand that investing in hedge funds is a suckers game. 2+20 fee structure ...

    Lets say long term the stock market raises 7% per anum. How well does a hedge fund have to make for it to do well for its clients?

    Cautious Granny invested $100 in an index fund. Worth a little less than $107 after a year on average.

    Joe Sucker invested $100 in a brilliant hedge fund; it beat the market by a very good 3% for a total of 10%, not bad. But 20% of that goes to Mr. Hedgefundmanager making it 8% for Joe. And of those 2% gets taken away as management fee. Oops 106, less than granny got.

    In this simple example the Hedgefund has to beat the market by more than 3% just to break even for clients ... *urks, sorry I get indegestion just thinking about it*

  • Report this Comment On November 09, 2012, at 8:36 AM, deckdawg wrote:

    That does raise the question of why we think we can beat the indexes by investing in individual stocks recommended by TMF newsletters. I'm sure that, Bogle, for example, would tell us we can't.

  • Report this Comment On November 09, 2012, at 10:48 AM, fool3090 wrote:

    Makes me glad my Roth and Rollover is a basket of low-cost ETFs broadly diversified. The whole reason I became a Fool was after I recieved a bill from a "full-service" broker for the pleasure of netting a several thousand dollar loss on an expensive emerging markets mutual fund that was the sector's absolute bottom worst performer. This fund was value-oriented during the emerging markets growth explosion. But I wasn't paying attention because I was paying an expert management fee. This fund had been going south for many quarters, the manager of it was fired, yet my broker didn't give a heads up and most likely didn't even know until I pointed it out. At that moment, I realized my broker was not my friend, not my ally and certainly not interested other than a once-yearly check-in. His fees, in hindsight, were some of the best money spent -- because now I'm free of that B.S. No more 2 percent yearly no matter how much inattention was paid to my small account. Fool on!

  • Report this Comment On November 09, 2012, at 10:50 AM, ershler wrote:

    People beat the S&P 500 index all the time, think long term and don't let your emotions rule your trading habits.

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