The World's Smartest Investors Have Failed

The poor performance of hedge funds.

Jan 27, 2014 at 9:33AM

Investors started getting excited about hedge funds in the 1990s, when people like George Soros and Steve Cohen were earning returns of 30% or more, year after year, crushing the market. More funds opened, and their marketing pitch went something like this: We have the best investors in the world, and their returns are not correlated to the rest of the market. We will earn you so much money that we deserve the absurd fees we're going to charge you for it. 

This worked for some funds for some time, but it's become plainly clear in recent years that the biggest bull market was in inflated promises. As a group, hedge funds -- which now manage $2.5 trillion -- have consistently underperformed a basic S&P 500 index fund over the last five years. 

Now a new hedge fund marketing pitch has been born, one I've seen over and over again. It goes like this: Sure, hedge fund managers say, maybe we don't outperform the S&P 500. But that was never our goal. Our goal is to manage risk, offering limited upside while protecting investors' downside with lower volatility than the rest of the market.

But if a hedge fund's goal is to manage downside risk, it shouldn't be compared to the S&P 500 (SNPINDEX:^GSPC) at all. It should be compared to a benchmark that also tries to manage downside risk, like a simple index that invests 60% of its assets in stocks and 40% in bonds. 

Vanguard has a 60/40 index fund with a super-low expense ratio of 0.24%. Here's its returns over the last decade compared to the returns of the average long-short and multistrategy hedge fund: 

Hfreturns

Source: S&P Capital IQ, Boomerang Capital, Bloomberg, author's calculations. 

The 60/40 Vanguard fund, which anyone can invest in, opening an account in about four minutes and 26 mouse clicks (I counted), beat the average multistrategy and long-short hedge fund over the last decade. And it did it with lower annual volatility (measured by standard deviation).

Fund

Average Annual Return, 2002-2013

Standard Deviation

Vanguard 60/40

7.57%

11.2%

Long-Short Hedge Fund

7.33%

11.5%

Multistrategy Hedge Fund

7.01%

11.9%

So, put all this together. 

  • Hedge funds' selling point used to be superior returns. But that went away.
  • Now their selling point is protecting downside risk. But they don't do that any better than an 60/40 index fund, either.

The results are actually worse than I'm showing here, because the hedge fund returns in this chart are from an index comprising hundreds of funds, which no one can actually invest in. The actual experience of investors in individual hedge funds is more volatile than this chart shows, with some funds doing better and others much worse. 

By almost any metric, the average hedge fund investor would have been better off in Vanguard's 60/40 fund over the last decade.

Maybe the future will look different. You don't need to be too imaginative to picture a world where both stocks and bonds do poorly, which could end the 60/40 portfolio's outperformance over hedge funds. But that's hypothetical. Hedge funds' fees, and their underperformance, are very real, here and now.

Be careful when worshiping the "smart money." 

Contact Morgan Housel at mhousel@fool.com The Motley Fool has a disclosure policy.

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